However, when copper prices began to fall, there was a wave of loan defaults leading to a run on the trusts that could not be stopped by the clearinghouse system. The resulting credit contraction sent the economy into recession, transmitting the problems to the banking sector. In the end, more than 240 banks failed even though the problem started outside of the banking sector. The basic mechanics of a bank run have remained the same over time. Due to the maturity mismatch involved in credit intermediation, banks in particular and financial institutions in general must rely on trust by their “depositors” that the institution’s assets will provide the ability to pay back the depositors. The fundamental connection between liquidity and trust was well described by Walter Bagehot in 1873: “Every banker knows that if he has to prove that he is worthy of credit, however good may be his arguments, in fact his credit is gone.” 2 There are two problems that depositors face. The first is that they typically know very little about a particular bank’s investments. This reflects both the lack of transparency in how banks are investing their funds, and a lack of incentive by individual borrowers to expend effort to try and learn this information – what economists call a public goods problem. The second problem is that a depositor does not know what other depositors think about the solvency of the bank.
Jaime Caruana: Reform of the international standard for bank capital Notes for the testimony by Mr Jaime Caruana, Governor of the Bank of Spain and Chairman of the Basel Committee on Banking Supervision, before the Committee on Economic and Monetary Affairs, European Parliament, Brussels, 18 January 2005. * 1. *  *  Introduction  I am honoured to appear before the Committee on Economic and Monetary Affairs today to discuss the reform of the international standard for bank capital. In past years, members of the European Parliament have kindly welcomed Bill McDonough, the prior Chairman of the Basel Committee, as well as other Basel Committee representatives. I would like to thank you for giving me this opportunity to contribute to the debate and to support your important work in considering the proposed directive on capital adequacy requirements for banks and investment firms. These hearings are extremely valuable and represent a vital stage in the European legislative process, where the European Parliament has a crucial role. I will be speaking today in my capacity as Chair of the Basel Committee. But I hope you will allow me to digress on one or two occasions to supplement my remarks with my perspectives as Governor of the Banco de España. The Banco de España is a central bank and banking supervisory authority within the European Union; it will therefore be a direct subject of the legislation that is enacted on capital adequacy.