BASEL II: A NEW REGULATORY FRAMEWORK FOR GLOBAL

BANKING
Robert Guttmann (Hofstra University; Université Paris-Nord)

Introduction

In June 2004 the Basel Committee on Banking Supervision (BCBS), affiliated

with the Bank for International Settlements (BIS) and comprising central bankers
from the leading economies, proposed a framework for converging capital standards
of banks across the globe.(1) This so-called Basel II initiative obliges banks to calculate
minimum capital standards by assessing on a regular basis prevailing credit, market,
and operational risks. Those risk assessments will have to be shared with banking
supervisors in both home and host countries. And the banks will at the same time
also have to abide by rather stringent reporting requirements pertaining to their risk
calculations and capital provisions so that investors can get a good sense of what
banks have done to meet the requirements of the new regulation.

Even though its full implementation is still several years away, it is fair to say
that Basel II will in all likelihood emerge as the dominant new financial regulation of
the next decade and a major milestone in the evolution of banking. For one, we are
talking here about a regulatory initiative of unprecedented global scope which in the
end will probably have been adopted by one-hundred or so countries – among them
all the industrialized countries (ICs) as well as the principal emerging-market
economies (EMEs). It will induce banks to manage their risk-return trade-offs in
much more organized fashion and make that management central to their operation.
It will also transform the interaction between banks, their shareholders, and their
supervisors into a much more densely structured and transparent set of
relationships, which is supposed to enhance financial stability and improve the
efficiency of capital allocation. Its enactment is so complex that full implementation
of Basel II will take years, only to be superseded by further adjustments and
revisions stretching over decades.

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 Such an ambitious and far-reaching initiative deserves a great deal of attention
on the part of bankers and government officials alike. And, indeed, conferences and
reports about Basel II have sprouted in both camps over the last couple of years in all
corners of the world. Carrying the potential of altering the modus operandi of
finance and its regulation, Basel II will also enter the radar screen of economists in
the near future. Addressing a gathering of heterodox economists working on money
and finance is a good occasion for my own learning process in that direction.

1. From Basel I (1988) to Basel II (2004)

Having witnessed the widespread undercapitalization of internationally

active banks and their credit overextension tendency in the unregulated
Eurocurrency market during the serious LDC Debt Crisis of 1982-87, the world’s
leading central bankers became convinced of the need for new, globally harmonized
regulations to address these dangers of transnational banking. The obvious vehicle
for such an effort was the Bank for International Settlements (BIS) comprising the
central bankers of the leading thirteen (“Group of Ten” or G-10) industrial nations.(2)
In 1975, after the first major crisis of the unregulated Eurocurrency market, the BIS
had set up the so-called Basel Committee on Banking Supervision (BCBS) to
coordinate regulatory and supervisory practices. The extension of its powers to
construct an internationally harmonized architecture of banking regulations occurred
in 1988 when the so-called Basel Accord charged the BCBS to impose a uniform, risk-
weighted minimum capital-asset ratio of 8% on internationally active banks across
their entire family of subsidiaries (Basel Committee on Banking Supervision, 1988).
The idea of giving different asset categories more or less weight depending on their
degree of credit risk was meant to encourage banks either to load up on low-risk
assets or put up more capital when investing in riskier, but higher-yielding assets. In
other words, the banks were forced to internalize and make explicit their calculation
of risk-return trade-offs while having to maintain a minimum level of capital.(3)

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 While the Basel Accord was put into effect rather smoothly in about 100
countries over a four-year period, its implementation had negative side effects in
several major economies. Most importantly, it took effect during a period of
economic slowdown in the United States and, above all, Japan where dramatic
declines in share prices made it difficult for banks to raise capital. Undercapitalized
banks, of which there were quite a few in both countries at the time, thus opted for
slowing down asset growth or, in more serious cases, even cut back lending to
comply with the new capital requirement. This constraint contributed considerably
to the rather serious credit crunches unfolding in Japan after 1989 and in the United
States during 1990/91.(4) Similar developments may also have contributed to credit
crunches elsewhere in the early 1990s, notably Sweden. After full implementation in
1992 the new regulation seems to have had only marginal macroeconomic effects.
And if at all measurable, those were probably on the positive side as tangibly higher
capital-asset ratios (rising from a G-10 average of 9.3% in 1988 to 11.2% in 1996)
strengthened the banking sector.

Still, the 1988 Basel Accord showed its limitations early on. Applying
exclusively to commercial banks, the new rule considered only loans as risk-carrying
assets worthy of regulation. Hence it focused solely on credit risk (i.e. the risk of
losses arising from loan defaults) to the exclusion of all other risks found in financial
transactions. And its consideration of credit risk, calculated as the sum of risk-
weighted asset values, was rather crude. Three broad asset classes were specified
according to their respective risk weights: 0% weight for G-10 government debt, 20%
for G-10 bank debt, and 100% for all other debt, including corporate debt and non-G-
10 government debt. Additional rules applied to mortgages, local-government debt
in the G-10 countries, and contingent obligations such as derivatives or letters of
credit.

Looking at the 1988 Accord’s “one-size-fits-all” capital charge for corporate

loans, the banks soon began to practice a sort of regulatory arbitrage, which
undermined the new rule’s original intent of prompting more accurate consideration

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of risk-return trade-offs (Greenspan, 1998). On the one hand, all corporate loans
carried the same regulatory risk charge of 8% (i.e. a 100% weight) irrespective of their
actual riskiness. On the other hand, banks would estimate the respective default
probabilities of their loans. Based on these internal economic-risk assessments banks
would typically set aside between 1% and 30% in capital to cover the estimated loss
distribution of individual loans. The banks then realized that it made very little sense
for them to hold on to the relatively safe loans whose internal capital allocations
reflecting economic risk were below the regulatory capital charge of 8%. Those loans
could be gotten rid of before maturity by means of securitization. This key financial
innovation of the 1990s enabled banks to repackage pools of standardized loans into
asset-backed securities, which could then be resold to investors. At the same time it
made equally good sense for banks to keep holding onto riskier loans with a
relatively elevated internal capital charge, since the 8% regulatory capital charge
having to be set aside was lower than the internal risk charge justified by the loan’s
actual risk profile. Banks thus responded to Basel I by looking for greater risk and
then learned how to live with this bias by seeking risk protection through another
important financial innovation, the use of credit derivatives, which enabled them to
transfer economic risk to others. Both loan securitizations and credit derivatives
exploded in volume during the second half of the 1990s, indicating extensive use of
regulatory arbitrage between uniformly set regulatory risk charges and highly
variable internal (economic) risk charges by banks seeking to profit from the
difference between the two.(5)

Not only did Basel I end up inducing progressively worsening capital

allocation, but it also sent misleading signals about the soundness of banks. The
regulatory capital change hid the economic-risk profile of banks based on actual
default and insolvency probabilities. Banks carrying, say, a capital base of 12% may
have looked good compared to the 8% minimum target for bank capital, but would
in reality be severely undercapitalized if their proper internal economic capital
allocation against their loan portfolio would require a 15% capital charge, for

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instance. The imposition of a one-size-fits-all regulatory capital standard obscured
proper allocation of economic capital.

Amidst growing signs that Basel I provoked some unintended and

counterproductive consequences, the BIS began in 1998 to contemplate how to
improve the capital-adequacy standard. After a series of proposals, impact
assessment studies, consultations, and revisions stretching over several years, its
Basel Committee finally proposed in 2004 a new capital accord. Officially entitled the
“Revised International Capital Framework” but generally referred to as Basel II
(Basel Committee on Banking Supervision, 2004), this reform is a far-reaching
regulatory initiative bound to have a transformational impact on the conduct of
banks. It will let eligible banks set their own capital requirement as a function of their
specific asset profile in order to match regulatory capital much more closely with
economic capital. In essence, the banks will be able to calculate the sum total of their
minimally required capital base through regular and extensive risk assessments of
their investments and business practices. Basel II rests on three pillars – minimum
capital requirements, supervisory review, and market discipline. Its implementation
is set to start this year, but the committee is giving non-G10 governments flexibility
in choosing whatever timetable fits them best.

Basel II proposes a radically different approach to risk assessment than its

predecessor’s crude “one-size-fits-all” weighting of credit risk. This change reflects
impressively rapid progress in the risk-modeling and –estimation capacity of banks
during the last decade, coupled with a greater managerial will to use that capacity in
the face of appreciably greater loss possibilities in today’s deregulated, fast-moving,
super-complex, and highly leveraged business of banking. The idea here is to prompt
banks to strive for continuously improved risk management while at the same time
making sure that they would at least undertake a minimum in terms of taking
account of their portfolio’s degree of riskiness. That objective involved giving banks
a choice in risk assessment methods, depending in part on the sophistication of their
respective activities and internal controls. Banks opting for the most advanced risk

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measurement techniques would gain the benefit of being allowed lower minimum
capital requirements, providing so a direct incentive to push progress in this area.

2. The Calculation of Credit Risk (Pillar One)

With regard to credit risk, which relates to losses from the possibility of
borrowers defaulting on their loans, Basel II wants banks to match their regulatory
risk calculations more closely to economic risk and so stop the incentive for
regulatory arbitrage practiced widely with regard to Basel I’s crude risk weights. The
new approach offered banks a choice of several risk-management approaches
pertaining to credit risk, all designed to allow for a much greater degree of
differentiation of likely default probabilities.

Smaller and medium-sized banks with less complex forms of lending and
simpler internal controls have the option of using a “standardized” approach. Much
like Basel I, this approach does not require banks to provide their own risk inputs.
Instead it uses external measures, including for the first time ratings of rating
agencies and export credit agencies, to assess credit quality of borrowers for
regulatory capital purposes. In contrast to Basel I it ties risk weights no longer to the
legal status of borrowers, but instead to their estimated default probability for a more
accurate assessment of actual credit risks. This revision contains almost twice the
number of risk weights for loans than used to be the case. Charges for various loan
categories have been lowered, such as retail lending (6% compared to 8% previously)
and residential mortgages (2.8% instead of 4%), with the aim of inducing banks to
commit more loans in these newly privileged areas of bank credit. The new standard
also recognizes a much broader range of risk-reducing features of loan contracts,
such as collateral or guarantees, which are rewarded with a correspondingly lower
capital charge on thus-secured loans.

Banks with more sophisticated profiles of risk exposure and better risk-
management capacity have two additional options, based to varying degrees on their

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own in-house assessments of credit risk and thus referred to as internal ratings-based
(IRB) approaches.(6) The first, called a “foundation approach,” uses several risk-
measure inputs which have already become widely practiced when rating credit risk
in retail, corporate, sovereign, and intra-bank lending (see note 6). The banks only
have to provide the default-probability input here. The other approach, reserved
mostly for the biggest and most sophisticated banks, is the so-called “advanced
approach” (A-IRB) which allows those institutions to use their own estimates of all
relevant risk inputs – probability of default (PD), the expected amount of loss in case
of default (LGD), the amount the borrower owes at the time of default (EAD), and
length of risk exposure (M). The BIS clearly wants to encourage progress in risk-
measurement technology and give banks incentives to adopt the latest state-of-the art
techniques as soon as possible.

This new system of credit-risk computation raises a few practical questions.

One concerns the consistency of risk weights for the standardized method. For
instance, after the defaults of Russia (1998) and Argentina (2001) on their respective
international bonds, it is not so clear why claims on sovereigns rated BBB+ to BBB-
should be weighted only 50% while debt to banks or to corporations with those same
ratings are both weighted 100%. Should those claims not all carry the same weight if
they have the same (or largely similar) risk characteristics? Moreover, low-rated
banks will now have rather high weights (150%) despite their lender-of-last-resort
protection, which will make it more difficult for them to obtain reasonable financing
in the inter-bank market or through bond issues. They will hence be rendered even
more fragile, making their possible failure and bail-out more likely.
the difference in weights between a borrower who is not rated (100%) and one who is
rated poorly (150%) seems in contradiction to Basel II’s purported goal of
encouraging the practice of ratings.

With regard to the IRB approaches, especially the advanced approach, we

should note that these are still in their infancy. Banks do not yet have a long track
record collecting and processing data for their credit risk models, which

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unfortunately tend to require a lot of information. In the same vein it is not clear how
accurate their forecasts of future loan defaults tend to be. Until now these in-house
calculations of credit risk by banks have often been used for purposes other than
credit risk weighting, notably to determine loan conditions, such as risk premium or
collateral, or to assess troubled loans. The Basel Committee has also noted the need
to standardize the methodologies used by different banks in their risk calculations so
as to ensure comparability between them, but it is not easy to assure a modicum of
homogeneity among the many individualized approaches chosen.

Under Basel II there will be a much greater reliance on rating agencies, such as
Moody’s, Standard & Poor’s, or Fitch Ratings. While such agencies and their
procedures are well established in the United States, they are less so in Europe and
frequently non-existent in EMEs. Many countries will therefore have to undergo a
catching-up process and create their own rating agencies, preferably more than one
to maintain a modicum of competition. It will in this regard be important to promote
also alternative entities for rating, specifically central banks and export credit
insurers. Even then, there is a real question as to how effective the rating agencies are
in making accurate assessments of relative degrees of creditworthiness and default
probabilities. Let us just remember that in the weeks preceding the collapse of Enron
in the fall of 2001 neither Moody’s nor Standard & Poor’s budged from their top
ratings for the firm or gave any indication of trouble brewing. Both repeated this
dismal performance when giving subprime-based mortgage-backed securities top
ratings right up to the point where most of those instruments were about to go up in
smoke (during the summer of 2007). It may be time to impose tougher performance
standards and conflict-of-interest guidelines for rating agencies to assure objective
and accurate risk assessment.

In the transition from Basel I to Basel II banks are likely to make significant
adjustments in their loan portfolios, responding to differentials in risk weights
between the old system and the one replacing it. Bankers are likely to expand loan
categories carrying relatively lower capital charges than before, while cutting back

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on those loan categories with now-bigger risk weights. (7) Once that adjustment
period has run its course, there will still be a significant macro-economic impact on
national economies from banks’ new lending priorities, with some sectors and/or
loan categories better off than before due to increased access to external funds while
other segments of debtors find themselves with less or more expensive access to
bank loans.

3. The Inclusion of Market Risk (Pillar One)

With regulators becoming more focused on advancing the risk management

practices of banks, they also used the opportunity of revising the original capital-
adequacy accord and consider other types of banking risk as needing capital backing.
One such risk category has been market risk, a form of price risk from adverse
fluctuations in the market value of a securities portfolio, which may potentially arise
in the wake of various negative scenarios weighing on financial markets. Inclusion of
that risk category was prompted not least by structural changes causing banks to
carry much larger amounts of securities on their balance sheets. Key here is the
worldwide convergence towards a financial structure centered on multi-functional
universal banks combining traditional commercial banking (i.e. taking deposits,
making loans) with market-making investment banking (i.e. acting as brokers,
dealers, and underwriters of securities). That convergence, which has undone
decades of separation between those two different types of banking in such crucial
economies as the United States, Japan, and Britain, has been fuelled as much by
financial innovation, most importantly securitization and derivatives, as by
regulatory changes.

Three crucial changes in the regulation of financial structures were especially

instrumental here. The first was the European Union’s Second Banking Coordination
Directive of 1989 whose “single market passport” allowed EU-based financial
institutions to operate throughout the union subject to the regulations of their home
country. This was followed by the global WTO Agreement on Financial Services in

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1997 which committed the vast majority of countries to “national treatment” of
foreign financial institutions. Finally, a decade-long debate in the U.S. Congress led
to passage of the Gramm-Bliley-Leach (Financial Services Modernization) Act in 1999
which allowed U.S. institutions finally to combine commercial-banking and
investment-banking functions.

With banks thus increasingly vested in the securities markets, they have gone
beyond market-making investment banking and engaged in either setting up or
managing institutional investors with large holdings of securities, notably mutual
funds, pension funds, and insurance companies. Today’s universal bank thus has
several venues to accumulate large holdings of securities among its income-earning
assets. Hence it faces not only credit risk (i.e. loan defaults), but also market risk
which reflects the possibility of losses arising from declines in the prices of securities
(e.g. stocks, bonds, derivatives) held in its portfolio.

The BIS tried to address the challenge of this structural change soon, but had
initially a hard time doing so. An early attempt in 1991 to negotiate, in conjunction
with the International Organization of Securities Commissions (IOSCO) representing
securities regulators, a globally harmonized market risk capital requirement for
universal banks and non-bank securities firms faltered because of U.S. resistance to
replacing its own long-standing Uniform Net Capital Rule (UNCR) in favor of
weaker rules favored by the EU. Progress accelerated in 1993 when the EU
introduced its Capital Adequacy Directive (CAD) to harmonize regulations
pertaining to bank capital across different national financial structures within the
newly created single market for financial services. That directive introduced the
notion of regulating functions instead of institutions in order to apply uniform
capital requirements to the securities operations of universal banks and to non-bank
securities firms alike. (8) Any EU-based universal bank would have to identify that
portion of its balance sheet comprising its securities operations as a “trading book”
(including holdings of equity shares, bonds, over-the-counter derivatives, repurchase
agreements, and certain types of loan-securitization instruments) and apply to it the

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CAD’s capital requirement while setting aside capital for its commercial-banking
operations in accordance with Basel I. The BCBS responded to the EU’s inclusion of
market risk by coming up with its own measure for this risk type just a few months
later, in April 1993, when it proposed capital requirements for open (on- and off-
balance-sheet) positions in bonds, equities, or foreign exchange to protect against
losses from adverse market-price movements, including interest rates, exchange
rates, and equity values (Basel Committee on Banking Supervision, 1993).

The proposed amendment met widespread criticism. The opposition was not,
as one would have thought, that the new regulation was going too far. On the
contrary, the general tenor of the comments submitted by financial institutions
expressed concern that the new BCBS proposal was not going far enough. Bankers
wanted better risk-management tools than the one the BCBS was suggesting to use.
Let us not forget that we were then, in the early 1990s, just witnessing the birth of
financial-risk management. Ever since the stock-market crash of October 1987 the
financial community across the globe had become aware of the presence of
considerable market risk. This sentiment was only reinforced in the early 1990s when
derivatives trades had created huge losses in a short span of time (Solomon Brothers,
Orange County in 1992; later Metallgesellschaft, Sumitomo Bank, Baring Bank). An
influential report of specialists (Group of Thirty, 1993) had shed light on the
inherently risky nature of derivatives and called for a systematic effort to manage
these risks in more organized fashion. In response several new risk-management
tools, notably Value-at-Risk (VaR), gained widespread and rapid acceptance. Based
on a probability distribution of a given portfolio’s market value at the end of one
trading period, this risk measure seeks to identify the worst-case scenario in terms of
likely maximum loss within a certain probability, say 90% or 99%. In its 1993
proposal the BCBS suggested a rather crude measure, a 10-day 95% VaR metric,
which recognized hedging effects only partially while ignoring both diversification
effects as well as portfolio non-linearities. Many commentators found this regulatory
standard for measuring VaR a bare minimum. Leading banks had at that point
already developed their own proprietary VaR measures which were more advanced

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and accurate, especially in terms of modeling diversification effects and even taking
account of non-linear exposures.(9)

Conscious of the rapid progress being made in this new field and not wanting
to stifle innovation in risk management techniques, the Basel Committee responded
to this criticism by going back to the drawing board. In April 1995 it came up with a
new and much improved proposal which it has also incorporated into Pillar One of
its Basel II Agreement. For one, the regulatory VaR measure, now called the
“standardized” measure and in essence still supporting a 10-day 95% VaR metric,
was modified to take account of diversification effects within (but not between)
broadly defined asset categories and prescribed additional capital charges for non-
linear exposures. Most importantly, the 1995 revision allowed banks to use their own
proprietary VaR measure for computing capital requirements provided this
alternative had been approved by regulators beforehand. Such approval would be
forthcoming if the bank could prove that it had an independent risk management
function, followed acceptable risk management practices, and used a sound measure
capable of supporting a 10-day 99% VaR metric and recognizing non-linear exposure
of options. The revision by the BCBS was approved in 1996 and put into effect by
1998.(10)

This last provision marked a crucial departure from standard regulatory

practice inasmuch as it gave banks the freedom to develop and use their own risk-
measurement techniques. Seeking to take advantage of rapid progress in this area of
banking, the regulators want to encourage further innovations and their rapid
diffusion by providing incentives for adoption of improved risk-management
methods in the form of lower capital requirements. In this way Basel II foresees the
world’s leading universal banks (e.g. HSBC, BNP Paribas, Deutsche Bank, Citibank)
using increasingly precise VaR measures, supplemented by marked-to-market
pricing, as well as stress testing of unlikely crisis scenarios which, if materializing,
would have potentially devastating consequences for the asset base of those banks.
Such progress needs to be encouraged, especially when considering the inherently

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uncertain nature of the future and the impossibility of predicting it with any degree
of accuracy. Measurable risk evaluations can at best only be proxies of intangible
uncertainty, imperfect approximations of what we are likely to experience. The better
these risk measurement models, they more relevant they are as guidelines for the
intangibly uncertain future.

Today’s VaR measures, while far better than just a short while ago, still are of
only limited usefulness. Even if the methodology of VaR and stress-test techniques
improves, the risk controllers at banks will still face serious problems of applicability.
Apart from varying greatly in their quality of measurement and finding it difficult to
consolidate data collected from different recording and processing systems, these
officers often lack reliable and complete data. They also have a hard time estimating
parameters, calibrating measurements, coming up with relevant stress scenarios, and
conducting meaningful back testing. Depending on the methodology chosen and
historical scenarios adopted as standards, different VaR models will yield greatly
different capital requirements for one and the same portfolio.

The VaR metrics and other market-risk models also contain considerable
theoretical weaknesses. This method tends to underestimate potential losses, because
the logic of its statistical profiling of expected price movements assumes a certain
order (and hence predictability) in price fluctuations – constancy of price variability
giving rise to recurrent patterns, reasonably limited standard deviations indicating
self-contained price movements, et cetera. Yet the market prices of securities and
currencies behave in particularly volatile fashion far beyond the normal law of error,
and their patterns constantly form new constellations of movement in defiance of
constant variance. Most important is the self-feeding nature of rapidly deepening
price collapses where the market’s propensity for widely shared panic selling
introduces an element of irrational excess. This “overshoot” tendency in financial
markets produces a systemic risk in the form of a collapse in market liquidity which
is typically not captured at all by prevailing VaR risk metrics (and only incompletely
by stress tests). As we shall note further below, the credit crunch of August 2007,

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which destroyed the markets for various securitized instruments (notably mortgage-
backed securities, collateralized debt obligations, and asset-backed commercial
paper), is a good case study of crisis scenarios beyond the purview of risk-
management models.

4. Preparing for Operational Risk (Pillar One)

In a crucial extension of its regulatory approach to risk management of banks,

the BCSB has also insisted on the inclusion of operational risk in the calculation of
capital requirements under the new Basel II rules. It defines this type of risk as “the
risk of loss resulting from inadequate or failed internal processes, people, and
systems or from external events.” (BCSB, 2004, p. 140). Implied here is a distinction
between “man-made risks,” be they mistakes, faulty models, fraud, terrorism, or
wars, and “god-made risks,” whether natural disasters (e.g. earthquakes, floods) or
mishaps in the technological infrastructure (e.g. electrical blackouts, telecom
disruptions).(11)

In recent years we have had ample opportunity to observe how devastatingly

swift and paralyzing sudden manifestations of acute operational risk can be across a
broad spectrum of possible manifestations. Whether we are looking at the market
manipulation of a single rogue trader bringing down Britain’s legendary Baring
Bank, the massive disruption of the US inter-bank market on 9/11/01 following the
destruction of the Bank of New York’s crucial transfer- and settlements system in the
World Trade Center, or the impact on local banks of such catastrophes as the
December 2004 tsunami or Hurricane Katrina, each time the loss potential was
staggering. But these examples also demonstrate the inherently unpredictable nature
of operational-risk events. While credit risk and market risk are both taken
voluntarily in the pursuit of bigger returns and follow recurrent patterns, operational
risk occurs beyond the control of a bank’s top management and in typically
unprecedented fashion. To put it differently, significant operational-risk events are
few and far between, hence very difficult to predict. When they do occur, however,

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they may have a devastating impact on a bank’s bottom line. It is for all these reasons
an especially difficult risk category to prepare for.

The BCBS is fully aware of these difficulties and recognizes that the art of
coping with operational risk is still in its infancy, only eight years after making its
debut with the launch of worldwide preparations against the Y2K Bug. All it wants
to achieve at this point is to have banks take account of it in their determination of
capital reserves and in their organization of risk controls. Once again, as in the case
of the other two risk-preparedness regimes described above, the committee has
proposed a choice of three possible approaches across a graduated spectrum of
increasing sophistication.
•The first method of operational-risk management, known as the Basic
Indicator Approach, requires a capital charge of 15% of a bank’s gross income,
averaged over the last three years of positive results.
•In the Standardized Approach the activities of banks are divided into eight
separate business lines – corporate finance, trading & sales, retail banking,
commercial banking, payment & settlement, agency services, asset management, and
retail brokerage. Reflecting different levels of operational risk, these lines are
assigned different capital-level percentages ranging from 12% to 18% of (three-year-
average) gross income per line.(12)
•Finally, under the Advanced Measurement Approaches (AMA) banks
calculate their own capital requirements on the basis of their internal operational risk
measurement and management systems. Subject to supervisory review, those
systems have to meet minimal quantitative (data-collection) and qualitative
(organizational and processing) standards. Since statistical models of the kinds used
to calculate credit risk or market risk are not applicable here, operational-risk
managers have to rely on a more complex calculation methodology using a
combination of internal loss event data, relevant external loss event data (for
industry-wide averaging or line-based benchmarking), business environment and
internal control factors, as well as scenario analysis. Whatever measurement method
they end up using, it should capture potentially severe “tail” loss events which are a

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typical feature of operating risk. For this reason Basel II set the very ambitious goal of
estimating aggregate operational risk loss over a one-year period at a soundness
standard consistent with a 99.9 percent confidence level. These loss estimations
include both expected losses as well as unexpected losses, with the possibility of
getting waivers for capital backing of estimated losses that are adequately measured
and accounted for. Banks can also push for other offsets besides capital, such as
reserves of product pricing.

The operating-risk requirement of Basel II will surely serve as catalyst for

significant and rapid progress in this relatively new area of risk management which
is increasingly seen by experts as key to both the competitiveness and soundness of
banks. In the last couple of years we have seen steadily intensifying efforts to discuss
the most promising AMA techniques and estimation models for operating risk to
define industry-wide benchmarks and promote reasonable standards.(13) Banks are
busy revamping their management structure in line with Basel II recommendations
to give this issue greater priority. More analysis of loss scenarios reinforces vigilance
in areas of in-house vulnerability, such as information technology or settlement
procedures, and recording of transactions. Regulators are pushing banks to
strengthen their internal controls and corporate governance, especially in terms of
auditors, transparency, and conflict-of-interest rules, both of which the BIS regards as
having a direct bearing on operating risk (BCSB, 1998, p. 2). Efforts in this regard
have even gone beyond the confines of individual banks to collective efforts. See in
this regard, for instance, the recent initiative of the leading Wall Street firms, the so-
called ‘Fourteen Families,’ under the auspices of the Federal Bank of New York to
develop an industry-wide protocol for the legal, technological, and paperwork-
handling infrastructure in the hitherto unregulated and chaotic market for credit
derivatives so that minor processing hiccups do not degenerate into market-wide
paralysis because no one knows who owes what (D. Wessel, 2006).

One of the most urgent outstanding issues of Basel II yet to be resolved

concerns the cross-border implementation of the AMA for operational risk by

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multinational banking groups. Operating risk, the chance of suffering operating
losses from such events as fraud, technology failures, or settlement errors, tends to
get reduced when spread across the entire group, since it is highly unlikely that two
or more of its subsidiaries will suffer operating losses at the same time. Hence the
banking group as a whole should be allowed to hold less capital than would be
implied by the sum of operational risks for all its subsidiaries combined. But this
benefit of group diversification conflicts with the obligation of national supervisors
to keep the subsidiaries of internationally active banks under their jurisdiction well
capitalized, irrespective of the position of the latter on a group level. The BCBS has
proposed a compromise (Basel Committee of Banking Supervision, 2004b), a so-
called “hybrid” solution, under which “significant” internationally active
subsidiaries of multinational banking groups would use their own stand-alone AMA
calculation for operating risk while all other internationally active subsidiaries would
be allocated their portion of the group-wide AMA capital requirement. What
constitutes a “significant” subsidiary was left up to negotiations between home-
country and host-country supervisors concerned.

Whether such coordination between different national supervisors can easily

achieve rational outcomes remains to be seen. Those agencies responsible for
domestic banking vary greatly from country to country in customs, practices, and
organizational capacities. They tend to be very turf-conscious and wedded to their
traditions. The BIS has afforded them for the most part a great deal of autonomy, as
exemplified in the case of Basel II by the large number of so-called “national
discretions” whereby banking supervisors adjust the general provisions agreed to
under the auspices of the BIS to their local conditions.

5. Supervisory Review (Pillar Two)

This last point, what the BIS refers to as home-host issues, goes to the heart of
the likely success or failure of Basel II – the quality of prudential supervision within
countries as well as across national jurisdictions. While building on a gradually

17
expanding set of guidelines, principles, and processes of prudential supervision
developed under the auspices of the BIS over the last decade, Basel II provides in its
so-called “Pillar Two” for the most comprehensive elaboration of banking
supervision so far. This ambitious initiative rests on the valid notion that profit-
seeking banks need to be watched more closely by regulators the larger their degree
of freedom in running their own affairs. So if you now let them determine capital
levels on the basis of their own risk assessments, you will have to supervise them a
lot more closely to make sure that they use their newly found freedom properly.

The bank regulators responsible for prudential supervision will have to

establish an ongoing dialogue and review process with all eligible banks under their
jurisdiction. That engagement focuses, first and above all, on evaluating and
approving the risk assessment methods of banks, especially those institutions that
are eligible to use A-IRB approaches for credit risk and/or AMA for operational risk.
Supervisors will also have to make sure that the banks’ risk measurements are
reasonably accurate and matched by adequate amounts of capital. If not, banks will
be asked to set aside more capital or reduce risk exposure or a combination of both.
Supervisory agencies are not only charged to enforce minimum capital levels
corresponding to any bank’s individual risk profile, but can also ask banks to set
aside additional capital above the minimum. The extent of that extra safety cushion
depends obviously on the aggregate risk exposure of the bank.

Supervisors are most likely to demand more bank capital beyond the
regulated minimum when they are worried about an imminent deterioration in
macroeconomic performance of the domestic economy. They are expected to
consider the actual state of the business cycle in their supervisory review and, by
extension, how cyclical downturns may aggravate the risk profile of the banks under
their jurisdiction. Such anticipation is crucial lest we wish to be surprised by
unexpected failures of undercapitalized banks in response to recession-induced
losses whose extent and likelihood were underestimated during periods of rapid
growth and relatively calm financial conditions. At the same time demanding higher

18
capital cushions in the face of worsening macro-economic conditions risks having a
pro-cyclical effect of making such an economic slowdown worse, since the quest for
higher capital levels might force banks to tighten their credit conditions.

Beyond being authorized to demand additional capital cushions for any of the
three Pillar I (credit, market, and operational) risks discussed above, banking
regulators have the additional power to make provision for consideration of risks
that are outside the domain of Pillar One because of their lack of easy measurability
or homogeneity. These include above all interest rate risk, credit concentration risk,
and counterparty credit risk each of which the Basel II accord discusses in some
detail how to take account of. Other sources of loss potential tied to bank operations
and hence considered as relating to operating risk can also become subject to Pillar
Two capital requirements if the regulator believes that the risk profile of the bank in
question warrants such an extra cushion of protection against losses.

Following a tradition put into effect three decades ago by the BCSB in its first
regulatory initiative, the Basel Concordat of 1975, Pillar Two clarifies the division of
labor between different national supervisors vis-à-vis internationally active banks
operating across jurisdictional boundaries.(14) While the earlier agreement addressed
mostly home-host information-sharing issues, Basel II necessitates a far more
ambitious range of cross-border cooperation between national supervisors as laid out
by the committee in its so-called High-Level Principles of cross-border
implementation. These specify the modalities of enhanced supervision involving
greater coordination and cooperation of different national supervisors vis-à-vis
multinational banking groups operating in their respective jurisdictions (Basel
Committee of Banking Supervision, 2003). Each internationally active bank is
uniquely structured in its transnational reach and will require a distinct approach
agreed to by its different national supervisors in consultation with its top
management. The principles resisted giving in to a widespread preference among
larger banks for a “lead supervisor” who in the case of any given bank would make
the ultimate regulatory decisions, validate advanced risk-measurement models, and

19
assure both a consensual approach and consistency of treatment among the different
regulators. Bankers prefer such a centralized approach, because they fear being
subject to different interpretations of the new capital adequacy accord by various
national regulators, hence be vulnerable to onerous reporting requirements and even
unduly high regulatory capital charges.

Still, the principles clearly imply a hierarchy of prudential supervision, with a

multinational bank’s home-country supervisor accorded a central role. That
regulator is responsible for all issues pertaining to consolidated group-level risk
management while host-country supervisors focus more narrowly on a bank’s
subsidiaries under their jurisdiction. There will obviously be a lot of communication
between the different supervisors concerned, not least because they have to achieve
consensus with regard to each and every internationally active bank. In contrast to
the sole decision-making power given to a “lead supervisor,” the BCSB’s softer
approach does not give the home-country supervisor that much authority and so
necessitates a consensual approach to jointly shared regulatory responsibilities. In
order to facilitate such consensus-building among banking supervisors coming from
very different national traditions, the BCSB set up in 2001 a so-called Action
Implementation Group (AIG) to define rules of engagement between them over a
whole range of issues.(15)

A similar struggle for the best method of cross-border implementation has

played itself out even more dramatically on the level of the European Union in the
wake of its 1987 decision to create a single financial-services market. While that
single-market concept encouraged adoption of a single currency (€) and a EU-wide
central bank (ECB), it failed to achieve similar centralization with regard to
prudential supervision of banks. That function was left in the hands of the national
supervisors. When the EU implemented the Basel II initiative, proposing the so-
called Capital Requirements Directive (CRD) in July 2004 which applied the revised
capital framework to all (approximately 8000) banks and (over 6000) investment
firms operating in the EU, it failed even to go as far as the BCSB in approving at least

20
the idea of a consolidating (typically home-country) supervisor. Article 68 of the
CRD requires that the quantitative capital requirements be applied only at the legal
entity level (of individual business units and subsidiaries) rather than on the group
level. Article 69 empowers EU member states to waive this individual application,
but only allows them to do so under the strictest of conditions and solely with regard
to subsidiaries under their jurisdiction. Those waivers do not apply across borders to
allow for consolidated group level results. While Article 129 gives ultimate
responsibility for internal model validation to a consolidating supervisor, it fails to
extend this to the supervisory review of Pillar Two or the information disclosure
requirements of Pillar Three without which there is no consolidated supervision.

Europe’s bankers are upset about their politicians’ inability to provide a

centralized and streamlined supervisory framework. They know fully well that
consolidated supervision is crucially important to their modus operandi. Both risk
estimations and capital requirements have to be calculated on the level of the group
rather than just by merely adding them up from its individual units. Only the top
managers at the head of the group have a sense of the whole and can take account of
diversification benefits. Hence the EU’s banks fear with good reason that the absence
of a lead supervisor or even of consolidated supervision will saddle them with more
onerous reporting and compliance requirements which may differ from one country
to the next. Even worse, they may actually end up with higher aggregate levels of
required capital, since diversification benefits will not be captured adequately.
Recognizing fully that this failure to integrate EU-wide banking supervision
constitutes a major comparative disadvantage for European banks relative to, say,
the more comprehensively supervised U.S. counterparts, its policy-makers in the EC
decided in 2005 to provide for a five-year transition period toward consolidated
group-level supervision. Only then will we have set the conditions for European
integration and restructuring of its financial-services industry in the absence of
which we have seen far fewer cross-border mergers and acquisitions of financial
institutions than anticipated.(16)

21
 Of course, the EU’s troubles pertaining to integrated banking supervision are
very much rooted in the high degree of institutional fragmentation across the union.
When looking at the 27 members of the union, we can see a stunning variety of
arrangements for the regulation of the financial services sector. One basic distinction
exists between countries favoring a single regulator for banking, securities, and
insurance combined (see Britain’s Financial Services Authority) versus those
preferring separate sectoral regulators for each of these three areas of finance (e.g.
Germany). Some countries combine a regulatory agency for two out of those three,
whether banking and insurance (e.g. France), banking and securities (e.g. Finland), or
securities combined with insurance (e.g. Czech Republic). Then there is also the
question whether banking supervision should be the domain of the central bank (as
in Spain, Italy, the Netherlands) or better put into the hands of independent
regulatory agencies (e.g. Austria).

These arrangements all reflect deeply rooted national traditions. They can also
be defended on grounds of institutional rationality. Relying on a single regulator
across all three broad areas of finance provides major economies of scale (e.g. pooling
of expertise, single approval, avoidance of dual efforts, enhanced status and power)
as well as economies of scope (in terms of having regulators who are knowledgeable
of the entire spectrum of financial services). Such super-regulators also correspond
more closely to today’s formation of universal banks, which as financial
conglomerates engage in all three sectors of finance. Having central banks serve as
such super-regulators makes sense inasmuch as prudential supervision is directly
linked to monetary policy (with banks the main source of money creation and
interest-rate determination) as well as financial stability, the two principal central-
banking functions. Yet it also makes sense to place supervision in the hands of a
separate regulator who focuses on enforcing prudentially responsible behavior and
so has a better sense of what the regulated and supervised actors are up to. In the
same vein, it might be sensible to rely, as many countries still do, on a decentralized
organization of supervision using specialist regulators for each segment of finance.
Apart from being smaller and presumably more flexible, better suited to close

22
monitoring, and capable of targeting more precisely the unique challenges posed by
each regulated actor, the specialists can also be justified by fundamental differences
in risks and regulatory needs between banking, securities, and insurance. Finally,
competition between different regulators can be an inducement toward improved
efficiency among them.(17)

While creation of a EU-wide super-regulator seems a good idea for a single

financial-services market (see M. Aglietta, L. Scialom, T. Sessin, 2001), a case can be
made in favor of maintaining a certain degree of national heterogeneity in regulatory
structures across the globe. For one, there is obviously no ideal model of regulating
financial institutions and markets at a time when both are in the midst of profound
structural transformation. Moreover, regulators everywhere will be so challenged by
implementation of Basel II over the next five years that they do not need the added
burden of reforming their existing institutional architecture before they know
precisely how best to do that. Instead they should at this point focus on training
many more supervisors in the intricacies of risk management and improving their
cooperation with each other. Increased ties among regulators from different
countries, a sine qua non for the success of Basel II, will allow for a collective
learning curve about the pros and cons of the different national arrangements.
Enhanced cooperation between national regulators envisaged by Basel II will surely
encourage a gradual convergence among them in developing norms and standards
for how to deal with multinational financial conglomerates operating across their
respective jurisdictions. Here the initial heterogeneity of experiences and structures
will add a lot to our understanding of how best to oversee risk management and
capitalization of those conglomerates. Still, amidst such decentralization it is
imperative to provide consolidated risk management on the group level as well as a
“lead supervisor” vis-à-vis each of the major internationally active banks as
centralizing counterweights. The BIS should assure a large degree of transparency
about national differences in regulatory structure and Basel II implementation.

6. Market Discipline (Pillar Three)

23
 The new regulatory approach of supervised self-regulation promulgated in Basel
II relies, beyond the watchful eyes of government regulators, also on the disciplining
force of the marketplace. Such market discipline arises from investors punishing
banks whom they deem inadequately prepared to cope with the innate risks built
into their portfolio or arising from their operations. Those banks can expect to pay
higher interest rates for their funds and face lower share prices. Well-prepared
banks, by contrast, will benefit from investors rewarding them with cheaper funding
opportunities and/or higher share prices. Such discrimination between punishing
poorly run banks and rewarding well-run banks also occurs among other
stakeholders, notably rating agencies, market analysts, counterparties, potential
merger partners, and scarce top talent for whose job commitment the banks compete.

The ability to exert such pressures of market discipline rests predominantly on

everybody involved having lots of accurate and reliable information about the
businesses targeted, in this case the banks. More specifically, shareholders and
stakeholders can only make meaningful decisions as to which banks to engage in and
which banks to abandon if they know quite precisely how those institutions calculate
risks, prepare for them in terms of risk mitigation strategies or crisis management,
and set aside capital as a safety cushion. The idea therefore is to make sure that banks
provide all material information related to their risk management and capital
provisions to the widest possible public in an accessible manner so that whoever
wants to form a judgment about a particular bank can easily do so.

Towards that objective the Basel II agreement proposes extensive and rather
precise specifications of what banks must let the public know about themselves and
in what format as well. These disclosure requirements include information about
how banks intend to deal with such key strategic questions as risk mitigation or
plans for raising capital. Basel II defines general disclosure rules and, in addition,
demands both specific quantitative data as well as qualitative information with
regard to capital (structure and adequacy), all areas of risk (i.e. credit risk, market

24
risk, operational risk, interest rate risk, counterparty credit risk), and risk mitigation
(including securitization). Depending on what risk assessment strategy any eligible
bank has opted for, there are different disclosure rules for standardized approaches
and the more advanced (e.g. IRB or AMA) approaches. Given its scope and its depth,
Basel II’s Third Pillar is without a doubt the most ambitious information-disclosure
regime ever applied to financial institutions.(18)

If you believe in efficient markets, like most U.S. economists and policy-
makers do, then you are likely to be convinced of the efficacy of market discipline as
an appropriately constraining force of caution on the behavior of bankers. In that
orthodox paradigm everybody has perfect information and acts rationally on it. This,
however, is not a given in the case of banks whose very existence as intermediaries is
based on having an information edge over others. For instance, banks are better than
ultimate savers in assessing creditworthiness of borrowers, which is precisely why
they get to loan out a large portion of the nation’s savings for a profit. The banks’
asymmetric information access clashes with the transparency needed for market
discipline to work, a contradiction nowhere more clearly manifest in the case of
derivatives where banks serve as counterparties on an absolutely massive scale (in
the trillions of dollars) without carrying any of this exposure on their balance sheets.
Just as bankers are in the business of absorbing risks (e.g. funding long-term assets
with short-term liabilities), so they are also in the business of monopolizing
information as a source of profit. Their ability to turn information into a commodity
renders their activities intrinsically opaque, a characteristic reinforced by the
intangible nature of their services. We therefore do not know at this point how well
transparency-based market discipline can work given the opacity of financial
intermediation. The massive write-down charges by leading money-center banks
(Citibank, UBS, HSBC, Barclays, etc.) during the second half of 2007 have shown that
not even the top bankers themselves have a clear idea of losses arising from their
massive risk exposures that do not show up on their balance sheets.

7. Implementation and Application Issues

25
 The implementation of Basel II, a gradualist step-by-step process planned over
the next four years, is bound to be a complex affair, an ambitious project of
establishing an institutional architecture of global governance in an area where the
globalization process has been the most advanced. While committing its member
countries to putting its multilateral agreements into effect, the BIS leaves national
authorities a measure of sovereignty and hence a certain degree of flexibility to adapt
those agreements to national specificities. It is this dialectical interplay between
supra-national needs of regulatory harmonization and national sovereignty that
renders this policy-coordination issue of financial regulation such a fascinating and
important experiment. Still, global governance does not happen in a vacuum. On the
contrary, its particular modalities certainly reflect (and in turn re-shape) the
prevailing hierarchy of political power relations. The dimension of Basel II with the
most long-lasting and far-reaching implications for global capitalism may well be its
impact in the emerging market economies (China, India, Russia, Brazil, Mexico, Iran,
etc.)
as those countries try to reconcile traditionally large-scale involvement of their state
apparatus in the domestic economy with vibrant participation in a free-market
capitalism of global reach. But Basel II will also play an important role in balancing
the co-existence of the two most powerful global actors, the United States and the
European Union.

The EU committed itself early on to full adoption of Basel II and an aggressive

agenda of its implementation. In the Capital Requirements Directive (CRD) of July
2004, which the European Parliament passed into law in September 2005, its policy-
setting European Commission (EC) proposed to apply Basel II to all of the EU’s
(approximately 8000) banks and (over 6000) investment firms. That directive also
managed to address some EU-specific priorities. Recognizing that it is less risky to
hold a large number of small loans than a small number of large loans, the CRD
permits a lower capital requirement for lending to small- and medium-sized
enterprises (SMEs). This will help the comparatively finance-constrained SMEs of the

26
European Union to obtain cheaper and easier external funding and so contribute
more effectively to the employment creation and growth dynamic of their national
economies, more akin to their American counterparts. A similarly reduced capital
requirement for banks has been put into place for their venture capital investments
carried out as part of a sufficiently diversified portfolio, boosting an aspect of equity
financing of small start-up companies crucial to technological progress which until
now has been quite marginalized in Europe when compared to the United States.
That latter superpower, never a great believer in subjecting its own national
interests to the logic of global harmonization of regulations and policies, has taken a
more cautious approach to Basel II. Its bank regulators, above all the Federal Reserve
(Fed), the Federal Deposit Insurance Corporation (FDIC), and the US Treasury’s
Comptroller of Currency which are grouped together in the so-called Federal
Financial Institutions Examination Council (FFIEC), agreed in October 2005 to a
revised capital-adequacy agreement which would require America’s so-called “core
banks,” its twenty or so leading, internationally active banking institutions, to use
the advanced risk assessment methods prescribed in Basel II exclusively. All the
other U.S. banks – nearly 8000 of them – will have the option of either following the
simpler risk formulae of Basel II’s “standardized approach” or, especially if they are
small community banks, stick with the Basel I rules.(19)

It is worth noting that U.S. banks face already two additional domestic capital
requirements which have kept their capital base fairly high by international
standards. One concerns the so-called leverage ratio, which divides total equity capital
by average assets and which should exceed 5% for a bank to be considered well-
capitalized. The other is a new mechanism of prompt corrective action (PCA) for
undercapitalized banks, introduced in the Federal Deposit Insurance Corporation
Improvement Act (FDICIA) of 1991 as part of a reform of that lender-of-last-resort
mechanism. That reform introduced five zones of capital adequacy ranging from
“well-capitalized” to “critically undercapitalized,” with any bank rated accordingly
(CAMEL-1 to CAMEL-5 ratings). When banks become “undercapitalized,” with a
leverage ratio below 4%, their regulators would impose specific remedial actions.

27
Those combined mandatory provisions, such as increased monitoring, suspension of
dividends and management fees, asset growth restrictions, prior supervisory
approval for certain expansion steps, and recapitalization, with discretionary steps
such as restrictions on certain activities, limits on deposit rates, replacement of top
management, or divestitures. The lower the capitalization of the bank concerned, the
more severe the remedial actions required by regulators. When banks have dropped
into the worst zone with a leverage ratio below 2%, regulators can begin closure
procedures. The ratings given to U.S. banks by regulators do not just take account of
capitalization levels, but also degrees of risk incurred.(20) U.S. regulators have
decided that the PCA framework complements Basel II well and should be
preserved. The idea here is to force problem banks make timely adjustments as they
become riskier and/or more undercapitalized. Huge write-down charges from
subprime-related losses among many leading U.S. banks in late 2007 remind us that
banks will overextend and in the process underestimate their risks to permit such
excess. They need to be obliged to correct their mistakes the moment their troubles
begin to reach a critical mass.

The FFIEC has been worried about Basel II ever since a Quantitative Impact
Study (QIS-4) in 2004 showed the 26 reporting institutions applying Basel II
provisions ending up with substantial declines of 15.5% in aggregate minimum risk-
based capital requirements compared to Basel I, with half reporting declines in
excess of 26%. Questions about the revised framework’s ability to provide for
sufficient levels of capitalization were further reinforced by the large variation of
results even among banks with relatively similar asset compositions. While some
degree of variability is inevitable in light of the inherent subjectivity of risk estimates,
the extent of dispersion found in the latest impact study was far too large to ignore.
In light of these troubling results, the FFIEC decided to delay the initial
implementation schedule planned for Basel II by one year. Its final implementation
rule of November 2007 includes transitional safeguards which limit the permissible
declines in a bank’s capital to 5 percent per year over three years.(21)

28
 7. Financial Instability and Systemic Risk

In August 2007, after years of relative calm in the world’s booming financial
markets, a relatively limited problem, located among U.S. subprime mortgages,
exploded into a global credit crunch. Doubts about the viability of these homeowners
with checkered credit histories amidst a rapidly worsening U.S. housing crisis
created a loss of confidence in mortgage-backed securities containing subprime loans
which deepened into a total collapse of liquidity for all securitization instruments,
notably collateralized debt obligations and asset-backed commercial paper, and - by
further contagion of spreading panic – into paralysis in the interbank market, the
nerve center of the world economy. Only massive, coordinated, and sustained
liquidity injections by a dozen or so central banks, led by the European Central Bank,
managed to prevent this full-blown credit crunch from getting totally out of control
to the point of triggering a global depression. While the worst of this crisis episode
may have passed, its damage will take some time to digest.

This horrifying experience of massively disrupted credit flows is stark

reminder that banks are subject to recurrent financial crises whose underlying forces
are potentially far more powerful than any restraints from Basel II’s three pillars of
“supervised self-regulation.” Such crises are a recurrent phenomenon in capitalist
free-market economies, part of that system’s cyclical modus operandi.(22) They start
typically during boom periods feeding on collective euphoria. At that point profit-
seeking investors become too enthusiastic about the future, which prompts them to
offer excessive amounts of credit at unrealistically easy conditions. It is precisely this
contagious “conspiracy of greed” embedded in boom-induced market euphoria
which drives the financial system collectively to a point of unsustainable
overextension. At the cyclical peak there occurs inevitably an unexpected disruption
which reveals starkly to everyone how overextended funding positions have become.
The mood suddenly shifts to pessimism, perhaps even panic, triggering a rush to
liquidity and a self-feeding wave of cutbacks which rapidly degenerate into open
financial crisis. Credit conditions deteriorate just when overextended debtors fall

29
short of cash. Assets get liquidated to boost dwindling cash positions, forcing asset
sales into declining markets, which can rapidly become self-feeding. In the face of
such recurrent sequences of greed-driven euphoria and fear-inspired panic banks
cannot escape these socially elaborated mood swings. Typically they collectively
downplay or disregard risks during boom periods, only to take then too pessimistic a
view when in the grip of retrenchment. Unless both banks and supervisors consider
the macroeconomic context of business and credit cycles when assessing the
effectiveness of risk management models, they will be inclined to underestimate
risks until they will come to regret it.

Acute financial crises may spread to a point where even the most
sophisticated risk-management models become obsolete. The statistical concepts
used to measure risk – probability distributions representing outcomes, arithmetic
means summarizing the most likely outcome in the form of the expected value, the
(standard) deviation of actual outcomes from the expected (mean) value, the
covariance measuring how different asset returns are interrelated – simply cease to
apply in such episodes of turbulence. Any well-behaved patterns of predictability,
which such statistical laws of modern portfolio theory imply, are simply
overwhelmed by the entirely unpredictable course of violent ruptures and
adjustments characterizing such crisis. As we have witnessed once again just a short
while ago, the course of full-blown financial crises defies the parameters of standard
risk-measurement models. The collapse of liquidity so typically found during acute
financial crisis, when everybody needs to sell in order to generate cash yet nobody
wants to buy, can deflate asset prices very quickly and push overextended borrowers
to the brink of default. The non-linearity implied here gets typically aggravated
because of the leverage factor magnifying negative rate of returns on capital for any
given loss as well as margin calls (i.e. requests on borrowers for immediate cash to
cover eroded collateral values) triggering cumulative asset sales and avalanche-like
price declines. Ever since the stock-market crash of 1987 we have come to appreciate
the mutually reinforcing inter-play of securities (stocks, bonds) and derivatives

30
(stock-index futures, bond futures) pulling each other’s prices down with amazing
ferocity.

Worst of all, if left unchecked, financial crises can intensify to the point of
posing systemic risk as they unleash a combination of paralyzing disruptions in the
credit system, huge losses shared by borrowers and investors alike, and sharp
declines in economic activity. Ever since the disastrous experience of the Great
Depression of the 1930s we are quite aware how devastating this worst of all risks
truly can be. Systemic risk, threatening the credit system and the economy it
supports in toto, arises when a financial crisis realizes its potential of contagion and
starts spreading like wildfire. The crisis deepens amidst a self-feeding loop of losses,
panic selling, further losses, more panic, and so forth. It could spread geographically,
as happened so extensively in the Asian crisis of 1997 which moved to Russia in 1998
and Brazil in 1999 before consuming itself in a last fire burning down the currency
board of Argentina in 2001). It may also spread from one financial market to another
- from derivatives to securities, from currencies to bank loans, from agency securities
to government bonds, et cetera. Today’s financial markets and institutions are
interwoven in a myriad of complex interconnections some of which only become
evident unexpectedly and violently in times of great stress. Such multi-level
contagion also carries the potential of transforming financial risks. As many banks in
East Asia found out painfully in 1997/98, when the local currency’s peg broke amidst
panicky capital flights, it turned to have been a really bad idea to have funded
liabilities in dollars while carrying most assets in the (now sharply devalued) local
currency. Market risk thus turned right away into credit risk, further compounded
by acute liquidity risks and interest rate risk. We have seen the same qualitative
amalgamation of mutually infectious risks in the current crisis of subprime
mortgages and securitization instruments.

None of these earthquake-like risk transformations and non-linear contagion

processes can be adequately captured a priori by even the most sophisticated risk-
estimation models. Those models focus ironically on predicting problems while

31
being rendered moot precisely when the worst-case scenarios become true. They
work in good times, but cease to be meaningful precisely in those bad times against
which they were supposed to protect us. Hence we need additional measures beyond
the Basel II approach of supervised self-regulation. We need a regulatory regime of
prompt corrective action for undercapitalized banks threatened by losses, as the U.S.
experience with such an PCR regime over last 15 years has proven. We also need
effective lender-of-last-resort mechanisms with which to manage financial crises by
containing their spread. Three major global debt crises, the LDC debt crisis 1982-87,
the Asian crisis 1997/98, and the subprime crisis of 2007/08, have taught us about
the need for effective global crisis management beyond the domestic lender-of-last-
resort mechanisms. The early-warning system being constructed by the International
Monetary Fund (IMF) and the mobilization of additional resources for its crisis
interventions are steps in the right direction, as are new clauses written into
international bond contracts providing for orderly restructuring in case of de-facto
defaults. Ultimately an effective lender-of-last-resort mechanism requires the ability
of (possibly unlimited) liquidity injections by central banks, perhaps even the IMF.
Notes

1) That proposal was published first in June 2004 and then again in a revised version
in November 2004 (Basel Committee on Banking Supervision, 2004).

2) The so-called “Group of Ten” (G-10) members of the BIS, represented by their
central bankers, actually have grown to thirteen since the group’s inception in 1960 -
Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands,
Spain, Sweden, Switzerland, UK and US.

3) The Basel Accord of 1988 also clarified the definition of bank capital. By
introducing different categories of bank capital, the BIS allowed banks to build up
capital from less conventional sources (e.g. loan-loss reserves, subordinated debt)
whenever primary capital sources were hard to get.

32
4) For empirical studies of this capital constraint effect in the wake of the 1988
Capital Accord on bank lending and economic growth in the United States see D.
Hancock and J. A. Wilcox (1997, 1998) as well as J. Peek and E. Rosengreen (1995).
For similar empirical findings of that connection in the case of Japan see A. D.
Brunner and S. B. Kamin (1998), S. B. Kim and R. Moreno (1994), as well as J. Peek
and E. Rosengreen (1997).

5) See the excellent report by P. Jackson et al. (1999) on the impact of Basel I,
including a detailed account of regulatory arbitrage practiced by banks.

6) According to Basel Committee on Banking Supervision (2001), the two IRB

approaches focused on the same four credit-risk variables, namely probability of
default, loss given default, exposure at default, and maturity of exposure, but to
different degrees of modeling and measurement.

7) For a preliminary analysis of such shifts in bank lending portfolios in response to

risk-weight differentials, especially comparing here EU-based banks and U.S. banks,
see N. Caillard, P. Laurent, and V. Seltz (2001).

8) The single-passport concept of the 1989 directive enabled universal banks from
Germany and France to implement themselves as such in places like Britain, where
commercial- and investment-banking functions are still separate. Those universal
banks would then have to compete with Britain’s securities firms and investment
banks which were subject to altogether different capital requirements. The EU’s 1993
directive overcame this problem by means of the crucially important institutional
innovation of shifting the focus of banking regulations from institutions (e.g. one set
of regulations for commercial banks, another for securities firms) to functions (i.e.
bank lending posing credit risk, securities holdings containing market risk).

33
9) For more detail on the rapid progress concerning VaR modeling see K. Dowd
(1998), P. Jorion (2000), G. A. Holton (2003) as well as the useful web sites
riskglossary.com or GloriaMundi.com.

10) See Basel Committee on Banking Supervision (1996). Since the original CAD of
the European Commission in 1993 had not provided for the use of internal risk-
measurement models, EU banks were put at a competitive disadvantage compared
to non-EU banks. To remedy this situation, the European Commission issued its own
revision, known as CAD II.

11) See R. Jayamaha (2005), p. 2.

12) According to Basel Committee on Banking Supervision (1998, p. 3), operational

risk is more likely in large-volume, low-margin business lines, such as transaction
processing and payments-system related activities, which may also have such risk-
prone characteristics as high turnover, fast-paced structural change, or complex
support systems.

13) Evidence of such efforts, in the case of the United States for instance, can be
collected by visiting the web sites of the American Bankers Association
(www.aba.com), the Institute of International Finance (www.iif.com), or the regional
Federal Reserve Banks (e.g. such as FRB Boston’s www.bos.frb.gov).

14) This so-called Basel Concordat (Basel Committee on Banking Supervision, 1975),
passed after two bank failures in 1974 (Herstatt, Franklin National) had revealed
serious cross-jurisdictional problems posed by the supranational Eurocurrency
market, offered a framework for increased cooperation among national authorities in
the supervision of liquidity, solvency, and foreign-exchange positions of banks that
operate in more than one country. That agreement among the world’s leading central
bankers paid particular attention to defining the coordination, information sharing,
and task allocations between home- and host-country authorities.

34
15) See B. Bernanke (2004) for a U.S. perspective on the host-home issues between
national supervisors raised by Basel II.

16) For more on this five-year plan of moving banking supervision to a more EU-
wide level of cooperation among national regulatory authorities see its Committee of
European Banking Supervisors (2005). Those CEBS guidelines have been widely
criticized by the lobbying groups of the financial-services industry in Europe (e.g.
European Banking Federation, European Federation of Finance House Associations)
as “too little, too late.” For a typical criticism by bankers, in this case the head of the
Dutch ING Group, see C. Maas (2005).

17) See D. Plihon (2001) for a good summary of the widely divergent practices and
structures of prudential supervision across the European Union.

18) This information-disclosure regime of Basel II will have to be integrated with the
emerging body of accounting rules for financial institutions being developed by the
International Accounting Standards Board (IASB) as well as the joint IMF-World
Bank analyses of member countries’ financial systems known as Financial Sector
Assessment Program.

19) Initially, the FFIEC had planned a different route to Basel II, namely letting its
8000 or so non-core banks follow a revised Basel I framework commonly referred to
as Basel 1A which still would have applied credit-risk weights over broadly defined
asset categories, but with greater sub-divisions reflecting differentiations in default
probabilities. But then the regulators dropped this idea, fearing Basel 1A would
discriminate too strongly between core and non-core banks while also moving U.S.
practice too far away from international rule.

20) For a good summary of the FDIC’s application of the new PCA rules see L.
Shibut, T. Critchfield and S. Bohn (2003).

35
21) See Federal Deposit Insurance Corporation (2006) for more details about the
results of QIS-4 and the worries expressed by the U.S. regulators. The final Basel II
implementation rule by the FFIEC is discussed by R. Kroszner (2007).

22) For more discussion on the inevitable dynamic of financial crisis see R. Guttmann
(1994, 1996), H. Minsky (1982), and M. Wolfson (1986).

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