An article in the Telegraph (U.K.) this weekend discusses the need to reduce the capital reserve requirements of banks (see http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2007/12/15/cnbanking115.xml). The reserve requirements of a bank dictate or govern the amount of money banks can loan. It is a "buffer" or reserve of cash to guard against bad loans. For example, if the reserve requirement of a bank is 10% and the bank has a capital structure of $100 million, then the bank can loan up to $1 billion. If you reduce the reserve requirement to 5%, then the bank can loan up to $2 billion. With one change to a bank regulation, the bank could double its lending capacity.
Another regulation impacts the concentration of loans. In the past, a bank could not loan more than 10% of its capital structure to any one customer. In the above example, the maximum loan amount to one customer would be $10 million. These regulations promoted safety to protect the bank’s capital which is its capacity to "keep the doors open".
Capital reserve requirements were put in place to protect the bank against itself. The regulators found that a bank could weather economic cycle downturns if it did not overextend itself. These requirements regulate the leverage capability of the bank. If a bank suffered a loan loss, it was a direct reduction in the capital structure. In the above example, if the bank had to write off a $10 million loan thus reducing its capital structure to $90 million, the resulting lending capability would $900 million (at a 10% reserve). Reduced lending ability of banks causes a contraction in the economy. With less lending capacity in the banking system, businesses and individuals cannot borrow money to finance expansion. If the contraction is severe, existing notes of borrowers are "called". In the fine print of loan documents, the bank generally can change the due date to "today" or change the due date by some formula.
On the other side of the bank’s balance sheet, they can restrict the cash outflow. In their contract with you, the bank may restrict withdrawals or bank transfers. The also can delay withdrawals for a period of time. If a bank gets into trouble due to its lending or investing practices, the depositors can be adversely affected. The law (banking regulations) was designed to protect the banking system. The depositors only have easy access to their funds if everything is operating normally. However if the bank (or banks) made poor investing/lending decisions, the depositors are the last to know and will be limited to their deposit withdrawals.
The derivatives crisis is not over, I believe it is still in its early stages. The fallout will be global. "Reliquifying" the banking system will be hyperinflationary. Letting banks fail would cause a severe economic downturn. This is ugly. The central banks are attempting to inject huge amounts of cash into the banking system which ultimately is inflationary. The unregulated derivatives market produced investments that banks participated in. Those investments are moving from "investment grade" to "junk" status. A bad investment is no different than a bad loan when considering its impact on the capital structure of the bank.
Protect yourself! You’ve been warned.