Banking on Basel: The Future of International Financial Regulation

by Daniel K. Tarullo

The turmoil in financial markets that resulted from the 2007 subprime mortgage crisis in the United States indicates the need to dramatically transform regulation and supervision of financial institutions. Would these institutions have been sounder if the 2004 Revised Framework on International Convergence of Capital Measurement and Capital Standards (Basel II accord)―negotiated between 1999 and 2004―had already been fully implemented? Basel II represents a dramatic change in capital regulation of large banks in the countries represented on the Basel Committee on Banking Its internal ratings–based approaches to capital regulation will allow large banks to use their own credit risk models to set minimum capital requirements. The Basel Committee itself implicitly acknowledged in spring 2008 that the revised framework would not have been adequate to contain the risks exposed by the subprime crisis and needed strengthening.

This crisis has highlighted two more basic questions about Basel One, is the method of capital regulation incorporated in the revised framework fundamentally misguided? Two, even if the basic Basel II approach has promise as a paradigm for domestic regulation, is the effort at extensive international harmonization of capital rules and supervisory practice useful and appropriate? This book provides the answers. It evaluates Basel II as a bank regulatory paradigm and as an international arrangement, considers some possible alternatives, and recommends significant changes in the arrangement.

256 pages, Paperback

First published September 30, 2008

Reviews

[Laura · Rating 3 out of 5]

Good chapter on history of US bank regulation with story of suspending leverage ratio during WW2 so banks would hold more Treasuries

[Frank Stein · Rating 4 out of 5]

This book finally clarified to me exactly what Basel was, and is, and why it remains so important for the international regulation of banks. The book also contains a useful review of the economics literature behind bank regulation more generally.

First, the book explains that in countries like the US, the shift from supervising the ratio of capital to deposits in banks (a relatively limited measure) to the ratio of capital to all assets (loans etc.) happened relatively late. Not until the late 1930s did the FDIC even begin monitoring this ratio, and the Comptroller of the Currency formerly denied the value of such regulation until 1971. Disagreements among the federal government's four major regulators hampered a move towards general capital-asset regulation until a Reagan request for a increased funding of the IMF (which was seen as a semi-bailout of the major banks) led Congress, as a way to appear tough against those they were subsidizing, to require them create such regulations in 1983.

Basel I was a series of negotiations taking place from 1987 to 1988 between national financial regulators with the goal of imposing similar capital standards on all developed countries, which would hopefully level the playing field between competing international banks. One of the main goals of the US and the UK, though, and, as the author points out, it was similar to their goals in many trade negotiations of the time, was to contain the Japanese. In just 7 years, the Japanese went from having only 1 of the top 10 banks in the world to 9 of them. High capital standards were supposed to dent their comparative advantage from government support, as well as improve bank regulation everywhere. After Japan negotiated some loopholes to benefit its banks, the accord passed. Capital standards were generally raised, and banks became relatively safer.

In 1997 Greenspan and some other federal reserve officials, however, became concerned that the raw capital standards (grouped into just a few "risk-weighted" groups like government bonds or industrial loans) had not kept up with new financial innovations, and they advocated a new round of negotiations. While the previous Basel accord had the goal of making banks safer, this one was created to reduce capital requirements, mainly for the largest banks. Yet without a clear vision of how or why this should be done, the negotiations for Basel II took until 2004.

Tarullo explains all the now so-obvious faults of this accord: the dangers of allowing reduced risk-weighting for mortgages, of allowing banks to estimate their own losses using "Internal Risk Based" models, and of focusing purely on capital as a substitute for, say, management standards. Since the book was written, in 2008, history have proven him abundantly correct, and now we're part-way through the next iteration, Basel III, which tries to raise capital standards dramatically. Often this book rambles and repeats basic statements, but for a good overview of international financial negotiations and regulations, this is a surprisingly clear and interesting read.