Deficiencies in the Basel II accord, which set recommendations on banking regulation, have been highlighted as one of the main causes of the global financial crisis that emerged in 2008. Manuel Becker and Simon Linder explain that a particularly problematic feature was the accord’s reliance on so called ‘regulatory import’, where regulators incorporate governance from an external forum into their own regulations, thus making their own performance dependent on external institutions.
The weak performance of the Basel II accord on capital requirements published by the Basel Committee for Banking Supervision (the Committee) was a central cause of the global financial crisis of 2008. Existing research has highlighted regulatory shortcomings of the Basel Accord, such as the capital requirements being too low in general.
Another negative effect resulted from the Committee’s uncoordinated relationship to other financial institutions. The Committee made use of ‘regulatory import’, a governance strategy where a regulator explicitly incorporates legal definitions from external institutions that are of functional importance. Regulators might have good reasons to make use of regulatory import, but it makes the regulator’s performance dependent on external governance.
Basel and the regulatory import of accounting and credit risk measurement
The Committee sets minimal capital requirements that shall function as a safeguard against potentially contagious series of bank failures due to credit default. For each claim, a bank must deposit some fraction of secure core capital. The first international accord that defined risk parameters was Basel I. The Accord had fixed risk weights for each asset class. For example, claims on the private sector had a weight of 100%, while claims on OECD banks had a risk weight of 20%. But 20% of what? The information to answer that question is derived from the balance sheet.
Frankfurt skyline, Credit: joshuawoodhead (CC BY-NC-SA 2.0)
The Committee was aware that the sub-issue of balance sheet regulation was of importance for its own regulatory performance. Instead of defining its own accounting rules, the Committee decided to make use of externally defined standards and to incorporate them into the Basel Accord. It did so for two reasons: First, accounting requires specialised knowledge, which the Committee did not possess at the time. Second, it wanted to avoid conflict with accounting authorities and legal inconsistencies in global financial regulation. The import of external accounting rules, however, made the Committee dependent on external accounting authorities regulating balance sheets in a complementary way.
The import of external governance went even further with Basel II. The new accord replaced the fixed risk weights with floating risk parameters. The Committee did not develop its own framework for these new floating risk weights. Constantly determining counterparty failure risk for each market participant was again a task outside the Committee’s competence. Therefore, the Committee delegated credit risk assessment to large banks with the necessary capacities to develop and use advanced statistical methods. Additionally, the Committee imported risk measurement frameworks from credit rating agencies for medium and small sized banks into Basel II, making the Basel Accord’s performance even more dependent on external risk assessments.
The unintended consequences of regulatory import
The first unintended consequences arose when the International Accounting Standards Board (the Board), the global authority in accounting, adopted an accounting standard that made “fair value accounting” the principal method for rating financial instruments on balance sheets. This method requires stock-listed companies to price their assets according to the current market price. The alternative method would be “historic cost”, meaning that assets keep the value they had upon purchase.
The Board adopted “fair value” to increase transparency of financial statements, but did not sufficiently consider the effects on the Basel Accord. With fair value displacing historic cost as the primary accounting technique, assets became visibly susceptible to market fluctuations. In booms, asset prices are high, which makes it easier for banks to fulfil their capital requirements. In downturns, asset prices fall, making it harder for banks to fulfil Basel requirements. This phenomenon is known as pro-cyclicality. Second, the rating behaviour of credit rating agencies has been identified as generally too pro-cyclical by overestimating solvency during boom phases and dropping ratings abruptly with signs of an economic downturn.
The import of external credit risk assessment undermined Basel II by transmitting failures of credit rating agencies into banking regulation. The pro-cyclical rating behaviour of credit rating agencies led to what we call multiplicative pro-cyclicality. Now, not only the capital to risk ratio is influenced by accounting practices, but also the value of the risk weight itself. Under economic downturns, because of falling asset prices, the capital base of a bank gets smaller while the counterparty failure risk increases, also because of falling asset prices. Thus, the Committee’s import of accounting standards from the Board and risk measurements from credit rating agencies accelerated pro-cyclicality. This led to a sudden decline in confidence on the interbank lending market and resulted in a credit crunch.
Lessons for global financial regulation
Since regulatory import creates a one-sided dependence and vulnerabilities towards external dynamics, it should be accompanied by the installation of inter-institutional coordination mechanisms to limit unintended consequences. Therefore, we assess post-crisis reforms as important but not sufficient steps towards greater coordination in global finance. The Committee and the International Accounting Standards Board instigated institutional dialogue and committed to a closer relationship after the crisis. However, the one-sided dependence remains and incentives for accounting authorities to adhere to concerns of banking regulators remain largely unheard. With respect to credit rating agencies, public attempts to limit their autonomy were not effective. Despite the overwhelming post-crisis critique, credit rating agencies remain as an integral part of the regulatory structure.
For more information, see the authors’ accompanying paper in the Journal of European Public Policy
Note: This article gives the views of the authors, not the position of EUROPP – European Politics and Policy or the London School of Economics.
Manuel Becker – Otto-Friedrich-University Bamberg
Manuel Becker is a lecturer and PhD candidate at the Otto-Friedrich-University of Bamberg. His research interests include international regulation, private authority and regime complexes.
Simon Linder – Otto-Suhr-Institute of Political Science
Simon Linder is researcher at the Otto-Suhr-Institute of Political Science in Berlin. His research interests include institutions in global financial regulation and the economic and political effects of global financial regulatory output.