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October 15, 2002

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Basel Capital Accord Should Be Scrapped, Says Cato Finance Expert
Proposed `Basel II' agreement would make financial system less, not more, stable

WASHINGTON -- Revisions to the Basel Accord, a 1988 accord that requires banks to hold the same percentage of capital in reserve, will not make the financial system any more stable and should be scrapped, according to a new Cato Institute report.

A one-size-fits-all standard of international banking regulation is "neither necessary nor desirable to promote the soundness of the financial system," argues Financial Services Analyst L. Jacobo Rodríguez in "International Banking Regulation: Where's the Market Discipline in Basel II?"

In 1988, central bank governors of the G-10 industrialized countries approved the Basel Capital Accord, the first attempt at worldwide regulation of the banking industry, which requires that banks meet a minimum capital ratio of at least 8 percent of total risk-weighted assets.

The Basel Committee on Banking Supervision is currently working on a major revision of the accord, known as "Basel II," but Rodríguez says the new proposal is complex and vague, and is likely to stifle market innovation in risk-management practices. The changes also give regulators a high level of discretion to determine whether banks are following the rules.

"The new proposal still maintains the 1988 accord's flawed approach to measuring risk, leaves the definition of regulatory capital unchanged, adds a new capital charge for so-called operational risk and, most important, does not rely enough on market discipline," writes Rodríguez. "The main problem with international harmonization of banking regulations is that they prevent competition among different regulatory regimes and innovation in those regimes."

Rodríguez argues that Basel II could also make the financial system less stable as the agreement would still encourage banks to engage in regulatory capital arbitrage. He adds that as with the current accord, Basel II doesn't take into consideration account portfolio effects that can greatly reduce risk.

"In short, a system that relies more on market discipline, innovation, and competition will achieve" safety of the international financial system better than either the old or new Basel Accord, Rodríguez argues.

"International Banking Regulation: Where's the Market Discipline in Basel II?"