Basel II: A Contracting Perspective

Edward J. Kane

Received: 14 November 2006 /Revised: 28 June 2007 /Accepted: 12 July 2007 /Published online: 27 September 2007# Springer Science + Business Media, LLC 2007

Abstract Financial safety nets are incomplete social contracts that assign responsibility tovarious economic sectors for preventing, detecting, and paying for potentially cripplinglosses at financial institutions. Basel II forces signatory countries to reopen safety-netbargaining across affected sectors. This paper uses the theories of incomplete contracts andsequential bargaining to interpret the Basel Accords as a framework for endlesslyrenegotiating minimal duties and standards of safety-net management across the communityof nations. Modelling the stakes and stakeholders represented by different regulators helpsus to understand that inconsistencies were bound to exist in prior understandings about therange of sectoral effects that the 2004 Basel II agreement might produce. The analysis seeksto explain why, in the U.S., attempting to resolve what turned out to be intolerableinconsistencies spawned an embarrassingly fractious debate and repeatedly pushed backBasel II’s scheduled implementation.

Keywords Basel II . sequential contracting . financial safety nets . financial regulation .

incomplete contracts

This paper uses the concepts of regulatory arbitrage, sequential decision-making, andincomplete contracting to explain why Basel II has so many loose ends and why U.S. effortsto implement Basel II have been roiled by controversy and delays. Perceived as a forum forre-regulation, the Basel Committee on Banking Supervision (BCBS) enlists central banks andsupervisory authorities (“regulators”) from financial-center countries to work together tocontrol regulatory arbitrage and to promote financial integration and better risk management(Barr and Miller 2006; Pattison 2006). But the success of BCBS negotiations is limited bythe largely nonbinding nature of the agreements its members ratify and by divergences inthe interests and political clout of the economic sectors BCBS conferees represent.

For this reason, the original 1988 BCBS Accord (Basel I) and its successor Accord(Basel II) are better viewed as a collection of strategic guidelines than as systems of rules.

J Finan Serv Res (2007) 32:39–53DOI 10.1007/s10693-007-0020-5

E. J. Kane (*)Department of Finance, Boston College, 140 Commonwealth Avenue, Chestnut Hill, MA 02467, USAe-mail: kaneeb@bc.edu

The agreements neither spell out explicitly the quasi-fiduciary duties that banking regulatorsowe to their counterparts in other countries nor explain how such duties are to be enforcedwhen they conflict with the interests of stakeholders to whom they are politically accountable.

The Accord fails to include clauses that could make regulators in individual countriesdirectly accountable to one another for breaching the standards the BCBS promulgates.Additional weaknesses exist both in the methods used to test Basel II arrangements for theireffects on the cross-country and within-country distributions of financial-institution risk andregulatory capital and in themethods that were originally used to set the 4-percent and 8-percentcapital standards.

Section 1 views the contracting process as unfolding in three phases and underscores thenontransparency of pre-Basel and post-Basel dealmaking between governmental andindustry stakeholders in individual countries (on the one hand) and the negotiating teamsthat participated directly in the Basel contracting process (on the other). To minimizecontracting costs, it is optimal in each country prior to letting agents undertake cross-country negotiations for interested economic sectors—as principals—to exchange under-standings with their particular negotiating team. Each understanding is meant to constrainthe concessions that the particular sector may be asked to absorb. Because inconsistenciesin sectoral understandings are unavoidable, individual-country negotiators must insist thatcross-country agreements incorporate design options (called “national adaptions andconcretions” by Kette 2006) that leave contract terms incomplete. National regulators needthese options to placate principals that might feel short-changed (or even betrayed) by theinternational agreement. The hope was that these options could be easily employed to craftsubdeals that would be mutually acceptable to competing interests in their home counties.However, to the extent that pre-Basel understandings made logically inconsistent promisesto different U.S. constituencies, the discounted value of contracting costs was notminimized. That disappointed parties were bound to regard themselves as shortchangedhelps to explain the gaps in regulatory accountability the Accord accommodates and theprotracted and sometimes waspish nature of post-Basel negotiations.

Section 2 describes the major options conveyed to banks and regulators by the Basel IIagreement. Although negotiators prefer not to acknowledge this, adherence to cross-countryguidelines will be tempered by the force of contrary domestic pressures and by the severityof financial troubles that different economies experience. Government responses to politicaland crisis pressures in the past indicate that clientele, career, and bureaucratic interests tendto outweigh international considerations. In tough times, whatever concern individualregulators might have for preserving or enhancing their standing within the internationalregulatory community (emphasized, e.g., in Whitehead 2006) will not matter very much.

Section 3 proposes a simplified nonmathematical model that can explain howinconsistencies in the goals and predeal understandings of interested domestic sectors haveprolonged post-Basel bargaining in the United States. Section 4 identifies some possiblepaths for resolving contradictory concerns. If delays and other contracting costs are to beminimized, the path of least resistance would be for regulators to focus on “competitiveequality” and to abandon efforts to link reductions in regulatory capital to the extent towhich an institution actually improves its risk management.

1 Viewing the Basel Accord as an Incomplete Multilevel Contract

The fairness and efficiency of the explicit terms of the contract (or “deal”) constructedin Basel fall short of the Basel Committee’s stated goals of eliminating perceived

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cross-country competitive inequalities by promoting comprehensive risk management andconsistency in international regulatory standards. However, just as our view of a forestmight be blocked by its trees, the redeeming social value of Basel negotiations as amultilevel and intertemporal strategy-making process can be obscured by focusing only ondifficulties observed in particular outcomes.

Marking off particular sequences of negotiations and assigning them a discrete numeralmisses the essential continuity and inconclusiveness of the patch-by-patch contractingprocess. This paper conceives of negotiation outcomes at any date T as “Basel (T)”: thevalue of an integral equation whose kernel “B(t)dt” is driven by the goals that stakeholders(Sik) in each of m different countries(k=1,..., m) hope to achieve and the resources (Rik)they plan to invest in lobbying for these goals.

Figure 1 identifies the so-called “pillars” of the Basel II Accord. Although the diagramdepicts the pillars to be of equal height and thickness, especially with respect to risks (suchas interest-rate risk in the banking book) that are not part of Pillar 1, the second and thirdpillars have been hollowed out by lobbying efforts and globally may not support muchweight. Until and unless the incentives of individual-country banks and regulators are betteraligned with those of world citizens, Pillar 2 options may be too feeble, too opaque, and tooriddled with conflict from regulatory competition to provide reliable reinforcement for theother pillars.

It is important to recognize that Basel II asks rather than forces national regulators tobehave in globally appropriate ways. Realistically, it frames a renegotiation game that bindsofficials only to monitor and to think about the global consequences of actions taken by theinstitutions they regulate. The outcome of this game is apt to prove more favorable for somecountries than for others.

As mutable multinational agreements, the contracts the BCBS writes establish anintertemporal structure within which to renegotiate complicated multiparty relationships.They are not treaties because signatories represent regulatory agencies rather than sovereigngovernments. Individual negotiators and the people they report to are short-lived agents fornumerous long-lived principals. The principals are constituencies that are modelled here asconcerned sectors of each agent’s home economy. Each tentative contract that agentsconsider in Basel promises to pass a series of rights and obligations through to thenegotiators’ home constituencies.

Figure 1 Metaphorical represen-tation of the pillars supportingbasel

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Within a country’s government, financial regulators are expected simultaneously tosupervise and to represent conflicting constituencies. Contracting theory presupposes thatcosts of reading and writing contracts are minimized. To minimize the total costs ofnegotiating with foreign and domestic constituencies, Basel II negotiations proceed in threephases. Prior to conducting dealmaking sessions in Basel, each negotiator mustprenegotiate hard and soft constraints on its ability to accept deals that might disadvantageits politically powerful domestic principals. It is useful to think of these restrictions aspredeal understandings. An understanding is neither as sharply worded nor as enforceableas a formal contract. To the extent that understandings are not made public, particularconstituencies can interpret their understandings in ways that might well be inconsistentwith understandings furnished to one or more other sectors. Moreover, as parties with apersonal and organizational interest in the game, negotiators may believe it is advantageousto accept soft constraints on key issues that they plan subsequently to violate.

Most twists and turns in the terms of Basel II promised to reallocate the costs andbenefits generated by individual-country safety nets. Hence, each time negotiators in Baselmaterially revised cross-country guidelines to meet objections raised by agents forparticular constituencies, negotiators returning from Basel had to describe the changes totheir national constituencies and reconcile them with prior understandings. Third-phaserecontracting occurs separately with other concerned officials within a given governmentand with interested sectoral constituencies. In this phase, negotiators are apt to paint theirneed to renege on predeal agreements as if they were necessitated by what they learned inBasel about the constraints faced or imposed by foreign negotiators.

Within countries, individual financial institutions hoped that Basel II would redistributesafety-net costs and benefits among competing governmental and sectoral interests inadvantageous ways. For U.S. regulators, the stated purpose of the negotiations was toenhance financial stability and improve risk management. As the negotiations wore on,negotiators from the European Union seemed more interested in using Basel II to promoteregulatory integration. The European Parliament apparently wanted to establish a uniformframework for internationally active European banking groups without burdening regionalbanks operating mainly in national markets.

Like bodily health, stability cannot be traded from one party to another. It is whatMaskin and Tirole (1999) and Hart and Moore (1999) characterize as an “undescribable”variable. Negotiators assume stability can be proxied and that the proxy can be defined asthe absence of worrisome forms of financial disorder. More concretely, Basel II presupposesthat changes in stability can be represented by obverse movements in the probability andloss severity of the particular disorders (such as economic insolvencies and operationalbreakdowns) that adjustments in the Accord seek to hold at bay. Implicitly, every draft ofthe second Basel Accord embodied a projection of how selected control variables(especially variously defined capital ratios) affect the components of a larger-dimensionalspace of global welfare. The implicit projection that Basel II will reduce individual-bank orsystemic risks is largely hypothetical. Empirical support consists mainly of qualitativeinferences about how widely recognized forms of risk-taking, risk transfer, and risk supportundertaken by individual financial institutions or their regulators ought in theory to affect asubset of default probabilities and loss severities in question.

1.1 Incompleteness

In a world of changing governments, it is impossible for one generation of regulators tocraft a contract that can firmly precommit their successors. In a world of changing financial

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technology, the list of contractable triggers of instability can never be completely described.For both reasons, explicit contractual rights and duties must have slack built into them. Inprinciple, the loose ends are intended to allow individual-country regulators enoughflexibility to expand their catalogue of approved and disapproved behaviors over time asunforseeable circumstances dictate. In practice, loose ends are reciprocal options that allowsafety-net subsidies to be distributed nontransparently to private financial interests.

From this practical point of view, the most disturbing loose ends concern Basel II’streatment of large and complex banking organizations. Regulators need the vision to seethrough the accounting numbers to the true condition of the institutions they supervise and theincentives to respond appropriately to what they see. A bank’s opacity, political clout, andorganizational ability to arbitrage regulatory systems increase both with its size and with itscomplexity. Even within countries, clever rogues or desperate managers can book particularloss exposures in ways that are too opaque for regulators to monitor and discipline themeffectively. It is possible that data-collection and risk-measurement standards under Basel IIare so loosely specified that close adherence to them in making business decisions cansupport an increase rather than a decrease in insolvency risk at many banks. To lessen thisdanger, capital requirements under Basel II ought to incorporate a measure of opacity andimpose an additional opacity-related capital requirement to account for the opportunities thatlarge and complex banks have to relocate exposures across instruments and borders to avoiddetection and/or to lessen their exposure to Pillar 2 discipline.

A good contract is easy to understand and creates incentives for its fulfillment. From theperspective of the individual constituencies, hard-to-decode loose ends are options that canbe characterized as opportunities for regulators to renegotiate or reinterpret the agreementwhen unforeseen or unspecified contingencies arise (Ben-Shahar 2004; Foss 1996; Hart andMoore 1999; Hart 2007; Macleod 2006). Retaining flexibility is a good thing, but grantingflexibility to a contractual counterparty authorizes it to act adversely to one’s interests. Nomatter how well-intentioned, any contract as complex as Basel II must be feared(Rasmussen 2001). The remedies for this fear are trust and independent analytic ability,but neither of these remedies is costless for an individual agent or stakeholder to establish.

An agent builds trust by making itself accountable for results. An agent buildsaccountability (A) in three ways: by making its actions and motives transparent, by bondingits commitment to the principal’s interests, and by giving the principal the power to deteropportunistic behavior. Bonus clauses and reputational costs are forms of bonding. Anopportunistic agent’s exposure to retribution from the principal has a deterrent effect.

For every stakeholder (Sj, j=1, ..., n), the value of each imbedded option k (Ojk, k=1, ...,mj) depends on the degree to which stakeholder j can reasonably trust the option’scounterparties to behave competently and nonopportunistically. At Basel, agents failed tobond the Pillar II activities of foreign regulators to the goal of financial stability or tonegotiate the kinds of inter-regulator and public disclosures that would reliably buttressmarket discipline by allowing independent experts to assess the quality of Pillar II activity.

U.S. negotiating teams are not personally accountable to voter-taxpayers for theseomissions. Members were allowed to renegotiate Basel I without direct Congressionalinvolvement or approval. What accountability exists comes nontransparently from post-Baselnegotiations with other U.S. regulators and industry groups. Ironically, these groups’ abilityto win new concessions traces to their option to lobby Congressional committees to weigh inon their side.

As post-Basel dealmaking evolves, the net value of an uninvolved sector j’s collection ofimplicit options Oj ¼

Pmj

k¼1Ojk

� �

are unlikely to be fully counterbalanced by the value of the netbenefits or burdens conveyed by the explicit and enforceable terms of the contract (Bj). This

J Finan Serv Res (2007) 32:39–53 43

is because involved sectors that see the deal as exposing them to harm have a strongincentive to hold up—or even to blow up—the deal.

2 Options Conveyed to Banks and Regulators by Basel II

Financial safety nets are social contracts between governments and their citizens. Prudentialregulation of financial institutions seeks to balance the social costs and benefits of acountry’s safety net. Both Basel Accords recognize the possibility that the cross-countryoperations of aggressive multinational banks or opportunistic interventions by theirregulators can upset this balance.

Government intervention in finance leads to a protracted series of collisions between politicaland economic forces (Kane 1981, 1984). Basel II represents the third stage in a dialecticalsequence of regulation, burden avoidance, and eventual re-regulation. The patterns of theregulatory arbitrage and response that Basel I induced are unusual in three ways. First, almostall banks have chosen to hold capital positions that are greatly in excess of minimum standardsand hope to continue to advertise themselves that way. Second, any bank that found theminimum standards burdensome could almost costlessly close the gap by securitizing low-riskloans and thereby increase its portfolio risk to raise its desired level of capital to the regulatoryminimum. Third, around the world, banks and regulators support the effort to narrow thisloophole by increasing the granularity of the risk categories used in setting capital standards.

Besides increasing the number of risk categories, Basel II proposes to use a mix ofstatistical methods and expert opinion to track a bank’s changing exposure to insolvencyrisk over time. It also envisions improved disclosure as a way to generate complementarymarket discipline on bank capital positions. However, Basel II does not improve on Basel Ieither in how it measures capital or in the arbitrary target ratios it sets.

Although influenced by prior consultation with other stakeholders, the June 2004agreement known as Basel II reflects direct bargaining only among members of the BaselCommittee on Banking Supervision (BCBS). Basel II leaves a number of options open forregulators in individual countries to use in responding to unforeseeable events and inrenegotiating prior understandings among themselves and with various client institutions.

Basel II is not easy to understand and promises to generate options that have potentiallyundesirable incentive effects. It grants national regulators an option to use any (or all) ofthree different schemes to determine the regulatory capital of client banks [see Kupiec(2004, 2006), Pennachi (2005), U.S. Office of Comptroller of the Currency et al. (2007),and Viets (2006) for details]. In turn, where a country authorizes more than one scheme,some or all banks receive the option to adopt whatever scheme they find most beneficial (orleast burdensome) and to implement the scheme they choose in the most advantageous way.By exercising their options optimally, similarly situated banks in the same country or indifferent countries could end up with widely divergent levels of required capital. Moreover,Kupiec (2006) confirms that in fact five Quantitative Impact Studies (QIS1 to QIS5)conducted under the aegis of the BCBS uncovered a number of worrisome divergences.

The most important national option concerns whether or not to use an Internal-Ratings-Based (IRB) Approach or the simpler Standardized Approach to determine an individualbank’s capital requirement. The Standardized Approach resembles Basel I, except that itincorporates a wider range of weights and asks countries to choose a set of external ratingagencies and use these agencies’ assessments of risk to determine country-level capitalrequirements. IRB Approaches allow banks to specify and submit for validation their own“internal” models to calibrate their exposure to insolvency risk. Basel II distinguishes the so-

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called Foundation IRB (FIRB) model from the Advanced IRB (AIRB) model for constructingthese estimates and calculating minimum capital requirements. For each individual credit,both models require banks to specify a probability of default (PD), a “loss given default”(LGD), and an expected exposure at default (EAD). The FIRB approach differs from theAIRB in specifying rules for calculating EAD and in using a single LGD for all of a bank’scredits. In calculating EAD, FIRB ignores the possibility that the rate of credit-line drawdownand borrower PD are likely to be driven by common factors (Kupiec 2007).

The internally generated data are plugged into a correlation function based on characteristicsof each credit and then passed through a model that ultimately produces a probabilitydistribution of potential losses over the next year. Minimum regulatory capital is determined bythe requirement that the bank must be able to absorb all but the last 0.1 percent tail of lossesdisplayed by this synthetic distribution. How artfully a bank parameterizes this distribution isdifficult to constrain. Because capital is costly, savvy regulators expect that most banks willuse legitimate reporting options to understate their true loss exposure to some degree. Ideally,regulatory protocols for validating models under the AIRB ought to focus on estimating howfast the uncovered tail of the true loss distribution might grow when and as adversecircumstances cause a bank’s economic capital to decline (Kane 2006).

3 A Non-Mathematical Model of Post-Basel Contracting in the United States

It is convenient to define Ij as the information and expertise needed to evaluate accuratelythe option values Oj and net contractual benefit or burden Bj stakeholder j faces from aproposed deal. Gaps can exist between Ij and the information and expertise Ij thatconstituency j or its agent aj actually possesses. When these gaps are not fully appreciatedby a constituency or its agent(s), it is unlikely that its interests will be adequatelysafeguarded. Rationally, constituencies that simultaneously do not trust their agents torepresent their interests energetically and have enough information to perceive adversemovements in their stake in the Accord should exert pressure to prolong the deal-makinguntil one or the other condition can be repaired.

To understand post-Basel developments in the U.S., it is helpful to construct a model.My model supposes that in each participating country (q=1,..., Q), national regulators areagents whose respective objective functions Wq combines welfare from four sources:

1. Personal rewards to particular leaders ( pq);

2. Bureaucratic benefits obtained for their particular organization through regulatorycompetition (bq);

3. Benefits generated for client financial institutions ( fq);

4. Mission-driven safety-net benefits that flow through to the representative voter-taxpayer vq).

In the United States post-Basel bargaining occurs both among regulatory agencies andbetween every agency and its various clienteles. Although all four federal deposit-institution regulatory agencies participated in Basel II discussions, the Fed had tworepresentatives at Basel (the New York Fed and the Board of Governors) and inherited acommanding leadership role among central banks from Basel I. Arguably, this and itsaspirations to be recognized de facto as the nation’s umbrella regulator affected its ability inthe pre-Basel process to think of other U.S. regulators as equal participants. In Basel, theBoard and New York have always had separate votes in the negotiations. Moreover, when

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Basel II discussions began, sister central banks occupied most of the seats at the BCBStable. As supervisory functions began to be split off from European central banks, the newsupervisory agencies were incorporated into the negotiation process, but no central banksurrendered its place in the process.

Tables 1 and 2 model the Accord’s main stakeholders in the U.S. and Europe,respectively. Table 3 models their objective functions and the conflicts in the goals they areassumed to have pursued. To apply the model, it is assumed that the first-order missions ofUS and European Union (EU) negotiators differed substantially. US negotiators sought

Table 1 Model of U.S. stakeholders and description of differences in regulatory missions and regulatoryclienteles

Description of players and their concerns

I. Federal Reserve Board and NY Fed (lead negotiators for the U.S.)a. Quantitative Staff at Fed (stake = advancement & “street creds”)b. Successive Leaders of Basel II push•Early leaders: William McDonough and Larry Meyer•Successors: Roger Ferguson, Susan Bies, and (in 2007) Randy Kroszner

c. Broad stability mission: Stabilize liquidity; oversee domestic and international value of the dollar;promote systemic stability

d. Special clientele: Larger financial holdings cos. and their quant. staffsII. Other federal regulators: The FDIC+a. FDICMission: Resolve insolvencies and protect the integrity of the DI fund.Special clientele: Community banks; Conference of State Bank Supervisorsb. OCCMission: Supervise national banks and strengthen their charterSpecial Clientele: Money-center and regional banksc. OTSMission: Support mortgage market (i.e., keep Basel risk weight for mortgages low), strengthen S&Lcharter, and supervise S&LS

Special Clientele: S&Ls & Building IndustryIII. Congress & AdministrationIV. Voter-Taxpayers

Table 2 Model of European stakeholders, missions, and sectoral clienteles

Description of players and their concerns

I. Changing mix of central banks and Financial Supervisory Authorities (FSA’s)a. Mission of central banks: stability of every kindb. Mission of FSAs: Application of Basel across countries and institution types (increased supervisoryauthority and uniformity as well as financial-institution stability)

c. International Organization of Securities Commissions and International Association of Insurance Supervisorsd. Clienteles: Systemically important institutions (Trend is for European central banks to transferresponsibility for financial stability to FSAs and to apply the Basel approach to every kind of financialinstitution)

II. European Central Bank and other authorities in European Uniona. Mission: To promote political and economic integration (rules for home and host countries within EU)b. Clientele: Sponsors of political and economic integration in Brussels and elsewhereIII. Elected officials in national governmentsIV. Voter-taxpayers

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principally to enhance financial stability and reward banks that improved their risk-management systems, while EU representatives sought primarily to promote uniformity insupervisory protocols in the hopes of lessening home-host differences in the regulatoryburdens imposed on multinational banks headquartered in the EU.

For modeling purposes, it is convenient to assume that the changing set of Fed leaderslisted in Table 1 negotiated the U.S. position in Basel, but that the Fed must now negotiateimplementation issues with the current leaders of other U.S. financial regulators taken as agroup. None of these leaders held office during the pre-Basel negotiation stage. I call thecollective group the Federal Deposit Insurance Corporation Plus (FDIC+) because I assumethat at the outset of post-Basel dealmaking, these regulators’ twofold concern in post-Baselnegotiations was to defend the interests of their particular regulatory clienteles and toprotect the deposit-insurance fund against the possibility that large banks might be able tooperate in a low capital position.

For simplicity, I assume that Fed personnel focus on maintaining their employer’sposition of global leadership with foreign regulators and its reputation for supportingfinancial innovation with large financial holding companies. Table 1 lays out how the FDIC+members channel the interests of other depository institutions.

I also assume that Congress and the Administration projected that, over their expectedterms in office, voter-taxpayers were prepared to let financial-institution regulators slug itout until and unless either they created a public controversy or systemic financial problemsemerged. If the first event occurred (and it did), elected politicians planned to jump in andhelp to sort things out.

To maintain their capacity for shifting blame, politicians had to accept any system onwhich the Fed and the FDIC+ could agree, but regulators and industry clienteles were freeto persuade politicians and voters to examine and defend their stakes in the outcome ifnegotiations were to proceed badly enough for their side.1 Finally, I assume that, because ofits less-elitist clientele and minimal contact with foreign regulators, the bureaucratic costs of

Table 3 Objective functions assumed to govern the benefits that regulators and regulated institutions hopedto gain from Basel II

Contract stakes

Objective function for regulators Objective function for regulated institutions

➢ Mission fulfillment ➢ Competitive advantages, including loyalty of clients and broaderreputational standing of firm➢ Reputational standing of their

organizationa. With clientelesb. With national politicians ➢ Regulatory forbearancesc. With foreign regulators ➢ Personal rewards to staff & leaders (incentive bonuses; career

trophies and opportunities)d. With taxpayer-voters➢ Personal and career benefits forstaff and leaders

1Of course, the New York Congressional Delegation was expected to weigh in on the side of the large banks.However, House Financial Services Committee Chairman Barney Frank was quoted in a February 20, 2007American Banker column on “Washington People” as saying: “My basic concern [about the Basel process] isthat I have to pay attention to it and it gives me a headache. It’s Rubik’s cube—every time you do one thing,six other people get upset.”

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exercising this or other hold-up threats is much less for members of the FDIC+ than forthe Fed.

3.1 Incentive Conflicts in Post-Basel Negotiations

Conflicts between the social missions of regulators and the interests of the sectors theyregulate cannot be avoided. Post-Basel negotiations must resolve not only these conflicts,but also conflicts among the missions and clienteles assigned to different regulators.

The interests of the nation’s largest institutions in inter-regulator negotiations are alsoconflicted. On the one hand, standards that would be tough enough to assure financialstability would help large banks by lessening the expected value of the FDIC’s right to levyex post assessments to finance losses that exceed the value of the FDIC’s insurance fund.On the other hand, they want to compete as strongly as possible with foreign institutions. Inevery financial-center country, the very largest institutions may reasonably think ofthemselves as too big to fail and unwind. In this case, they should resist standards toughenough to preclude them from pursuing heavy tail risks that extract government-contributedcapital from the safety net.

Neither Basel II nor U.S. regulatory protocols include specific plans for resolving largemultinational financial organizations. The obvious opportunities for risk-shifting that thisgap in planning poses leads me to infer that the nation’s largest banks do not want abenchmark cross-country resolution protocol to be designed and tested. As a group, theymay believe that an unstructured environment would enhance their ability to lobby forforbearances and/or to negotiate away their assessment exposure if a large bank wereactually to become insolvent. This hypothesis can explain why large U.S. institutionscontinue to lobby uniformly for further capital relief. At each agency, the vast majority ofemployees are involved in supervising and servicing their clienteles. These operationscreate a bureaucratic interest in preserving the size and competitive positions of the sectorthey regulate. At the same time, no member of the FDIC+ community would like to test thesystem’s ability to resolve the insolvency of a giant firm. For both reasons, these agenciesare bound to oppose adjustments that promise to increase the probability that a largeinstitution might become economically insolvent.

Policymakers agreed at the outset that their goal was to improve risk management atlarge banks, not to help banks to operate with markedly lower levels of capital. In thepredeal phase, U.S. regulators agreed publicly that very large U.S. banks2 would berequired to use whatever version of the Advanced IRB approach (AIRBus) regulators finallyauthorize. Other U.S. institutions could choose, but only between the AIRBus and aStandardized approach. The second part of the understanding among regulators was that theoverall level of U.S. bank capital would not be allowed to decrease much under Basel II.“Much” is of course a word that could be interpreted differently by different constituencies.Behind this understanding lay regulators’ statutory duty under the FDIC Improvement Actof 1991 to define a series of simple leverage-ratio triggers (measured by capital to totalassets) for Prompt Corrective action (PCA) intervention that are tough enough andtransparent enough to make authorities accountable ex post for losses suffered by thefederal insurance fund. FDICIA designates an unweighted leverage ratio of two percent asthe threshold at which an undercapitalized bank that does not promptly recapitalize itself

2The mandate applies to banks or thrifts that have either $250 billion in total assets or $10 billion in assetsheld abroad.

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must surrender its charter. However, the numerical values or accounting tripwires thatrequire lesser interventions are set by interagency agreement.

Perhaps because they fear that PCA requirements impinge on Fed independence, FederalReserve personnel have often mischaracterized regulatory concern for the leverage ratio asa mere transitional safeguard meant to “backstop” Basel protocols for banks whoseinformation or control systems might initially mishandle the complicated AIRB capitalcalibration. However, Congress and the FDIC+ recognize that the greater simplicity andtransparency of a troubled bank’s leverage ratio create the personal and bureaucraticaccountability that ultimately enables PCA requirements to restrain capital forbearance.

PCA obligations and the second understanding undermined predeal assurances that ledthe banking industry to expect that individual banks that designed and operated state-of-the-art risk-management systems would be rewarded with reduced levels of regulatory capital.In an offhand effort to sort out the conflict in understandings, one Fed Governor—GovernorSusan Schmidt Bies—was quoted as saying, “The leverage ratio down the road has got todisappear.”3 This was good news for large institutions, because the disappearance ofleverage-ratio triggers is a development they favor.

However, the length of this road was noticeably extended by the outcome of the fourthQuantitative Impact Study (QIS4). As Fig. 2 shows, QIS4 indicated that if the 26 bankholding companies surveyed met only AIRB-generated requirements, 17 of them wouldshow a leverage ratio that PCA standards would classify as undercapitalized.

This result was both surprising and disturbing. It was surprising in that it seems as if thequantitative staffs at these 17 giant holding companies used QIS4 survey instruments todemonstrate to their superiors how effectively Basel II would let them arbitrage restrictionson leverage without stopping to appreciate the parallel danger of demonstrating this samecapacity to regulators in other industry segments. The outcome was disturbing in two ways.First, it supports the hypothesis that quantitative personnel at large banks and the Fed havebeen the engine driving the Basel II train in the U.S. and that disconnects exist in the way

3See Heller and Davenport (2005).

Figure 2 Divergences shown by QIS4 in the effective changes in minimum required capital estimated byindividual U.S. banks likely to use the AIRB method

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risk-management technocrats interface with the rest of their organization. Second, neitherthe competitive upheaval nor the threat to the deposit-insurance fund that these resultsimplied was sustainable politically. Smaller members of the FDIC+ clienteles demandedthat the formulas embodied in the Standardized Approach be recalibrated to afford themequal capital relief, whether or not they did anything to improve their risk management.This scaled-down capital standard (which never came to fruition) came to be known as“Basel IA.”

4 The Path to Compromise

In September 2005, the Fed and the FDIC+ took a first step in the post-Basel process offormally reconciling inconsistent understandings about bank prospects for capital reduction.Regulators agreed that, during the first three years of implementation, no individual bank’sBasel II capital would be allowed to drop more than 5 percent a year, relative to pre-Basel IIstandards. In March 2006, U.S. regulators indicated [and in September 2006 stated in amassive notice of proposed rulemaking (NPR)] that if aggregate capital held by AIRBbanks fell by 10 percent, they reserved the right to redesign the AIRB system. BecauseQIS4 indicated that this so-called “transition floor” might be hit in the second year, a 10-percent reduction seemed likely to be the recalibration target for which FDIC+ clienteleswould lobby.

This regulatory rewriting of predeal understandings not only reduced projected returns atlarge banks and thrifts, it left all segments of the industry less trustful of the options theymight enjoy under the still-evolving regulatory system. All parties were annoyed that thetime and resources invested in supervisory negotiations and bank measurement systems hadnot yet produced a workable arrangement. Undoubtedly, large-bank investments in risk-management systems offered a mix of regulatory and nonregulatory benefits—not justregulatory ones. However, divergences between the AIRB model and a large bank’s ownrisk-measurement protocols threatened to create deadweight compliance costs. These costscould have been greatly reduced by relocating the tasks of monitoring and regularlyrevalidating the internal models banks might use into Pillar 2. Pillar 2 would then focus onunderstanding divergences between the value of risk-weighted assets set by a bank’sinternal model and the value that would arise under the standardized approach.

In July 2006, four giant institutions—Citigroup, JPMorgan Chase, Wachovia, andWashington Mutual—openly asked to renegotiate their stake by requesting that large U.S.banks be granted the option either to help design improved AIRB formulas or to usesomething like the Standardized approach that competing European banks enjoy. OnAugust 3, the American Bankers Association sent a letter to Dr. Bernanke and leaders of theFDIC+ asking “the agencies to permit U.S. banking organizations of all sizes the option ofadopting alternative methodologies.”

Federal Reserve Chairman Bernanke had previously dismissed this option, but largebanks and FDIC Chairman Bair challenged his answer. To get large banks back on the train,the Fed either had to attract at least the OCC away from the FDIC+ coalition or postponethe AIRB mandate (e.g., by proclaiming a need to await further advances in risk modeling).The main costs of making AIRB optional would be a slight loss of face in the internationalregulatory community for the Fed and for individual personnel most closely identified withimplementing the 2004 agreement. In a February 2007 comment on the 2006 NPR, the fourbanks attacked the transition floors and the relevance and validity of the QIS4 data thatspawned them. The banks also reasserted their claim that the provisions officials agreed to

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add to Basel II conveyed unfair competitive advantages to foreign banks.4 Playing the“international competition card” triggered Treasury and Congressional opposition to theproposed transition floor.5

Finally, the four banks’ February 2007 comment asks that level and composition of theleverage ratio be reviewed at a future date. This concession mitigated the concerns of theFDIC and other officials who understood the dangers of regulatory forbearance. Tomaintain financial stability, PCA triggers must incorporate the commonsense hypothesisthat a sustained decline in the accounting value of capital is a reliable, albeit laggingindicator of bank weakness. To counter accountability resistance, it is important to keeptough and transparent leverage-ratio thresholds as the key to identifying failing and zombiefirms. It is equally important to continue to give these thresholds incentive force bymandating that every agency’s Inspector General conduct a thorough “material loss review”whenever an institution it supervises imposes a substantial loss on the insurance fund. Aconscientious material loss review publicly unveils a failed institution’s supervisory historyin excruciating detail. The credible threat of ex post accountability for imprudentforbearances is what imparts incentive force to PCA standards.

Taylor (2007) notes that accountability resistance can explain why IRB approaches arebeing embraced in countries whose banks and regulators lack both the data and humancapital to use an IRB model prudently. It is important to recognize that protocols adopted infinancial-center countries may be emulated slavishly in other environments. This is why itis important for US authorities to avoid loose ends and why they must not cede control ofthe inevitably politicized capital-assessment process to bank quants in the hope that, in thenot-too-distant future, transparent and reliable statistical methods for objectively measuringrisk exposure will emerge.

At strongly capitalized banks, it might seem defensible to measure risk exclusively byIRB procedures if the Basel approach to risk-weighting could be made truly comprehen-sive. However, measuring bank risk comprehensively is not the role that the leverage ratioplays in PCA. The simpler tests embodied in PCA thresholds are designed to triggeraccountable end-game regulatory discipline. Because they are complicated, Basel protocolswill always contain loopholes that facilitate regulatory forbearance. It is no accident thatPillar I neglects exposures to interest-rate risk in the banking book and numerousconcealment options created by the complexity of a bank’s balance sheet. Hence, even ifregulators could appropriately measure all of a bank’s loss exposures, it would still be wiseto develop clauses that confront nontransparencies in the forbearance pressures thatregulators in individual countries might experience.

Whatever protocols US regulators finally approve for risk weighting, they ought alsoincorporate market-value losses into their operative definition of institutional capital.Consistent with evidence presented by Berger et al. (2000), leverage-ratio supervisorytriggers would be improved if accountants were required to define contra-asset loan-lossreserves as the higher of either: (1) incentive-conflicted estimates now routinely prepared

4If true, the fault lies either in the procedures used to validate IRB models in particular countries or in theabsence of PCA requirements from Basel II (Nieto and Wall 2006). Ironically European banks routinelyexpress the opposite fear: that regulatory foot-dragging generates advantages for U.S. banks. They alsocomplain that post-Basel negotiations within the EU have made little progress in narrowing home-hostdivergences.5Paletta (2007) quotes Comptroller of the Currency John Dugan as saying, “We heard the comments loudand clear that we had deviated too far from the international standards.”

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by bank personnel or (2) estimates generated by a rolling-regression model that agencyresearchers would be asked to develop and update each quarter.

Acknowledgement For valuable comments, the author is indebted to Richard C. Aspinwall, RosalindBennett, Fred Furlong, Gillian Garcia, Richard Herring, Paul Horvitz, George Kaufman, John Krainer, PaulKupiec, Geoffrey Miller, James Moser, John Pattison, Haluk Unal, an anonymous referee, and participants inresearch colloquia at Bocconi University, Boston College, Tsing Hua University, York University, the FederalReserve Banks of Chicago and San Francisco, the Federal Deposit Insurance Corporation, and at the 2007meetings of the International Atlantic Economic Society and Taiwanese Finance Association.

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