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Banking on Basel

The Future of International Financial RegulationDaniel K.Tarullo October 2008 256 pp. ISBN 978-0-88132-423-5 $26.95

Te turmoil in nancial markets that resulted rom the 2007 subprime mortgage crisis in the United States

has revealed massive ailures o risk management by nancial institutions and o regulation and supervision o

these institutions by government authorities. Would these institutions have been sounder i the 2004 Revised

Framework on International Convergence o Capital Measurement and Capital Standards (Basel II accord) had

already been ully implemented? Te objective o Basel IInegotiated between 1999 and 2004was to produce

the rules by which minimum capital requirements would be set under domestic bank regulatory policy in each

country represented on the Basel Committee on Banking Supervision. Te exercise resulted in a dramatic change

in capital regulation o large banks: Basel II permits large, sophisticated banks to base their minimum capital

requirements on inputs rom their own internal credit risk models through the use o either a oundational or

advanced internal ratingsbased approach.

Te Basel Committee itsel implicitly acknowledged in spring 2008 that the revised ramework would not

have been adequate to contain the risks exposed by the subprime crisis and needed strengthening. Tis crisis has

highlighted two more basic questions about Basel II: One, is the method o capital regulation incorporated in the

revised ramework undamentally misguided? wo, even i the basic Basel II approach has promise as a paradigm

or domestic regulation, is the eort at extensive international harmonization o capital rules and supervisory

practice useul and appropriate?

In this book, Daniel arullo provides extended and, on balance, reasonably negative answers to both ques-

tions. His criticisms o the Basel II approach relate directly to the onset o the nancial crisis last year and have

broader implications or reorming the regulation o large nancial institutions. He rst assesses the eectiveness

o Basel II as a model or domestic capital regulation, ocusing on the advanced internal ratingsbased (A-IRB)

approachthe undamental innovation o Basel II that most large multinational banks will adopt to calculate

capital requirements.

While arullo lauds the two core aims o Basel IIto align capital requirements more closely with the risks

actually assumed by banks and to continuously prompt banks to adopt the best-available risk management prac-

ticesas being absolutely desirable, he questions the potential o the Basel II A-IRB proposal to achieve those

aims. He examines the potential advantages o the IRB approachesgreater risk sensitivity, the prod given to

large and complex banks to improve their internal risk management systems, and the creation o a common

language o risk proles to assist supervisors and market actors in their evaluation o banksand concludes that

numerous problems, including the unproven character o internal ratings assessments and the administrative di-

culties in monitoring bank implementation o IRB requirements, raise signicant doubts that these advantages

will be realized.

At the same time the A-IRB model is enormously complex, ull o opportunities or bank and national su-

pervisory discretion, and only indirectly related to the state-o-the-art risk evaluation and management systems

actually used by banks or business purposes. Te latter eature may present an opportunity or a dierent orm o

regulatory arbitrageone based on shaping the IRB process or regulatory purposes. Tus, there is a strong pos-

sibility that the Basel II paradigm might eventually produce the worst o both worldsa highly complicated and

impenetrable process (except perhaps or a handul o people in the banks and regulatory agencies) or calculating

capital but one that nonetheless ails to achieve high levels o actual risk sensitivity.

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Te shortcomings o the IRB method as the oundation or domestic regulation will only be magnied at

the international level. arullo expresses signicant doubts about the efcacy o this approach in the many coun-

tries in which there is no tradition o extensive on-site supervision o risk management systems. Moreover, there

are substantial monitoring problems or regulators attempting to conrm that their counterparts in other Basel

Committee countries have successully validated and supervised the internal ratings models o banks in those

countries.arullo then considers alternatives to Basel IIboth substitute paradigms or domestic capital regulation

that could be incorporated into an international arrangement and dierent approaches to international coopera-

tion. In the rst category are three options: retaining a standardized risk-based capital approach, substituting

market-based discipline or regulatory capital requirements, and instituting a precommitment approach to

regulatory capital. Te second category presents two airly dramatic possibilities: eliminating international eorts

to harmonize capital regulation andperhaps even more controversialmoving beyond harmonized national

regulation toward direct regulation o internationally active banks by a supranational authority.

However, none o these alternatives presents either a substantive approach or a mode o international coop-

eration preerable to Basel II, at least not at present. But elements o several o these alternatives may be planted

rmly onto the modied Basel II suggested in the nal chapter, where arullo makes ve recommendations with

respect to capital regulation:

Accelerate work on redefning capital. Te Basel Committee has long recognized the need to revisit the de-

nition o capital. Although the committee decided not to address this topic in Basel II, it has included the

denition o capital as part o its post-Basel II work program. Tus this rst recommendation is endorse-

ment o the committees agenda, rather than a call or a change o course. However, the rather deliberate pace

with which the committee has begun this review should be accelerated. Te allout rom the subprime crisis

has again underscored the importance o ensuring that regulatory capital truly possesses the stable buering

characteristics that should dene core capital.

Adopt a simple leverage ratio requirement, such as that included in US law. Tis admittedly blunt measure o

capital is highly transparent and not subject to easy evasion. It provides a kind o regulatory saety net, even

though it is not highly risk sensitive. Te committee should also consider implementing a minimum ratioo capital to income in order to take account o o-balance-sheet bank activities in a similarly blunt but

transparent ashion.

Institute a requirement that complex, internationally active banks issue subordinated debt with specifc, harmo-

nized characteristics. While not an assured outcome, there is a reasonable chance that the market pricing o

this debt would serve a canary in a coal mine role in alerting supervisors to potential problems at a bank.

Remove the detailed rules o pillar 1 (minimum capital rules) in avor o augmenting the current pillar 2 prin-

ciples, which guide national agencies supervision o complex, internationally active fnancial institutions. Tese

principles would include (1) some orm o risk-based capital requirement, (2) a requirement that banks

maintain a credit risk model or use in calculating internal capital requirements and an operational risk sys-

tem, and (3) more detailed expectations or supervisory intervention when capital requirements all below

minimum levels. National implementation o these principles would be subject to regular and sophisticatedpeer review. While less detail is needed on the minimum capital rules, more detail would be needed on the

inormation that banks adopting the internal ratingsbased approach would have to disclose.

Strengthen the monitoring role o the Basel Committee. Tis should include regular and substantially more

robust peer review o national regulatory activity to implement Basel rules and principles. Te committee

should regularly report on bank capital positions and capital supervision. Finally, and most importantly, the

committee should establish a special inspection unita supranational team o experts that conducts in-bank

validations o the credit risk models used by internationally active banks in the Basel Committee countries.

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To learn more about this book, visithttp://bookstore.petersoninstitute.org/book-store/4235.html.

To learn more about Daniel Tarullo, visithttp://www.petersoninstitute.org/staf/author_bio.cm?author_

id=567.

Tis unit would serve both to disseminate expertise among the various national supervisors and to provide

some monitoring o their own validation o their banks models and attendant risk management.

In closing, arullo considers the degree to which Basel II oers a promising new mode o international eco-

nomic cooperation. Te Basel Committees work in general, and Basel II in particular, is an example o a system

o structured international activities intended to make national laws and regulations more congruent or eective,implemented by national government ofcials with domestic regulatory responsibility. Te question has arisen,

should this model o international governance be emulated by other ofcials wrestling with the challenge o regu-

lating global economic activity in a world o nation-states? Some have even speculated that this model could be

an alternative to conventional trade agreements, at least where the aim is to remove barriers to trade created by

signicant divergence in national regulatory practices.

In light o his assessment o Basel II, arullo is cautious about drawing conclusions on the desirability o

taking a similar approach in other regulatory areas, nancial and nonnancial. His emphasis on the interac-

tion among a substantive regulatory approach, international institutional capabilities, and prevailing political

economy renders such a conclusion highly specic to an issue area. However, he does explain how attention to

each o these actors, inormed by the Basel II experience, useully illuminates analysis o the potential utility o

this model.

http://bookstore.petersoninstitute.org/book-store/4235.htmlhttp://www.petersoninstitute.org/staff/author_bio.cfm?author_id=567http://www.petersoninstitute.org/staff/author_bio.cfm?author_id=567http://www.petersoninstitute.org/staff/author_bio.cfm?author_id=567http://www.petersoninstitute.org/staff/author_bio.cfm?author_id=567http://bookstore.petersoninstitute.org/book-store/4235.html