I admit that treating investment banks more like the retail bit of banks would only reduce the availability of credit, which is probably not what we want right now, but it is certainly what we want in the future. It is patently obvious that the capital ratios these banks have been keeping available up until now has been wholly inadequate, and it is what permitted the Icelandic debacle.

There is of course the problem that this constitutes more regulation but there needs to be a few basic rules of the game, as there already are, so would there be a problem in mandating higher reserves to be held in all banks?

The fundamental weakness of the business model is the mismatch of the maturity between assets and liabilities. If banks with inadequate retail deposits were forced to do their wholesale borrowing on much, much longer terms (maybe even equal to the term of the mortgage book) then the problem would largely go away. Having to keep rolling over short term debt is nuts when your in a long term lending game. (OK it can be profitable – but it is horribly risky and as soon as confidence goes and you can’t borrow today to repay your debts of only days or weeks previously then you’re straight into Northern Rock territory). Ina world of matched maturities the profits would be lower but the bank would still earn the difference the terms it could borrow at vs the terms it could lend out mortgages at – a simple leveraging of its credit rating vs that of individuals. Systemic risk would be all but eliminated.

My understanding is that retail banks, operating under the fractional reserve system have to keep about 20% of their deposits in cash to cover deposit withdrawals, the rest being available for subsequent lending. Why is it that the investment banks, which are now pretty much blurred with retail banks, do not have to hold a similar amount of reserve?

If I have got it right – and I accept that I possibly have not – then this seems like a stupid imbalance in the system. After all, there is not really any difference between an investment bank and a retail bank. They take deposits and make loans and investments on those deposits. Retail banks usually make loans to companies for capital investment and investment banks usually invest in ‘other mysterious things’ whilst building societies make loans called mortgages.

And I also thought the reserve requirement was a critical mechanism to control the amount of money – and hence inflation – the banks could produce. It seems that the retail system has a decent break on this expansion but the other banks do not. Is it any wonder that money has been chasing assets, especially housing, with the inevitable result of a bubble?

Reply: Clearly a bank which has taken lots of retail deposits from the public should keep more cash in its tills in case they walk in from the street and want to withdraw their cash. Investment banks don’t usually have that problem.

But I think you are missing one key element from all this:

1) Let’s assume the assets side is a fixed amount, and that we don’t want total lending to households and businesses to shrink unduly. OK, the balance sheet value might have to come down by a couple or per cent for provisions against bad debts, but taking UK banks as a whole, even if house prices dropped by a third and million homes were repossessed, the total losses would only be 3% or so of total lending.

2) Then there’s the liabllities side. As you point out, for a given amount of equity/Tier One capital (call it what you will), an increase in the required Tier One ratio would reduce the total amount that the bank can lend out. But it appears that an increase in the Ratio is necessary (i.e. at current low levels, nobody will lend to UK banks, they won’t even lend to each other).

3) Further, banks are finding it difficult raising capital (and this whole taxpayer funded bailout worries me greatly!!).

4) So here’s the clever bit – all banks have to do is to cancel some of their long term debt and replace it with share capital (or replace bonds with Tier 2, or replace Tier 2 with Tier 1, that’s just details).

5) In the case of (A Bank – ed) even assuming a nightmare worst case write down of 10% of all mortgage advances, to reinstate a superbly healthy Tier 1 ratio of 13%, all it would require is for every £1 of debt (other than ordinary customer deposits) to be cancelled and replace with 61.5p of new debt and new shares worth 23p.

6) I did the worked example here.

7) Problem solved. The precise maths of course would have to be rejigged to ensure fairness between bondholders (whose bonds must have been trading at much less than par anyway) and shareholders (who will be diluted down, but on the other hand, they will subsequently own shares in a much healthier bank), but again, that’s just details. Anything must be better than being nationalised.

Reply: From the markets on its current government borrowing terms.