Basel II: A Post-Crisis Post-Mortem

• Author: Jeffery Atik
• Position: Professor of Law and Sayre Macneil Fellow, Loyola Law School
• Pages: 731-759

Basel II: A Post-Crisis Post-Mortem

Jeffery Atik*

I. INTRODUCTION ......................................................................................... 731

II. THE MISPLACED HOPES OF BASEL II ...................................................... 735

A. Introduction ....................................................................................... 735

B. Why National Capital Adequacy Standards? ................................. 737

C. Why Harmonize Capital Adequacy Standards? .............................. 740

D. Competitiveness (Level Playing Field) Concerns ............................. 743

III. DIAGNOSTICS ......................................................................................... 746

IV. BASEL II WEAKNESSES .......................................................................... 748

A. False Sense of Security ..................................................................... 748

B. Reliance on Rating Agencies............................................................. 750

C. Cyclicality .......................................................................................... 751

V. FUTURE ROLE OF HARMONIZED CAPITAL ADEQUACY STANDARDS ......... 754

A. A Return to Basel .............................................................................. 754

B. Parallel Responses ............................................................................ 757

VI. CONCLUSION .......................................................................................... 758

I. INTRODUCTION

The outbreak of the Global Financial Cr isis (“Crisis”) coincided with

the programmed phase-in of the second-generation Basel1

* Professor of Law and Sayre Macneil Fellow, Loyola Law School, Los Angeles. This article was

developed for the Global Financial Crisis symposium sponsored by TRANSNATIONAL LAW AND

CONTEMPORARY PROBLEMS, held on Feb. 20, 2009, at the University o f Iowa College of Law. An

earlier version of this Article was presented at International Law Weekend, sponsored by the

American Branch of the International Law Association held in New York City, on Oct. 17, 2008. I

am grateful for the helpful comments of Timothy Canova, Michael Guttentag, Heidi Mandanis

Schooner, Lauren Willis and David Zaring and for the contributions of reference librarian Laura

Cadra, and research assistants Lawrence Keller and Michael Boardman.

internationally

1 Basel, Switzerland is home of the Bank for International Settlements [BIS], which has served

as the central forum for international cooperation in banking regulation. The 1988 Basel Accord

was the first effort to systematically harmonize bank capital requirements. Weaknesses and

gaps in the 1988 Basel Accord lead to the promulgation of Basel II. The BIS ho sts the Basel

Committee on Banking Supervision, the body that drafts and supervises Basel II.

732 TRANSNATIONAL LAW & CONTEMPORARY PR OBLEMS [Vol. 19:731

harmonized capital adequacy regime (“Basel I I”). The Basel II framework2

built upon the 1988 Basel Accord rules but gr eatly increased their complexity

and, it was hoped, their accuracy.3 The Basel Accord provided a unitary

capital requirement for each ide ntified asset class—such as commercial

loans, mortgages, and sovereign debt.4 In contrast, Basel II rules generate a

range of values for regulatory capital depending on the credit worthiness of

the borrower, among other factors.5 For the most sophisticated cla ss of banks,

Basel II permits a customized assessment o f a bank’s capital for holding

particular assets based on that ban k’s own assessment of the riskine ss of

these assets.6 B asel II thus replaces a set of values of mandated capital

(expressed as a percentage of the value of an asset under the 1988 Basel

Accord) with a range of permitted methodologies for determining the amount

of required capital. Basel II also deepens harmo nized regulation by extending

capital requirements to additional financial products, such as complex

derivatives and off-balance sheet items, and br oadens regulation by imposing

new operational and transparency requirements on banks.7 Basel II

transformed the 1988 Basel Accord’s pr imitive capital adequacy rules into a

more general risk management regime. In so do ing, it largely abandoned the

one-size-fits-all rule for more elastic, institution-specific requirements.8

2 BASEL COMM. ON BANKING SUPERVISION, INTERNATIONAL CONVERGENCE OF CAPITAL

MEASUREMENT AND CAPITAL STANDARDS: A REVISED FRAMEWORK, COMPREHENSIVE VERS ION

(2006) [hereinafter BASEL COMM. ON BANKING SUPERVISION, INTERNATIONAL CONVERGENCE OF

CAPITAL MEASUREMENT, COMPREHENSIVE VERSION], available at

http://www.bis.org/publ/bcbs128.pdf?noframes=1. The Basel II Framework includes the Jun e

2004 Basel II Framework, unrevised elements of the 1988 Basel Accord, the 1996 Amendment to

the Capital Accord to incorporate market risks, and the July 2005 paper on the application of

Basel II to trading activities and the treatment of double default effects. Id.

3 David Zaring notes that “the contrast between the first Basel Accord on capital adequacy,

which was concluded in secret by the Basel Committee in 1988 and released in a twelve-page

document, and Basel II, which was put through most of a decade’ s worth of comment by

hundreds of interested individuals and institutions and resulted in a correspondingly long and

detailed regulatory product.” David Zaring, Three Challenges for Regulatory Net works, 43 INT’L

LAW. 211, 212 (2009) (citing David Zaring, Informal Procedure, Hard and Soft, in International

Administration, 5 CHI. J. INT’L L. 547, 572–80 (2005)).

4 BASEL COMM. ON BANKING SUPERVISION, INTERNATIONAL CONVERGENCE OF CAPITAL

MEASUREMENT AND CAPITAL STANDARDS 17–18 (1998).

5 See, e.g., BASEL COMM. ON BAN KING SUPERVISION, INTERNATIONAL CONVERGENCE OF CAPITAL

MEASUREMENT, COMPREHENSIVE VERSION, supra note 2, at 19 (weighting sovereign debt

according to credit worthiness as opposed to a fla t rate assigned under Basel I); Susan Burhouse

et al., Basel and the Evolution of Capital Regulation: Moving Fo rward, Looking Back, FED.

DEPOSIT INS. CORP. (Jan. 14, 2003), http://www.fdic.gov/bank/analytical/fyi/2003/011403fyi.html.

6 BASEL COMM. ON BANKING SUPERVISION, INTERNATIONAL CONVERGENCE OF CAPITAL

MEASUREMENT, COMPREHENSIVE VERSION, supra note 2, at 52.

7 Id. at 1–4.

8 Under the 1988 Basel Accord, the general level of required capital was 8 percent. Thus, a

portfolio of $100 million in commercial loans would require the maintenance of $8 million of

regulatory capital. The capital requirement was not sensitive to the credit worthiness of the

borrowers, nor to the concentration or granularity of risk. Under Basel II’s methodologies, banks

would take these factors into account either by weighing capital according to the credit ratings of