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The Basel Capital Adequacy Accords and the governance of global finance

ProQuest Dissertations and Theses, 2011
Author: Daniel Louis Herman
What is the net contribution of the Basel Accords to the governance of global finance? The methodology used in this dissertation for assessing the costs and benefits of the Basel Process is the comparison of intended consequences and unintended consequences. Intended consequences are in the public interest and regarded as benefits. The unintended consequences are the side effects of those regulations which, it is assumed, no regulator would have deliberately selected or favored. They are the costs of the Basel Process. The major unintended consequence discussed in this dissertation is the accumulation of over-leveraged and undercapitalized financial risks outside the banking supervisory framework of the Basel Accords. The conclusion of this dissertation is that while the Accords have contributed to the stability of the international banking system, they have also given market participants the incentive to evade regulations and create financial risks in the "shadow banking system." The Basel Accords, in short, indirectly contributed to the Panic of 2008 and the Global Financial Crisis. Therefore, the costs of the Basel Process have outweighed its benefits.

Table of Contents


Chapter 1: Overview of the Dissertation This dissertation will attempt to answer the question: have the costs of the Basel Capital Adequacy Accords outweighed the benefits? 1 Regulating capital adequacy is a blunt instrument. Like the regulation of interest rates or exchange rates, regulating capital inherently benefits some banks and harms the competitiveness of other banks. The issues here are large versus small banks, investment banks, banks dealing with small enterprises, home mortgages, consumers versus corporations, and so on. 2 However “harmonizing” international capital regulations is not an obscure academic proposition: regulating the level of capital in the banking system is like regulating the level of economic activity in an individual economy and ultimately in the global economy. In the aftermath of the Global Financial Crisis (GFC), we now know that regulating the capital adequacy of banks alone is not sufficient to insure stability and competitiveness. The central focus is the interplay between the concepts of global financial stability and economic competitiveness, and the role of the Basel Accords in the harmonization of global capital adequacy standards in the banking industry. The Basel Accords were an essential building block for achieving global financial stability once the Bretton Woods system was abandoned and international capital flows became increasingly unregulated. 3 The Accords have contributed to the stability of the international banking system but, in the process, have given market participants the incentive to evade regulations and create financial risks in new markets.


Almost every aspect of the matters discussed in this dissertation is contentious. How should the riskiness of bank investments be measured? What is the distinction between “Tier 1” and “Tier 2” capital? How can a global regulatory standard be crafted which does not confer competitive advantages on certain types of banks? Does the profusion of loopholes dilute the effectiveness of the agreement? Should bank capital levels be adjusted during recessions and expansionary phases of the business cycle? The “Basel Process” is often used to refer to the role of the Bank for International Settlements in the governance of the global financial system and to the coordination efforts needed to achieve global financial stability shared between finance ministries, central banks, and regulators. 4 The term “Basel process” is used in this dissertation to refer to the policymaking process for the regulation of capital in the financial system (not only banks) and the stability of the global financial system. The Basel Accords themselves are a number of documents that are continually under revision. Parties articulate, negotiate, and reconcile their perceived interests and implement agreements, which are then reevaluated in a continually iterative process. The first agreements, Core Principles, established the principle of Home Country (rather than Host Country) control over international banking and a global set of “best practices”. The second set of documents, on which this dissertation concentrates, concerns the harmonization of national standards for maintaining adequate capital in the banking system. The timing of implementation is a large part of the challenge for global governance. Since there are no treaties to be debated and ratified, the Basel Process is based on the


implementation of global regulations once the national regulators have approved them. In fact, there were no grand negotiations to involve all or even most affected nations. There have been numerous exceptions made by which national regulators are given the “discretion” to apply the regulations or even to ignore them. 1.1. Hercules, Sisyphus and the Governance of Global Finance “Getting the Basel II agreement involved a torturous process of international negotiations amid massive lobbying by different groups of bankers.” 5

‘I hope that you can in fact bring the Basel process to a conclusion and I never have to think of it again for about six years,’ Rep. Barney Frank told the Fed chief…‘My basic concern is that I have to pay attention to it and it gives me a headache. It's Rubik's Cube -- every time you do one thing, six other people get upset.’ " 6

The goals set by the Basel Committee on Banking Supervision (BCBS) were the result of a Herculean effort to devise a comprehensive set of standards, to implement those standards without the use of international treaties or law, and to do so with any enforcement power of their own. One might think that the relationship between competitiveness and regulation is straightforward since it is clearly in the interest of countries to foster competitiveness while protecting the stability of the financial system. A proper system unshackles entrepreneurs from bureaucratic oversight and allows them to deliver their product to the broadest markets at the least cost.


Basel I has been applied in more than 120 countries and thus has progressively assumed the role of a global standard. Basel II is much more complex and problems posed by its implementation have been a major focus of attention for many years. .7 Basel I represented the first attempt to govern financial globalization and to regulate “the infrastructure of the infrastructure” of world order. 8 The Basel Process has had two main dimensions. The first (and earliest focus of the Basel Committee) was the promulgation of a set of “best practices” in banking, including assignment of responsibility to the home country rather than the host country. 9

The Basel Accord of 1988 was a significant milestone in the governance of the global financial system: defining regulatory capital, measuring risk-weighted assets, and setting minimum acceptable levels for regulatory capital. Basel I incorporated a risk-weighted approach and a two-tier capital structure. The latter means that there was base primary capital (stocks, retained earnings, general reserves, and some other items) and a second tier of limited primary capital including some types of subordinated debt. The second tier capital could not exceed half of total base capital in counting towards the capital adequacy ratio. 10

Basel I was as much a response to the fragility of the international banking system as a reaction of US banks to the dramatic growth of the Japanese presence in the international banking market. 11 Woods notes that while the regulatory authorities sought to contribute to international financial stability, the regulated banks sought to gain (or protect) their competitive advantages in the marketplace for financial services. 12 Although U.S. congressional hearings on Basel I began with a focus on the threat to financial stability,


the focus soon shifted almost entirely to their demand to confront the Japanese banks by “leveling the playing field”. 13

In the mid 1990’s, pressures grew from the largest international banks to revise the first Basel agreement. Basel II attempted to achieve seemingly irreconcilable goals: increase the risk-sensitivity of capital requirements without exacerbating the pro-cyclicality of lending; increase the safety and soundness of the banking system without changing the overall level of capital in the banking system; and provide capital reduction incentives for the adoption of more sophisticated techniques. Consensus remained that all of these goals should be pursued but only while maintaining a “level playing field”. 14

The Basel Accords were initiated through bilateral negotiations between the US and Britain in the early 1980’s. Those negotiations were expanded to the G10 nations and led to the first Basel Accord in 1988. The agreement created an international standard for banking regulation that has been voluntarily adopted by approximately 120 nations. The negotiation and implementation of those standards appears to be a Sisyphean effort. The Basel Committee has been working on the harmonization of global regulatory capital standards since the early 1980’s. The standards have been continually revised to cope with new challenges from financial instruments and financial risk management techniques. 15 Strulik summarizes the dynamic between the regulators and the regulated: “the banks have answered the regulatory demands for improvements in equity… with an increase in non-balance sheet business (in particular innovations in derivatives) which does not have an effect on the supervisor’s equity demands.” 16


This Sisyphean effort has institutionalized an “iterative” process in the governance of global finance. The Committee announces proposals; the financial industry is invited to evaluate those proposals; programs are undertaken to determine the impact of the new proposals (Quantitative Impact Statements); the proposals are revised again, critiqued, and retested. Meanwhile a number of countries may choose to implement some of those proposals while others still debate them. The resulting process is disjointed, inadequately implemented and, since the Basel Committee lacks enforcement, can be circumvented by the adoption of the use of supervisory “forbearance” based on the unique conditions of each banking system. 17

When economic growth is strong and sustained, the role of business in the governance of global finance generally goes unchallenged. It is only after a financial catastrophe that regulatory endeavors such as the Basel Accords come into open question. In the popular literature, the regulation of banking capital is equated with regulatory capture. 18 Quite likely, the Basel Process would have remained a topic of little general interest were it not for the recent Global Financial Crisis. However, most of the writers on the subject only mention the role of Basel in passing. 19

Post-crisis analysis has revealed that the adequacy of capital (and the “adequacy of liquidity” or access to readily available cash) were keys to global financial stability. Without adequate capital, the credit-creating function of the global financial system “froze up” resulting in tremendous global economic damage. The Basel Process provides ample illustrations of Robert Putnam’s observation that multilateral diplomacy is a multilevel bargaining process. 20 While negotiations occur at


the international level, negotiations are occurring within each participating state, between regulators and the industry, regulators and the legislature, within the financial industry, among domestic negotiators, between domestic and foreign negotiators, as well as among academic policy experts, think tanks, and the financial press. 21

To appreciate its true complexity, the Basel Process can be broken down into types of banks, financial regulators, lobbyists, and so on. The United States, for example, is characterized as having a “dual banking system” divided between the “money center” banks and the “community” banks. This sets American national regulators (the Federal Reserve, FDIC, Controller of The Currency, Office of Thrift Supervision and state bank supervisors) at odds with each other because of the financial constituencies they represent.


1.2. Disciplinary Perspectives: A Literature Matrix on the Basel Process The following chart shows the extensiveness of the literature on Basel Process and its relevance to this dissertation. AUDIE NCE / SUBJECT MATTER TOPICS OF INTEREST

RELEVANCE TO DISSERTATION Financial Regulators, Bank supervisors, central bankers, auditors, compliance officers Detailed banking business practices

Need to understand concepts and concerns (at a high level) Quant itative analysts: credit analysts, financial risk Algorithms, validation of models, results of quantitative impact Out of scope

Bankers and traders

Implications of regulations

A key piece in the puzzle

Lawyers: Banking Law

Interaction of Basel “soft l aw” with national and international law Conflicts in national regulations and statutes Market analysts

Competitive impact of regulations

Out of scope

Financial journalists

Current developments

Essential “raw data”

Financial historians

Historical devel opments

Essential “raw data”


Economic impact of Basel rules

Vital questions and answers

Political Scientists

International political economy and global politics of the Basel Process In scope


Certain aspects of the Accords lend themselves to quantitative analysis. Has the increase in regulatory capital led to a slowdown in economic growth in advanced industrial nations or in emerging markets? Has the increase in regulatory capital enhanced competitive advantage of one state over another or one type of bank over another? Has it benefited nations that rely on capital markets (rather than banks) for working capital? How effective will new regulations be if they do not deal with the underlying incentives to take reckless (but potentially lucrative) speculative positions? Continuing with the perspectives on the Basel Process, one can take the professional perspective of a bank regulator or examiner, a risk analyst, a financial industry analyst or lobbyist, a lawyer, or an information systems architect. 22 Credit analysts and risk modelers are concerned with techniques of credit and market risk analysis. 23 Market analysts look at the Basel Process and its impact of market shares (since the regulation of bank capital fundamentally affects the profitability and competitiveness of banks internationally). 24

Bank supervisors and compliance auditors are professionally interested in the technical definition of regulatory capital. The mathematically oriented will focus on the application of modern risk management techniques in designing the Basel Accords. 25 To the financially oriented, Basel involves statistical concepts such as probability of default (PD), loss given default (LGD) and exposure at default (EAD). To the business oriented, it involves studies of the market impact of changes in bank capital structures and costs of doing business. To computer scientists, it involves massive projects on a scale similar to Y2K to analyze and communicate complex capital calculations between the large banks and the regulators.


To those interested in banking law, it is involves the interaction of international “soft law” and national laws in multiple national regulatory environments and the interaction of those “laws” with laws enacted domestically and internationally, given that some countries intend to implement Basel II more broadly or sooner than others. 26

1.3. In and Out of Scope “Most Global Governance actors operate with little publicity and far off the radar except for those relatively few states and citizens most closely affected by their activities.” 27

This dissertation incorporates insights from all of the above perspectives. However, it is not intended for an audience of banking supervisors, central bankers, credit analysts, auditors, risk modelers, economists, or legal scholars. It is based primarily on the literature of International Political Economy and Global Governance. 28 The main concern of that literature is the interaction of political and economic forces shaping the regulations and standards that govern the global banking industry. The Basel Process is often criticized as favoring those with specialist knowledge and private interests rather than the wider public interests in financial stability and economic development. It is a “black box” subject in the sense that all of the actual negotiations of the Basel Committee are conducted behind closed doors without records of discussions, debates, and votes. A further obstacle to assessing the effect of Basel Capital Adequacy regulations is the fact that the information on bank supervisory effectiveness and enforcement is confidential information. 29 Reporting by financial journalists and the few examples of “insider reporting” in the scholarly literature will be utilized extensively in this dissertation. Since this author does not possess “inside information” about the Basel


Process, insiders and journalists have been relied on. There is very limited scholarly literature in political science on the Basel Process. 30

Daniel Tarullo has provided the most useful scholarly account of the Basel Process (specifically of Basel II). Appointed by President Barack Obama in January 2009 to a 14- year term on the Board of Governors of the Federal Reserve, Tarullo’s book on Basel II (Banking On Basel: The Future of International Financial Regulation) has been of great help in conducting this dissertation. 1.4. The Chapters Ahead Chapter 2 will present the research question: what is the net contribution of the Basel Process to the governance of global finance? The cost-benefit methodology will be discussed. The concepts of Regulatory Capture and Public Choice will be utilized to justify the classification of Intended Consequences as benefits and of Unintended Consequences as costs of the Basel Process. The major Unintended Consequence discussed is the incentive created by Basel I to solve “the Basel problem” by removing investments from the balance sheets of banks. This practice, known as “regulatory capital arbitrage,” is not to be confused with “regulatory arbitrage” (shopping for the most lenient regulator whenever possible). 31 The “net contribution” to the governance of global finance” is simply defined as the benefits minus the costs of the Basel Process. As discussed above in “Disciplinary Perspectives: A Literature Matrix on the Basel Process”, there are many ways to approach the study of the Basel Process. Chapter 3 will locate this study of the Basel Process in the literature of Global Governance. The chapter will describe the most useful concepts and paradigms--ways of looking at the subject--in


the literature. Controversies in the literature, as well as suggestions for controversies missing from the literature, will be described. They have been divided into the following categories:  Universal Controversies  Controversies resulting from structural differences between national financial systems  Controversies emerging from innovations in financial markets, products and risk management techniques  Controversies inherent in the international negotiating process  Controversies inherent in the national negotiating process  Controversies inherent in the implementation and enforcement phases of global agreements  Controversies inherent in applying “lessons learned”  Controversies over the best method for the assessment of major global governance projects These controversies will be explored in the future chapters. The next three chapters are organized around the “5W-H” format (who, what, when, where and how). Chapter 4 deals with the participants in the Basel Process representing close to 120 nations, their individual governmental and non-governmental units, and the transnational elements of banking supervisors, other financial regulators, and supranational entities including the Basel Committee, IMF, and World Bank. A goal of this dissertation is to show that the popular view of the Basel Process is an oversimplification. One cannot speak of “the banks” as if they were a monolithic force in the Basel Process even in the United States. From a traditional International Relations perspective, the Basel Process can be analyzed in terms of types of countries, such as the


wealthy members of the OECD, the middle ranking states, and the emerging market economies. This brings shifting balances in the distribution of global power into focus. However, within each of the more than 120 governments involved, the Basel Process may be analyzed in terms of the executive branch versus the legislative and judicial branches. Central banks within each state may be independent but they too may favor certain constituencies. Thus, the conflicts between central banks, finance ministries, and other financial regulators in each state must be taken into account (to the extent that such dynamics are public knowledge). Chapter 5 discusses the when, where and how questions under the heading of the “International Financial Diplomacy of The Basel Process.” Why have the discussions over the international harmonization of regulatory capital been in session for the past three decades? What have been the major milestones in those negotiations? Have any patterns emerged? How does the process of negotiating international soft law compare to the formal process of international treaty making? Although the Basel Accords are an example of international soft law, the process of formal international negotiations will be utilized to describe the iterative nature of Basel. A brief historical synopsis will be presented including the outline of the Basel Process in its latest iteration known as “Basel III”. In Chapter 6, some of the specific topics of negotiation will be discussed. The “structural differences” between countries participating in the negotiations (as well as the vast majority which are not party to the negotiations) will be highlighted. The subject is one of international political economy in that it affects competitive position within the financial


systems of individual countries and in the financial position between them. These issues will be organized around the three “pillars” of the Basel II Agreement: (Pillar 1) minimum capital requirements, (Pillar 2) the supervisory review of an institution's internal assessment process and capital adequacy; and (Pillar 3) the effective use of disclosure to strengthen market discipline as a complement to supervisory efforts. Chapters 7 and 8 will offer an answer to the research question posed in Chapter 2, namely, given the costs and benefits, what is the net contribution of the Basel Process to the governance of global finance? Since the subject of this dissertation (banking regulation, financial market instruments and practices) is not commonly studied in the global governance literature, a section has been added at the end entitled “Abbreviations, Terms and Concepts” which the reader should perhaps consult before reading further. Endnotes and Bibliography have been provided as well as numerous sources for online access to sources consulted. If any web addresses do not work correctly, the reader is advised to copy those web addresses from this document and open them in a separate browser window. All of the web addresses in this dissertation were validated as of publication date.


Chapter 2: What is the Net Contribution of the Basel Process to the Governance of Global Finance? 2.1. Cost-Benefit Methodology The research question of this dissertation is “what is the net contribution of the Basel Accords to the governance of global finance?” A simple listing of costs and benefits will not help answer the question as one could list 100 costs and only 10 benefits. This does not answer the research question because each benefit may be “10 times more important” than each of the 100 costs. Thus the challenge of this dissertation is ultimately whether a method of weighting costs and benefits can be devised such that the value of each type of cost and benefit can be directly assessed, aggregated, and yield a reasonable answer to the research question. In theory, it would be most efficient to assign a numerical value to the outputs of policy. Like the grading procedure in a classroom, we would add up the results and implicitly subtract points for what the student failed to accomplish. The net result would be a grade. This dissertation will not attempt to “grade” the Basel Accords numerically because that narrows the focus of what is being evaluated too drastically. 2.1.1. Regulatory Motivations and Outcomes What criteria can we use for weighing the costs and benefits of the Basel Process? The literature on regulation distinguishes the motivations from the outcomes of regulators. 32 It describes an ideal type of regulator, one who is dedicated to advancing the Public


Interest. This type of regulator, the “Burkean” type, is seen as so dedicated to advancing the Public Interest that he or she will make every effort to achieve those goals without any public discussion. 33 Having devoted almost fifty years to central banking and financial regulation, former Fed Chairman Paul Volcker can be regarded as the quintessential embodiment of this type of regulator. 34

While the controversy between Public Choice and Regulatory Capture is central to understanding the methodology for weighing costs and benefits of the Basel Process, a fuller discussion will be deferred until the second half of the following chapter in the section entitled “Public Choice versus Regulatory Capture Theory.” Doubtless, it is offensive to professionals involved in the design or implementation of the Basel Process to discuss whether their work has been tainted by the influence of Regulatory Capture. This is even more so because the work on the Basel Accords failed to provide the global financial stability originally intended. Regulators might respond that that Basel I and II were not intended to provide global financial stability, were only applied to banks (not shadow banks) and had not been fully implemented when the GFC began. Participants in the Basel Process may prefer to avoid the limelight in defending the effectiveness of Basel II. The set of policy goals pursued by the Burkean regulator is being equated with the Intended Consequences because they are, by definition, in the Public Interest. However, while regulators attempt to advance the Public Interest, there is normally a countervailing process at work to advance Private Interests.


The approach to identifying the costs and benefits of the Basel Process is to attribute “Burkean motivations” to regulators and assume that they have the Public Interest at heart; have the specialized knowledge required to understand the subject matter; and have devoted their professional careers to advancing the policy (in contradiction to the “revolving door” school of thought). The Intended Consequences of this ideal type of Burkean regulator, by definition, advance the Public Interest, unless they become victims of their own conflicts of interest or other forms of criminal behavior. Basel II is implicated as a cause of the Global Financial Crisis in the recent scholarly literature because of its “unintended consequences”. The Unintended Consequences are the side effects of those regulations, which result in financial risks being accumulated outside the banking supervisory framework of the Basel Accords. In terms of the Basel Process, once a new proposal is issued through a “consultative paper,” an iterative process starts whereby the industry assesses those standards and the bargaining process begins. Once the industry evaluates and reacts, the chances that the regulators will achieve their intended goals are diminished by the pursuit of the economic goals of the regulated industry, which is by no means monolithic. Referring to the chart in Section, the tension between stability and competitiveness pulls the regulators from the Public / Public quadrant to the Public Officials / Private Goals quadrant (that is, from Quadrant 1 to 2). The positive Intended Consequences then become contaminated with the negative Unintended Consequences.


2.2. The Intellectual Puzzle: Stability versus Competitiveness “…To grasp the scale of total assets in the global banking system, total bank assets are as great as the combined total of the stock-market capitalization of all the world’s exchanges added to total public-debt securities. This is more than twice the size of total global pension-fund assets, and more than 40% larger than world GDP. It follows that 8–10% of this total is a very big number indeed, which is what the Basel II capital-adequacy ratios demand banks retain as, basically, unusable capital in their capital reserves. 35

A Rutgers instructor of mine suggested that an effective dissertation should have two concepts in mind that are encountered throughout the entire dissertation. 36 These two concepts should be defined and then investigated as to whether A causes B or B causes A or what the relationship is between them (if any). The two concepts identified in this dissertation are global financial stability and economic competitiveness. Referring to the chart below, Curve A (“managers’ preferences”) represents the goal of “economic competitiveness” as pursued by the financial industry. Curve B (“regulators’ preferences”) represents the goal of “global financial stability” as pursued by banking supervisors, central banks, and other financial regulators. As the Risk-Return frontier increases (greater risks requiring greater rewards), the preferences of “managers” and “regulators” follow different trajectories. This is the heart of the regulatory dilemma.


“Varying the degree of leverage creates a tradeoff for shareholders between risk of insolvency and rate of return. Bank regulators, who are concerned about the spillover effects that bank failures have on the rest of the economy, tend to prefer less risk, less leverage, and more capital than do bank managers. To limit risk to the financial system, regulators set minimum standards for bank capital.” 37

Full document contains 257 pages
Abstract: What is the net contribution of the Basel Accords to the governance of global finance? The methodology used in this dissertation for assessing the costs and benefits of the Basel Process is the comparison of intended consequences and unintended consequences. Intended consequences are in the public interest and regarded as benefits. The unintended consequences are the side effects of those regulations which, it is assumed, no regulator would have deliberately selected or favored. They are the costs of the Basel Process. The major unintended consequence discussed in this dissertation is the accumulation of over-leveraged and undercapitalized financial risks outside the banking supervisory framework of the Basel Accords. The conclusion of this dissertation is that while the Accords have contributed to the stability of the international banking system, they have also given market participants the incentive to evade regulations and create financial risks in the "shadow banking system." The Basel Accords, in short, indirectly contributed to the Panic of 2008 and the Global Financial Crisis. Therefore, the costs of the Basel Process have outweighed its benefits.