The Banking Crisis: Causes, Consequences and Remedies

The paradigm that financial markets are efficient has provided the intellectual backbone for the deregulation of the banking sector since the 1980s, allowing universal banks to be fully involved in financial markets, and investment banks to become involved in traditional banking. There is now overwhelming evidence that financial markets are not efficient. Bubbles and crashes are an endemic feature of financial markets in capitalist countries. Thus, as a result of deregulation, the balance sheets of universal banks became fully exposed to these bubbles and crashes, undermining the stability of the banking system. The Basel approach to stabilise the banking system has as an implicit assumption that financial markets are efficient, allowing us to model the risks universal banks take and to compute the required capital ratios that will minimise this risk. I argue that this approach is unworkable because the risks that matter for universal banks are tail risks, associated with bubbles and crashes. These cannot be quantified. As a result, there is only one way out, and that is to return to narrow banking, a model that emerged after the previous large-scale banking crisis of the 1930s but that was discarded during the 1980s and 1990s under the influence of the efficient market paradigm. 1. The basics of banking In order to analyse the causes of the banking crisis it is useful to start from the basics of banking. Banks are in the business of borrowing short and lending long. In doing so they provide an essential service to the rest of us, i.e. they create credit that allows the real economy to grow and expand. This credit creation service, however, is based on an inherent fragility of the banking system. If depositors are gripped by a collective movement of distrust and decide to withdraw their deposits at the same time, banks are unable to satisfy these withdrawals as their assets are illiquid. A liquidity crisis erupts. In normal times, when people have confidence in the banks, these crises do not occur. But confidence can quickly evaporate, for example, when one or more banks experience a solvency problem due to nonperforming loans. Bank runs are then possible. A liquidity crisis erupts that can also bring down sound banks. The latter become innocent bystanders that are hit in the same way as the insolvent banks by the collective movement of distrust. The problem does not end here. A devilish interaction between liquidity crisis and solvency crisis is set in motion. Sound banks that are hit by deposit withdrawals have to sell assets to confront these withdrawals. The ensuing fire sales lead to declines in asset prices, reducing the value of banks’ assets. This in turn erodes the equity base of the banks and leads to a solvency problem. The cycle can start again: the solvency problem of these banks ignites a new liquidity crisis and so on. The last great banking crisis occurred in the 1930s. Its effects were devastating for the real economy. Following that crisis the banking system was reformed fundamentally. These reforms were intended to make such a banking crisis impossible and had three essential ingredients. First, the central bank took on the responsibility of lender-of-lastresort. Second, deposit insurance mechanisms were instituted. These two reforms aimed at eliminating collective movements of panic. A third reform aimed at preventing commercial banks from taking on too