No. 681 July 29, 2011 Capital Inadequacies The Dismal Failure of the Basel Regime of Bank Capital Regulation by Kevin Dowd, Martin Hutchinson, Simon Ashby, and Jimi M. Hinchliffe Executive Summary The Basel regime is an international sys- ness is regulatory capture. tem of capital adequacy regulation designed to The Basel regime is powerless against the strengthen banks’ financial health and the safe- endemic incentives to excessive risk taking that ty and soundness of the financial system as a permeate the modern financial system, particu- whole. It originated with the 1988 Basel Accord, larly those associated with government-subsi- now known as Basel I, and was then overhauled. dized risk taking. The financial system can be Basel II had still not been implemented in the fixed, but it requires radical reform, including United States when the financial crisis struck, the abolition of central banking and deposit and in the wake of the banking system collapse, insurance, the repudiation of “too big to fail,” regulators rushed out Basel III. and reforms to extend the personal liability of In this paper, we provide a reassessment of key decisionmakers—in effect, reverting back to the Basel regime and focus on its most ambi- a system similar to that which existed a century tious feature: the principle of “risk-based regu- ago. lation.” The Basel system suffers from three The Basel system provides a textbook exam- fundamental weaknesses: first, financial risk ple of the dangers of regulatory empire build- modeling provides the flimsiest basis for any ing and regulatory capture, and the underlying system of regulatory capital requirements. The problem it addresses—how to strengthen the second weakness consists of the incentives it banking system—can only be solved by restoring creates for regulatory arbitrage. The third weak- appropriate incentives for those involved. Kevin Dowd is a visiting professor at the Cass Business School, City University, London, and an adjunct scholar at the Cato Institute. Martin Hutchinson is a journalist and a former investment banker who writes the weekly “Bear’s Lair” column at www.prudentbear.com. Simon Ashby is a senior lecturer at Plymouth Business School in the United Kingdom, and Jimi M. Hinchliffe is an investment banker based in London. Kevin Dowd and Martin Hutchinson are coauthors of Alchemists of Loss: How Modern Finance and Government Intervention Crashed the Financial System. At the dawn of Introduction community has been to patch up the system the crisis, the as quickly as possible. A new, improved Basel One of the most important and distinc- system is already agreed in principle, with ne- big banks in the tive features of modern central banking is gotiations underway regarding its implemen- United States and the growth of bank capital adequacy regula- tation. Its designers tell us that this new Basel Europe were fully tion—the imposition by bank regulators of regime takes on board the lessons of the crisis minimum capital standards on financial in- and the weaknesses of its predecessors, and Basel-compliant stitutions. The main stated purpose of these assure us that it will deliver a safer and more and more than regulations is to strengthen institutions’ fi- stable financial system in the future. nancial health and, in so doing, strengthen Let’s see if we understand this correctly. adequately the safety and soundness of the financial The regulators spent most of a fairly quiet capitalized. system as a whole. decade producing Basel II—which, in essence, Until the second half of the 20th century, is just thousands of pages of regulatory gob- capital regulation was fairly minimal and bledygook—designed to make sure that the often quite informal. In the 1980s, however, international banking system is safe. The the major economies attempted to harmo- banking system then collapsed shortly after- nize and expand the scope of bank capital ward. In the resulting panic, they rushed out regulation under the auspices of the Bank thousands of pages of new draft rules, plus for International Settlements’ Basel Com- many more pages of discussion and con- mittee. The defining event was the 1988 Ba- sultation documents. Indeed, the deluge of sel Accord, now known as Basel I. This “Basel regulatory material was so great that by the regime” was a rapidly expanding work-in- spring of 2010 observers were jokingly refer- progress as the regulators attempted to keep ring to it being tantamount to a Basel III. up with developments in banking, finance, But by the fall, the joke—Basel III—had be- and financial risk management. The most come a reality. But surely the real jesters were significant overhaul was Basel II, published those telling us that the solution to all that in 2004, which was the subject of protracted gobbledegook was now to have even more of negotiations around the turn of the millen- it, crafted on the fly under crisis conditions nium. Member countries had either just ad- by the very same people who had gotten it opted Basel II, as the European Union had wrong before. Now these same people ask us in 2007, or, in the case of the United States, to believe that they have gotten it right this were preparing to adopt it when the finan- time around, and never mind all those previ- cial crisis hit. ous failures. At the dawn of the crisis, the big banks With a track record like this, it must be ob- in the United States and Europe were fully vious that what is needed is not some rushed Basel-compliant and, as far as Basel was con- patch-up of the Basel system, but a serious cerned, more than adequately capitalized. reassessment from first principles. That is The crisis then revealed the true weakness what this paper seeks to provide. In particu- of the banks in the starkest possible terms. lar, it aims to offer a (fairly) readable guide to Many of the biggest banks failed, and most the policy economics of the Basel system: the of the banks that have survived are likely to underlying issues and objectives of the main remain on government life support for years players, the policy issues Basel presents, the to come. The collapse of the banking system effectiveness of the system, and how it might is, of course, the clearest imaginable evi- be reformed. It seeks to outline the big pic- dence that Basel has not worked as intend- ture and, as far as possible, avoid the vast and ed: not to put too fine a point on it, but ev- oppressive minutiae that render this subject ery ship in the fleet passed inspection—and almost impenetrable to the outsider.1 At the then most of them were lost at sea. same time, it highlights the most innova- The knee-jerk reaction of the regulatory tive and ambitious feature of the Basel sys- 2 tem: the principle of “risk-based regulation,” are reminiscent of King Canute ordering the which attempts to build a capital adequacy incoming waves to stop rising. In the case regime on firms’ own risk models using the of the modern financial system, the waves rapidly evolving practices of modern finan- are the endemic incentives to excessive risk cial risk modeling. taking, particularly those associated with We suggest that the Basel system suffers government-subsidized risk taking such as from three fundamental weaknesses. First, deposit insurance, the lender of last resort, financial risk modeling provides the flimsi- and the now-established doctrine of “Too est basis for any system of regulatory capital Big to Fail.” These waves are now so strong requirements. This is, in part, because of the that even another massive overhaul of Basel intrinsic weaknesses of such models, in part would still leave the financial system open because physical science models do not easily to being overwhelmed when the next wave carry over to social and economic problems, of crisis occurs, which will probably happen and in part because of basic economics—that sooner rather than later. is, neither the models nor the regulators’ use This said, the financial system can be fixed, of those models allow for the bankers’ incen- but to do so would require much more radi- tive to produce low-risk estimates to obtain cal reform. This would include the abolition low regulatory capital charges. Taken to- of central banking and deposit insurance, the Basel capital gether, these factors suggest that risk-based repudiation of “too big to fail,” and the estab- rules are the regulation is fundamentally unsound even lishment of reforms to extend the personal primary factor in principle, let alone in practice. liability of key decisionmakers—in effect, re- The second weakness consists of the incen- verting back to a system similar to that which driving the tives that Basel creates for regulatory arbitrage, existed a century ago. At the same time, the securitization typically taking the form of securitizations restoration of a sound monetary standard—or bonanza of the designed to produce lower regulatory capital at the very least, the abandonment of mone- charges. Indeed, it is no exaggeration to say tary policy activism typified by successive Fed- last two decades. that the Basel capital rules are the primary fac- eral Reserve chairmen Alan Greenspan and tor driving the securitization bonanza of the Ben Bernanke—would put a stop to the cen- last two decades, the main consequence of tral bank stoking the highly damaging boom- which has been to greatly weaken the financial bust cycles of recent years. The combination system by depleting it of much of its capital. of extended liability, market forces, and sound The third weakness is regulatory capture.