4 June, 2012Issue 19.4EconomicsPolitics & SocietyWorld Politics

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Capital Rules

Philipp M. Hildebrand and Rahul Prabhakar

BritishCharles Goodhart
The Basel Committee on Banking Supervision
CUP, 2011
624 pages
ISBN: 978-1107007239


Charles Goodhart once referred to himself as a “court jester” around central bankers. In reality, few other scholars have been more interested and involved in the evolution of modern global banking regulation. In The Basel Committee on Banking Supervision: A History of the Early Years, 1974—1997, Goodhart has provided neither a narrative nor analytical history, but rather an invaluable, roughly chronological encyclopedia of key ideas, recollections, and documents for an audience of economists, political scientists, historians, regulators, finance ministers, and of course, the central bankers and regulators who comprise this powerful Committee. Instead of us having to make a trip to Basel—an industrial Swiss port city on the river Rhine—and request access to the archives of the Bank for International Settlements, Goodhart brings a mountain of material for readers to bore through. If you want to explore why European banking is in a crisis today, how 29 “too-big-to-fail” banks have come to dominate global finance, and what motivates regulators and central bankers behind closed doors, then this tome is for you.

Simply put, the Basel Committee sets global, non-binding rules for banks that central banks and financial regulators are then meant to translate into nationally binding standards. The Committee has achieved an impressive level of influence through technocratic legitimacy: the idea that bringing together financial “Talmudic scholars” to discuss regulatory concepts, best practices, and potential consequences will result in banking rules that the world over can adopt. As regulators, central banks, legislatures, and markets accepted the Committee’s legitimacy, over one hundred countries adopted the first landmark in global financial regulation: the 1988 Basel Accord. The Accord established “risk-based capital rules”, which operate on an intuitively appealing basis: the riskier an asset (e.g. a loan) a bank possesses, the more capital that should be available to absorb losses in case that asset underperforms. But this basic principle belies many devils in the detail. These crucial details defined the challenges that the Basel Committee tackled in the 1980s (1988 Accord), then again from the late-1990s to mid-2000s (Basel II), and again after the most recent crisis (Basel III): What counts as capital? How do you define risk? How much capital is sufficient?

Presenting the story of a rational, scientific exercise is, as they say, only one version of the truth. Goodhart quotes from a speech by Peter Cooke, a senior Bank of England official and chairman of the Basel Committee in the 1980s, that reveals a frankness not often seen in today’s debates on financial regulation: “There is no objective basis for ex cathedra statements about levels of capital. There can be no certainty, no dogma about capital adequacy: it is therefore an area, par excellence, where the supervisors have to play a role in setting standards to fill what could otherwise be a vacuum.” This vacuum was filled by Paul Volcker, the (literally) towering American central banker, who pushed the Committee in 1984 to go beyond its nascent progress in surveying capital rules across countries to actually developing what became the 1988 Accord. As Goodhart tells the story, Volcker forged a bilateral accord with the Bank of England, a power play that ultimately foisted the preferences of the US and Britain onto the rest of the Committee. Germany actually had the toughest capital rules of any country represented at Basel, but, as with other continental European countries, which were all hamstrung and surprised by the US-UK Accord, they settled for a few national exceptions. Goodhart’s interpretation is sufficient because it is concerned about deliberations within the Committee, but it is incomplete. For example, as political economist Kentaro Tamura shows, Japanese regulators were not the real subject of the US-UK power play, but (mostly) willing negotiators, who were attempting to find international leverage to raise huge Japanese banks’ dastardly low levels of capital.

Reform of capital rules within the Basel Committee is not merely then a consensus-based, technocratic exercise, but also an arena in which national interests, power politics, and bargaining between major financial centers come to the fore. It is nevertheless still startling for Goodhart to conclude in his assessment of the 1988 Accord that “there were no attempts to relate the measures to underlying theory, such as ‘Why do banks need capital?’, or ‘What is the market inefficiency (failure) which justifies regulatory intervention?'” First principles were not debated, a worrying gap that widened by 2004, when the Basel II agreement was concluded. Basel II endorsed the use by global banks of Value-at-Risk (VaR) models to internally calculate how much capital they required to withstand losses. Unsurprisingly, these models calculated lower levels of required capital than those derived under the 1988 Accord. Goodhart’s history ends in 1997, before Basel II negotiations really begin. But, as he demonstrates, in the lead-up to the Market Risk Amendment in 1996, the Committee was initially caught unaware of the internal models that banks had developed to calculate their capital needs.

Is internal modelling in Basel II a case of regulatory capture? It’s a question which Goodhart does not address, leaving it “for a later historian to determine.” Because of the complexity of such models and regulators’ limited resources in monitoring and understanding their implications, it can be reasonably argued that internal modelling tilted the playing field in favour of global banks. But, can it really be considered capture if important regulators agreed with global banks on the utility of internal models? In 1996, well before internal modelling was incorporated in Basel capital rules, US Federal Reserve chairman Alan Greenspan was certainly receptive to the banks’ case: “These capital allocations, as I noted, are for internal management, not regulatory, purposes. But I am impressed with what they teach us and what they imply for regulatory capital.” In the end, Basel II was never fully implemented in the United States, as European Union officials often point out. But the long process of implementation in the US was fortuitous. Full implementation of Basel II may have well led to even lower levels of capital and thus could have done more harm than good in the run up to the disastrous financial crisis, which unleashed its full force in autumn 2008.

If the 1988 Accord was about defining capital across countries and Basel II was about internal modelling that led to lower capital levels, then Basel III (officially endorsed in September 2010) responded to the need for more and—crucially—higher-quality capital on the balance sheets of global banks. The Committee broke new ground in creating liquidity standards, which, if effective, would make banks more resilient during stressful periods. Ideally, the Committee would have gone further than it did, but the same political dynamics for which Goodhart provides reams of evidence were again at play as several countries sought to dilute rules or delay implementation.

In this impressive volume, Goodhart takes us far in providing an institutional portrait of the Basel Committee: attendance records, formal and informal memos, and personal correspondence abound. Scholars across disciplines will have a field day in examining the myriad motivations, stages of bargaining, and technical detail that absorb the well-intentioned members of this influential body. But, given his purpose, Goodhart doesn’t provide answers either, for the bigger questions about global financial regulation, which do not reveal themselves easily in the Basel exercise. What kind of global financial system best serves the needs of the international economy? What market failures are not being addressed? What should global banks look like in ten, twenty, and fifty years? These are the essential, albeit sometimes frustrating, questions that need to be confronted. Maybe Basel IV will.

Philipp M. Hildebrand is former chairman of the Swiss National Bank and Senior Visiting Fellow at the Blavatnik School of Government. Rahul Prabhakar is a DPhil student in International Relations at St John’s College, Oxford, and Lead Research Fellow of the Globalization & Finance Project . He is a senior editor at the Oxonian Review.