Robert Guttmann (Hofstra University; Université Paris-Nord)


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 Its enactment is so complex that full implementation of Basel II will take years, only to be superseded by further adjustments and revisions stretching over decades.


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, riskweighted 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)


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 riskweighted 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-G10 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


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


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


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 riskmanagement capacity have two additional options, based to varying degrees on their


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 riskmeasure 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 riskmeasurement 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 BBBshould 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


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


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 capitaladequacy 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 9

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


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 offbalance-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


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 nonlinear 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 riskmeasurement 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


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,


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


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-yearaverage) 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


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 socalled ‘Fourteen Families,’ under the auspices of the Federal Bank of New York to develop an industry-wide protocol for the legal, technological, and paperworkhandling 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


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 socalled “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 homecountry 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


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 profitseeking 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


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


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 socalled 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


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)


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 centralbanking 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


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)


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


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 policymakers 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


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 policysetting 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


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 wellcapitalized. 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.


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 riskbased 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)


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 profitseeking 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


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


(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 riskestimation models. Those models focus ironically on predicting problems while


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-lastresort 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.


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).


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 or

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 riskmeasurement 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 riskprone 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 (, the Institute of International Finance (, or the regional Federal Reserve Banks (e.g. such as FRB Boston’s

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.


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 EUwide 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).


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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