11.5 Basel II’s Third Pillar

Due to the prevalence of banking crises worldwide and the financial system’s increasingly global and integrated nature, international regulators, especially the Bank for International Settlements in Basel, Switzerland, have also been busy. Their recommendations are not binding on sovereign nations, but to date they have obtained significant buy-in worldwide. America’s financial reforms in the 1990s, for example, were influenced by the so-called Basel I recommendations of 1988. Almost all countries have complied, on paper anyway, with Basel I rules on minimum and risk-weighted capitalization. Risk-weighting was indeed an improvement over the older capitalization requirements, which were simply a minimum leverage ratio:

So the leverage ratio of the following bank would be 6 percent (6/100 = .06, or 6%), which in the past was generally considered adequate.

Of course, leverage ratios are much too simplistic because a bank with capital of only 4 percent but with a diversified portfolio of very safe loans would be much safer than one with capital of 10 percent but whose assets were invested entirely in lottery tickets!

The concept of weighting risks is therefore a solid one. A bank holding nothing but reserves would need very little capital compared to one holding mostly high-risk loans to biotech and nanotech startups. Bankers, however, consider the Basel I weights too arbitrary and too broad. For example, Basel I suggested weighting sovereign bonds at zero. That’s great for developed countries, but plenty of poorer nations regularly default on their bonds. Some types of assets received a weighting of .5, others 1, others 1.5, and so forth, as the asset grew riskier. So, for example, the following assets would be weighted according to their risk before being put into a leverage ratio:

And so forth. But the weights were arbitrary. Are mortgages exactly half again as risky as commercial loans? Basel I basically encouraged banks to decrease their holdings of assets that the regulations overweighted and to stock up on assets that it underweighted. Not a pretty sight.

In response to such criticism, the Basel Committee on Banking Supervision announced in June 2004 a new set of guidelines, called Basel II, for implementation in 2008 and 2009 in the G10 countries. Basel II contains three pillars: capital, supervisory review process, and market discipline. According to the latest and greatest research, Rethinking Bank Regulation by James Barth, Gerard Caprio, and Ross Levine, the first two pillars are not very useful ways of regulating banks. The new risk weighting is an improvement, but it still grossly oversimplifies risk management and is not holistic enough. Moreover, supervisors cannot monitor every aspect of every bank all the time. Banks have to make periodic call reports on their balance sheets, income, and dividends but, like homeowners selling their homes, they pretty up the place before the prospective buyers arrive. In more developed countries, regulators also conduct surprise on-site examinations during which the examiners rate banks according to the so-called CAMELS formulation:

C = capital adequacy

A = asset quality

M = management

E = earnings

L = liquidity (reserves)

S = sensitivity to market risk.

A, M, and S are even more difficult to ascertain than C, E, and L and, as noted above, any or all of the variables can change very rapidly. Moreover, as discussed in Chapter 10 "Innovation and Structure in Banking and Finance", much banking activity these days takes place off the balance sheet, where it is even more difficult for regulators to find and accurately assess. Finally, in many jurisdictions, examiners are not paid well and hence do not do a very thorough job.

Barth, Caprio, and Levine argue that the third pillar of Basel II, financial market monitoring, is different. In aggregate, market participants can and in fact do monitor banks and bankers much more often and much more astutely than regulators can because they have much more at stake than a relatively low-paying job. Barth, Caprio, and Levine argue persuasively that instead of conceiving of themselves as police officers, judges, and juries, bank regulators should see themselves as aides, as helping bank depositors (and other creditors of the bank) and stockholders to keep the bankers in line. After all, nobody gains from a bank’s failure. The key, they believe, is to ensure that debt and equity holders have incentives and opportunities to monitor bank management to ensure that they are not taking on too much risk. That means reducing asymmetric information by ensuring reliable information disclosure and urging that corporate governance best practices be followed.Frederick D. Lipman, Corporate Governance Best Practices: Strategies for Public, Private, and Not-for-Profit Organizations (Hoboken, N.J.: Wiley, 2006).

Regulators can also provide banks with incentives to keep their asset bases sufficiently diversified and to prevent them from engaging in inappropriate activities, like building rocket ships or running water treatment plants. Screening new banks and bankers, if regulators do it to reduce adverse selection (omit shysters or inexperienced people) rather than to aid existing banks (by blocking all or most new entrants and hence limiting competition) or to line their own pockets (via bribes), is another area where regulators can be effective. By focusing on a few key reachable goals, regulators can concentrate their limited resources and get the job done, the job of letting people look after their own property themselves. The market-based approach, scholars note, is most important in less-developed countries where regulators are more likely to be on the take (to enact and enforce regulations simply to augment their incomes via bribes).