The London School of Economics and Political Science Why do countries implement Basel II? An analysis of the global diffusion of Basel II implementation Young Bong Cho January 2013 A thesis submitted to the Department of International Relations of the London School of Economics and Political Science for the degree of Doctor of Philosophy, London, January 2013 Declaration I certify that the thesis I have presented for examination for the MPhil/PhD degree of the London School of Economics and Political Science is solely my own work. The copyright of this thesis rests with the author. Quotation from it is permitted, provided that full acknowledgement is made. This thesis may not be reproduced without my prior written consent. I warrant that this authorisation does not, to the best of my belief, infringe the rights of any third party. I declare that my thesis consists of 98,585 words. Abstract Like its predecessor, Basel II has profoundly shaped bank capital adequacy regimes across the world. However, there has been little systematic research on the state of Basel II implementation across developed and developing countries, and the factors that promote or hinder the implementation of these voluntary standards are particularly under-researched. By drawing on a new global dataset of Basel II implementation across 150 countries compiled by the author, this thesis evaluates the state of Basel II implementation at the global level and investigates why countries implement Basel II. Three novel channels of policy diffusion formed across supervisory authorities, global banks and financial sectors were specifically constructed to study the diffusion of Basel II policies using a mixed-method research design. A quantitative study tests the effects of policy diffusion on Basel II implementation across four distinct channels of diffusion formed by inter- supervisory authority networks, the cross-border structure of international banks, competition between financial sectors and the nexus of international economic exchange. This is complemented by in-depth case studies that unpack the causal process through which policy diffusion shaped the national implementation of Basel II in Chile, Hong Kong, Korea and Malaysia. I find that the state of Basel II implementation at the global level is highly uneven and clustered, and show that Basel II policy decisions in countries are highly interdependent on the policy decisions of other countries with which those countries are closely interconnected. Policy diffusion not only promotes the degree of convergence with Basel II, but also reinforces partial, gradual and delayed implementation. The diffusion of implementation policies can thus be a curse and a blessing for the future of Basel II and the broader global financial regulatory architecture due to its double-edged power to promote as well as hinder the degree of regulatory convergence with international financial standards. Acknowledgements I would like to express my deepest gratitude to my supervisor, Professor Andrew Walter. I owe a large part of this thesis to Professor Walter, as it was his pioneering work on international financial standards that opened my eyes to this topic in the first place and motivated me to pursue a PhD on the implementation of Basel II. Professor Walter has been a fantastic role model and I feel extremely lucky to have been his supervisee. I am grateful for his critical, insightful, constructive, detailed and timely comments on all aspects of this thesis from start to finish. I would like to thank my parents and brother in Korea for their unconditional support. I am particularly indebted to my sisters and their family for their endless support, especially Sora, Do and Joo. I am especially thankful to Suyoun for always being there for me. Having spent over eight years at the LSE, I have many people to thank, but in particular, I would like to express my sincere gratitude to the Department of International Relations, Department of Economics and my colleagues at the LSE, especially Rajeev Sibal, Daniel Capparelli, Natali Bulamacioglu, Silvia Pepino, Kevin Young and fellow inhabitants of Q1. I would also like to thank Steve Crosby and Richard Jordan at Standard Chartered Bank. I dedicate this thesis to my father, Dr Kay Shek Cho. Table of Contents List of Figures and Tables ......................................................................................... 1 List of Acronyms and Abbreviations........................................................................ 2 Chapter One Introduction 1.1 Why do countries implement Basel II? ...................................................... 3 1.2 Research question and central explanatory framework .......................... 7 1.3 Overall research design ............................................................................. 10 1.3.1 A global dataset of Basel II implementation ........................................ 11 1.3.2 Quantitative study: Testing the effects of policy diffusion on Basel II implementation across the world .......................................................... 12 1.3.3 Six country case studies: Unpacking the process of policy diffusion ... 16 1.4 Chapter plans and summary of main arguments ................................... 20 Chapter Two Literature Review 2.1 Introduction ................................................................................................ 27 2.2 The Basel Committee, Basel I and Basel II ............................................. 28 2.2.1 The Basel Committee ............................................................................ 28 2.2.2 Basel I ................................................................................................... 31 2.2.3 Basel II .................................................................................................. 32 2.3 The empirical literature on the Basel Accords ........................................ 37 2.3.1 The empirical literature on Basel I ....................................................... 38 2.3.2 The empirical literature on Basel II ...................................................... 47 2.4 The theoretical literature: Explaining compliance with international norms ........................................................................................................... 49 2.4.1 The state-based enforcement approach ................................................. 49 2.4.2 The market-based approach .................................................................. 50 2.4.3 The managerial approach ...................................................................... 51 2.4.4 Functional institutionalism ................................................................... 53 2.4.5 Role of ideas ......................................................................................... 54 2.4.6 Domestic-level explanations ................................................................. 55 2.5 The policy diffusion literature .................................................................. 58 2.5.1 Policy diffusion: definitions and features ............................................. 58 2.5.2 Four policy diffusion mechanisms: How do policies diffuse? ............. 59 2.5.3 Strengths and weaknesses of the policy diffusion literature ................. 66 2.6 Conclusion .................................................................................................. 71 Chapter Three Basel II implementation at the global level: A quantitative analysis of Basel II implementation and its diffusion across 150 countries 3.1 Introduction ................................................................................................ 73 3.2 A global overview of Basel II implementation ........................................ 74 3.2.1 Measuring Basel II implementation across 150 countries .................... 74 3.2.2 The state of Basel II implementation across the world ......................... 79 3.3 Testing the effects of policy diffusion on Basel II implementation ........ 86 3.3.1 The Model ............................................................................................. 86 3.3.2 The dependent variable ......................................................................... 88 3.3.3 Policy diffusion variables ..................................................................... 89 3.3.4 Control variables ................................................................................... 94 3.4 Findings ..................................................................................................... 102 3.4.1 The effects of policy diffusion ............................................................ 104 3.4.2 The effects of control variables .......................................................... 107 3.5 Limitations of the quantitative analysis ................................................. 110 3.6 Conclusion ................................................................................................ 113 Chapter Four Case study design and case selection 4.1 Introduction .............................................................................................. 115 4.2 Case study design and methods .............................................................. 116 4.2.1 The within-case method of process tracing ........................................ 117 4.2.2 The cross-case method of controlled comparison ............................... 120 4.2.3 Case selection procedure ...................................................................