A system analysis of the basel capital accord´s regulatory control over the behaviour of modern banking systems

The banking system plays a critical role in the economy controlling both the supply of money and a significant percentage of total debt. Originating in medieval book keeping practices, it has developed into a distributed recursive feedback system, where money in the form of bank deposits is created by banks when loans are made, and removed as they are repaid. The total quantity of loan capital that can be created by the entire banking system, and by extension the total amount of money in the economy is locally controlled at each bank by several factors including the bank´s individual capital reserve, its required central bank reserves, and its liquidity with respect to the daily difference between its income, expenses and liquidity holdings. With the stability and successful operation of the pricing mechanism for the entire economy directly linked to the money supply, understanding the mechanical operation and behaviour over time of banking systems under different regulatory frameworks can be regarded as a critical problem for modern systems analysis. In this paper we present a computer simulation of a simplified banking system using the internationally agreed Basel Accords in use since the 1980´s. We show that the Basel Framework does not appear to provide the stability guarantees that might be expected for such a critical system, especially with respect to its regulation of the supply of money and credit over time, and the multiplier relationships embedded in the system. We show that loans to customers at other banks, interbank lending relationships, and failures in loan demand, continue to be a source of instability for the system. We also show that in the current regulatory framework, there appear to be no absolute constraints on the bank deposit creation/lending process and that the main factor controlling the expansion rates of the system appears to be the individual bank´s liquidity constraints, which originate from the difference between their profits an- expenses. Since banking profits are directly proportional to interest rates minus their loan defaults, this implies that the the relationship between interest rates and expansionary economic policies may be significantly more complex than currently presented by economic theory. It also suggests that interest rate raises may be required in order to stimulate lending in many of today´s economies.