Bank capital - From a trickle to a flood
In the old days bank regulation was simple. A bank could go bust for two reasons. On the asset side of the balance sheet, its loans could turn sour. On the funding side, its customers could all demand their deposits back at the same time, causing a run on the bank. So prudential regulations were designed to ensure that banks knew who they were lending to and kept enough capital to cope with their funding requirements.
The guidelines issued by the Bank for International Settlements in 1988, which are the world's benchmark regulations, set out how much capital a bank should have. The thinking is that if a bank has capital equivalent to 8% of its assets - and that if at least half of that is in the form of tier one capital - it should have enough of a cushion to protect itself against bad loans and flighty depositors.
In the 1990s, bank regulators, ever on the ball, began to notice that many banks do a lot more than simply take deposits and make loans. They also trade and underwrite securities, they enter into derivatives contracts and they trade commodities and currencies.