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Capital Inadequacies: The Dismal Failure of the Basel Regime of Bank Capital Regulation, Cato Policy Analysis No. 681

Capital Inadequacies: The Dismal Failure of the Basel Regime of Bank Capital Regulation, Cato Policy Analysis No. 681

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Published by Cato Institute
The Basel regime is an international system of capital adequacy regulation designed to strengthen banks' financial health and the safety and soundness of the financial system as a whole. It originated with the 1988 Basel Accord, now known as Basel I, and was then overhauled. Basel II had still not been implemented in the United States when the financial crisis struck, and in the wake of the banking system collapse, regulators rushed out Basel III.

In this paper, we provide a reassessment of the Basel regime and focus on its most ambitious feature: the principle of "risk-based regulation." The Basel system suffers from three fundamental weaknesses: first, financial risk modeling provides the flimsiest basis for any system of regulatory capital requirements. The second weakness consists of the incentives it creates for regulatory arbitrage. The third weakness is regulatory capture.

The Basel regime is powerless against the endemic incentives to excessive risk taking that permeate the modern financial system, particularly those associated with government-subsidized risk taking. The financial system can be fixed, but it requires radical reform, including the abolition of central banking and deposit insurance, the repudiation of "too big to fail," and reforms to extend the personal liability of key decisionmakers — in effect, reverting back to a system similar to that which existed a century ago.

The Basel system provides a textbook example of the dangers of regulatory empire building and regulatory capture, and the underlying problem it addresses — how to strengthen the banking system — can only be solved by restoring appropriate incentives for those involved.

The Basel regime is an international system of capital adequacy regulation designed to strengthen banks' financial health and the safety and soundness of the financial system as a whole. It originated with the 1988 Basel Accord, now known as Basel I, and was then overhauled. Basel II had still not been implemented in the United States when the financial crisis struck, and in the wake of the banking system collapse, regulators rushed out Basel III.

In this paper, we provide a reassessment of the Basel regime and focus on its most ambitious feature: the principle of "risk-based regulation." The Basel system suffers from three fundamental weaknesses: first, financial risk modeling provides the flimsiest basis for any system of regulatory capital requirements. The second weakness consists of the incentives it creates for regulatory arbitrage. The third weakness is regulatory capture.

The Basel regime is powerless against the endemic incentives to excessive risk taking that permeate the modern financial system, particularly those associated with government-subsidized risk taking. The financial system can be fixed, but it requires radical reform, including the abolition of central banking and deposit insurance, the repudiation of "too big to fail," and reforms to extend the personal liability of key decisionmakers — in effect, reverting back to a system similar to that which existed a century ago.

The Basel system provides a textbook example of the dangers of regulatory empire building and regulatory capture, and the underlying problem it addresses — how to strengthen the banking system — can only be solved by restoring appropriate incentives for those involved.

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Published by: Cato Institute on Jul 28, 2011
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Executive Summary 
The Basel regime is an international sys-tem of capital adequacy regulation designed tostrengthen banks’ financial health and the safe-ty and soundness of the financial system as a whole. It originated with the 1988 Basel Accord,now known as Basel I, and was then overhauled.Basel II had still not been implemented in theUnited States when the financial crisis struck,and in the wake of the banking system collapse,regulators rushed out Basel III.In this paper, we provide a reassessment of the Basel regime and focus on its most ambi-tious feature: the principle of “risk-based regu-lation.” The Basel system suffers from threefundamental weaknesses: first, financial riskmodeling provides the flimsiest basis for any system of regulatory capital requirements. Thesecond weakness consists of the incentives itcreates for regulatory arbitrage. The third weak-ness is regulatory capture.The Basel regime is powerless against theendemic incentives to excessive risk taking thatpermeate the modern financial system, particu-larly those associated with government-subsi-dized risk taking. The financial system
can
befixed, but it requires radical reform, includingthe abolition of central banking and depositinsurance, the repudiation of “too big to fail,”and reforms to extend the personal liability of key decisionmakers—in effect, reverting back toa system similar to that which existed a century ago.The Basel system provides a textbook exam-ple of the dangers of regulatory empire build-ing and regulatory capture, and the underlyingproblem it addresses—how to strengthen thebanking system—can only be solved by restoringappropriate incentives for those involved.
Capital Inadequacies
The Dismal Failure of the Basel Regime of   Bank Capital Regulation
by Kevin Dowd, Martin Hutchinson, Simon Ashby,and Jimi M. Hinchliffe
No. 681July 29, 2011
 Kevin Dowd is a visiting professor at the Cass Business School, City University, London, and an adjunct scholar at the Cato Institute. Martin Hutchinson is a journalist and a former investment banker who writes the weekly“Bear’s Lair” column at www.prudentbear.com. Simon Ashby is a senior lecturer at Plymouth Business School in the United Kingdom, and Jimi M. Hinchliffe is an investment banker based in London. Kevin Dowd and Martin Hutchinson are coauthors of 
 Alchemists of Loss: How Modern Finance and GovernmentIntervention Crashed the Financial System
.
 
Introduction
One of the most important and distinc-tive features of modern central banking isthe growth of bank capital adequacy regula-tion—the imposition by bank regulators of minimum capital standards on financial in-stitutions. The main stated purpose of theseregulations is to strengthen institutions’ fi-nancial health and, in so doing, strengthenthe safety and soundness of the financialsystem as a whole.Until the second half of the 20th century,capital regulation was fairly minimal andoften quite informal. In the 1980s, however,the major economies attempted to harmo-nize and expand the scope of bank capitalregulation under the auspices of the Bankfor International Settlements’ Basel Com-mittee. The defining event was the 1988 Ba-sel Accord, now known as Basel I. This “Baselregime” was a rapidly expanding work-in-progress as the regulators attempted to keepup with developments in banking, finance,and financial risk management. The mostsignificant overhaul was Basel II, publishedin 2004, which was the subject of protractednegotiations around the turn of the millen-nium. Member countries had either just ad-opted Basel II, as the European Union hadin 2007, or, in the case of the United States,were preparing to adopt it when the finan-cial crisis hit. At the dawn of the crisis, the big banksin the United States and Europe were fully Basel-compliant and, as far as Basel was con-cerned, more than adequately capitalized.The crisis then revealed the true weaknessof the banks in the starkest possible terms.Many of the biggest banks failed, and mostof the banks that have survived are likely toremain on government life support for yearsto come. The collapse of the banking systemis, of course, the clearest imaginable evi-dence that Basel has not worked as intend-ed: not to put too fine a point on it, but ev-ery ship in the fleet passed inspection—andthen most of them were lost at sea.The knee-jerk reaction of the regulatory community has been to patch up the systemas quickly as possible. A new, improved Baselsystem is already agreed in principle, with ne-gotiations underway regarding its implemen-tation. Its designers tell us that this new Baselregime takes on board the lessons of the crisisand the weaknesses of its predecessors, andassure us that it will deliver a safer and morestable financial system in the future.Let’s see if we understand this correctly.The regulators spent most of a fairly quietdecade producing Basel II—which, in essence,is just thousands of pages of regulatory gob-bledygook—designed to make sure that theinternational banking system is safe. Thebanking system then collapsed shortly after-ward. In the resulting panic, they rushed outthousands of pages of new draft rules, plusmany more pages of discussion and con-sultation documents. Indeed, the deluge of regulatory material was so great that by thespring of 2010 observers were jokingly refer-ring to it being tantamount to a Basel III.But by the fall, the joke—Basel III—had be-come a reality. But surely the
real 
jesters werethose telling us that the solution to all thatgobbledegook was now to have even more of it, crafted on the fly under crisis conditionsby the very same people who had gotten itwrong before. Now these same people ask usto believe that they have gotten it right
thistime
around, and never mind all those previ-ous failures.With a track record like this, it must be ob- vious that what is needed is not some rushedpatch-up of the Basel system, but a seriousreassessment from first principles. That iswhat this paper seeks to provide. In particu-lar, it aims to offer a (fairly) readable guide tothe policy economics of the Basel system: theunderlying issues and objectives of the mainplayers, the policy issues Basel presents, theeffectiveness of the system, and how it mightbe reformed. It seeks to outline the big pic-ture and, as far as possible, avoid the vast andoppressive minutiae that render this subjectalmost impenetrable to the outsider.
1
At thesame time, it highlights the most innova-tive and ambitious feature of the Basel sys-
2
At the dawn of the crisis, thebig banks in theUnited States andEurope were fully Basel-compliantand more thanadequately capitalized.
 
tem: the principle of “risk-based regulation,”which attempts to build a capital adequacy regime on firms’ own risk models using therapidly evolving practices of modern finan-cial risk modeling.We suggest that the Basel system suffersfrom three fundamental weaknesses. First,financial risk modeling provides the flimsi-est basis for any system of regulatory capitalrequirements. This is, in part, because of theintrinsic weaknesses of such models, in partbecause physical science models do not easily carry over to social and economic problems,and in part because of basic economics—thatis, neither the models nor the regulators’ useof those models allow for the bankers’ incen-tive to produce low-risk estimates to obtainlow regulatory capital charges. Taken to-gether, these factors suggest that risk-basedregulation is fundamentally unsound evenin principle, let alone in practice.The second weakness consists of the incen-tives that Basel creates for regulatory arbitrage,typically taking the form of securitizationsdesigned to produce lower regulatory capitalcharges. Indeed, it is no exaggeration to say that the Basel capital rules are the primary fac-tor driving the securitization bonanza of thelast two decades, the main consequence of which has been to greatly weaken the financialsystem by depleting it of much of its capital.The third weakness is regulatory capture.The key players in the modern banking sys-tem have little interest in maintaining highlevels of capital or even practicing serious riskmanagement. Both are drags on the short-term profit-making (via excessive risk tak-ing) that really drives the system. Again andagain, they have been able to overwhelm thefeeble attempts of the regulatory system tocontrol them, capturing the regulatory sys-tem and manipulating it for their own ends.We suggest that this weakness is simply in-tractable and that any worthwhile reform of financial regulation needs to start from thepremise that capture will be inevitable.These weaknesses suggest that Basel IIIhas much the same chance of success as itspredecessors—that is to say, none. Its rulesare reminiscent of King Canute ordering theincoming waves to stop rising. In the caseof the modern financial system, the wavesare the endemic incentives to excessive risktaking, particularly those associated withgovernment-subsidized risk taking such asdeposit insurance, the lender of last resort,and the now-established doctrine of “TooBig to Fail.” These waves are now so strongthat even another massive overhaul of Baselwould still leave the financial system opento being overwhelmed when the next waveof crisis occurs, which will probably happensooner rather than later.This said, the financial system
can
be fixed,but to do so would require much more radi-cal reform. This would include the abolitionof central banking and deposit insurance, therepudiation of “too big to fail,” and the estab-lishment of reforms to extend the personalliability of key decisionmakers—in effect, re- verting back to a system similar to that whichexisted a century ago. At the same time, therestoration of a sound monetary standard—orat the very least, the abandonment of mone-tary policy activism typified by successive Fed-eral Reserve chairmen Alan Greenspan andBen Bernanke—would put a stop to the cen-tral bank stoking the highly damaging boom-bust cycles of recent years. The combinationof extended liability, market forces, and soundmoney would then force the banks to becomesafe and stable again: their capital levels wouldrise and excess risk taking would be reined inbecause the risks would again be borne by therisk takers and not innocent parties—most ob- viously, the taxpayers. Within that context, thecapital adequacy “problem” would disappear;capital adequacy regulation would become re-dundant and could be safely scrapped.
A Tale of Two BankingSystems: AmericanBanking Then and Now 
The issue of bank capital adequacy is best understood in historical context.
3
Basel capitalrules are theprimary factordriving thesecuritizationbonanza of thelast two decades.

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