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

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In 1988 the Basel Committee on BankingSupervision completed the Basel Capital Accord,which set risk-weighted minimum capital standardsfor internationally active banks. The accord,which has been adopted by more than 100 countries,seeks to strengthen the banking system andlevel the playing field. It is not clear, however, thatit achieves either of those goals or that the lattergoal is even desirable.

Indeed, there is broad agreement among regulators,market participants, and academics thatthe accord's risk classification scheme has madethe international financial system less stable, notmore, while failing to level the playing field. Theaccord has encouraged banks to assume greatereconomic risk without a commensurate increasein capital. It has also encouraged banks to makeshort-term loans to other banks, which contributedto the Asian crisis in 1997-98.

The Basel Committee has attempted to fine-tunethe accord over the years. Since 1999, thecommittee has been working on a major revisionof the accord in an effort to "align capital regulatoryrequirements more closely with the underlyingrisks." The result, Basel II, is a work inprogress that is expected to be finalized by theend of 2003 and fully implemented by the end of2006.

Basel II is based on three mutually reinforcingpillars: capital requirements, supervisory review,and market discipline. Risk-based capital requirementsare the major focus of the accord. Theaccord will allow some banks to use their internalrisk-management models to determine capitalcosts, but that option could turn into a regulatorynightmare, even in industrialized countries.Worse yet, the accord's overly prescriptive andcomplex approach could end up stifling market-basedinnovation in risk management practices.

Consequently, a system that relies more oncompetition among different national regulatoryregimes is preferable to the current approach.At the national level, the trend should be towardregulatory simplicity. If there are to be minimumcapital standards, necessitated by government-sponsoreddeposit insurance systems, a simplecapital leverage rule with no risk weights wouldsuffice, especially if there is an emphasis on marketdiscipline through a subordinated-debtrequirement and disclosure. Countries without apublic deposit insurance system should movetoward a system of financial laissez-faire.