Policy Analysis No. 681

Capital Inadequacies: The Dismal Failure of the Basel Regime of Bank Capital Regulation

By Kevin Dowd, Martin Hutchinson, Jimi M. Hinchliffe & Simon Ashby
July 29, 2011

The Basel regime is an international system of capital adequacy regulation designed to strengthen banks’ financial health and the safety and soundness of the financial system as a whole. It originated with the 1988 Basel Accord, now known as Basel I, and was then overhauled. Basel II had still not been implemented in the United States when the financial crisis struck, and in the wake of the banking system collapse, regulators rushed out Basel III.

In this paper, we provide a reassessment of the Basel regime and focus on its most ambitious feature: the principle of “risk-based regulation.” The Basel system suffers from three fundamental weaknesses: first, financial risk modeling provides the flimsiest basis for any system of regulatory capital requirements. The second weakness consists of the incentives it creates for regulatory arbitrage. The third weakness is regulatory capture.

The Basel regime is powerless against the endemic incentives to excessive risk taking that permeate the modern financial system, particularly those associated with government-subsidized risk taking. The financial system can be fixed, but it requires radical reform, including the abolition of central banking and deposit insurance, the repudiation of “too big to fail,” and reforms to extend the personal liability of key decisionmakers — in effect, reverting back to a system similar to that which existed a century ago.

The Basel system provides a textbook example of the dangers of regulatory empire building and regulatory capture, and the underlying problem it addresses — how to strengthen the banking system — can only be solved by restoring appropriate incentives for those involved.

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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.