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
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
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.
At thesame time, it highlights the most innova-tive and ambitious feature of the Basel sys-
At the dawn of the crisis, thebig banks in theUnited States andEurope were fully Basel-compliantand more thanadequately capitalized.