The turmoil in financial markets that resulted from the 2007 subprime mortgage crisis in the United States indicates the need to dramatically transform regulation and supervision of financial institutions. Would these institutions have been sounder if the 2004 Revised Framework on International Convergence of Capital Measurement and Capital Standards (Basel II accord)-negotiated between 1999 and 2004-had already been fully implemented? Basel II represents a dramatic change in capital regulation of large banks in the countries represented on the Basel Committee on Banking Supervision: Its internal ratings-based approaches to capital regulation will allow large banks to use their own credit risk models to set minimum capital requirements. The Basel Committee itself implicitly acknowledged in spring 2008 that the revised framework would not have been adequate to contain the risks exposed by the subprime crisis and needed strengthening. This crisis has highlighted two more basic questions about Basel II: One, is the method of capital regulation incorporated in the revised framework fundamentally misguided? Two, even if the basic Basel II approach has promise as a paradigm for domestic regulation, is the effort at extensive international harmonization of capital rules and supervisory practice useful and appropriate? This book provides the answers. It evaluates Basel II as a bank regulatory paradigm and as an international arrangement, considers some possible alternatives, and recommends significant changes in the arrangement.
. . . can be read and appreciated by the non-economist who wants to understand how global efforts to keep up with speculative bank maneuvers failed as dismally as domestic regulation did, and what should be done now.
Daniel K. Tarullo is a professor of law at Georgetown University Law Center. He has taught at Harvard Law School (2005) and Princeton University (2004). He held several senior positions in the Clinton administration, ultimately as assistant to the president for international economic policy, responsible for coordinating the international economic policy of the administration. From 1993 until early 1996, he was assistant secretary of state for economic and business affairs. In March 1995, President Clinton appointed Tarullo as his personal representative to the G-7/G-8 group of industrialized nations, with responsibility for coordinating US positions for the annual leaders' summits. He continued this assignment after he moved to the White House, participating in four summits. He serves on the editorial advisory board of the International Economy and the Advisory Committee of Transparency International.
Preface ix Acknowledgments xiii
1 Introduction 1 Summary of Argument 5 Outline of the Book 7 A Note on Timing 13
2 Role of Capital Regulation 15 Rationale for Capital Regulation 16 Evolving Role of Capital Regulation 29 Conclusion 42
3 Basel I 45 Origins of the Accord 45 Elements of the Accord 54 Assessment of Basel I 64 Conclusion 84
4 Negotiating Basel II 87 Launching the Review Process 87 Curious Release of the First Consultative Paper 93 Shift to an Internal Ratings-Based Approach 104 Process of Continuous Revision 113 Revised Framework 122 Responding to the Subprime Crisis 131 Conclusion 135
5 Assessing Basel II as a Regulatory Model 139 Do Regulatory Capital Requirements Matter? 141 Potential Benefits of the Advanced Internal Ratings-Based Model 150 Potential Negative Effects of the Advanced Internal Ratings-Based Model 177 Conclusion 189 Appendix 5A 191
6 Basel II as an International Arrangement 195 Safety and Soundness 197 Competitive Equality 209 Cooperative Supervision of Multinational Banks 214 Indirect Benefits 222 Conclusion 223
7 Alternatives to Basel II 225 Retaining a Standardized Approach 226 Market Discipline: Mandatory Subordinated Debt 231 Precommitment Approach 246 Establishing an International Supervisory Role 251 Eliminating International Cooperation on Safety and Soundness 255 Conclusion 256
8 Conclusions and Recommendations 259 Recommendations 262 Implications Beyond Capital Regulation 279 References 285 Index 299 Tables Table 2.1 US bank capital ratios, 1970-81 32 Table 3.1 The world's 10 largest banks, 1974, 1981, and 1988 47 Table 3.2 Capital ratios of selected large banks, 1981 and 1988 48 Table 3.3 Credit conversion factors foroff-balance-sheet items in Basel I 60 Table 3.4 Capital charges for debt instrument market risks in the Basel Committee 1993 proposal 62