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Peterson Institute for International EconomicsWashington, DCAugust 2008 Banking on Basele Future of International Financial RegulationDaniel K. Tarullo Daniel K. Tarullo is a professor of law atGeorgetown University Law Center. He hastaught at Harvard Law School (2005) andPrinceton University (2004). He held severalsenior positions in the Clinton administra-tion, ultimately as assistant to the presidentfor international economic policy, responsi-ble for coordinating the international eco-nomic policy of the administration. From1993 until early 1996, he was assistant sec-retary of state for economic and businessaffairs. In March 1995, President Clinton ap-pointed Tarullo as his personal representa-tive to the G-7/G-8 group of industrializednations, with responsibility for coordinatingUS positions for the annual leaders’ sum-mits. He continued this assignment after hemoved to the White House, participating infour summits. He serves on the editorial ad-visory board of the International Economy andthe Advisory Committee of TransparencyInternational.PETER G. PETERSON INSTITUTE FOR INTERNATIONAL ECONOMICS1750 Massachusetts Avenue, NWWashington, DC 20036-1903(202) 328-9000 FAX: (202) 659-3225www.petersoninstitute.orgC. Fred Bergsten, DirectorEdward Tureen, Director of Publications, Marketing, and Web DevelopmentTypesetting by Xcel Graphic ServicesPrinting by Edwards Brothers, IncorporatedCover by Barbieri & Green, Inc.Author photo by Jeremey TrippCopyright © 2008 by the Peter G. PetersonInstitute for International Economics. Allrights reserved. No part of this book maybe reproduced or utilized in any form orby any means, electronic or mechanical,including photocopying, recording, or byinformation storage or retrieval system,without permission from the Institute.For reprints/permission to photocopy pleasecontact the APS customer service depart-ment at Copyright Clearance Center, Inc.,222 Rosewood Drive, Danvers, MA 01923;or email requests to: info@copyright.comPrinted in the United States of America100908 54321Library of Congress Cataloging-in-Publication DataTarullo, Daniel K.Banking on Basel : the future of interna-tional financial regulation / Daniel K. Tarullo.p. cm.Includes bibliographical references andindex.1. Banks and banking, International—State supervision. 2. Banks and banking,International—Standards. 3. Bank capital.4. Banking law. I. Title.HG1725.T37 2008332’.042—dc222008037233The views expressed in this publication are those of the author. This publication is partof the overall program of the Institute, as endorsed by its Board of Directors, but doesnot necessarily reflect the views of individual members of the Board or the AdvisoryCommittee.ch00_FM_15092_Peterson_Basel 9/16/08 10:52 PM Page ii To VTch00_FM_15092_Peterson_Basel 9/4/08 8:26 PM Page iii ch00_FM_15092_Peterson_Basel 9/4/08 8:26 PM Page iv vContentsPreface ixAcknowledgments xiii1 Introduction 1Summary of Argument 5Outline of the Book 7A Note on Timing 132 Role of Capital Regulation 15Rationale for Capital Regulation 16Evolving Role of Capital Regulation 29Conclusion 423 Basel I 45Origins of the Accord 45Elements of the Accord 54Assessment of Basel I 64Conclusion 844 Negotiating Basel II 87Launching the Review Process 87Curious Release of the First Consultative Paper 93Shift to an Internal Ratings–Based Approach 104Process of Continuous Revision 113Revised Framework 122ch00_FM_15092_Peterson_Basel 9/4/08 8:26 PM Page v Responding to the Subprime Crisis 131Conclusion 1355 Assessing Basel II as a Regulatory Model 139Do Regulatory Capital Requirements Matter? 141Potential Benefits of the Advanced Internal Ratings–Based Model 150Potential Negative Effects of the Advanced Internal Ratings–Based Model 177Conclusion 189Appendix 5A 1916 Basel II as an International Arrangement 195Safety and Soundness 197Competitive Equality 209Cooperative Supervision of Multinational Banks 214Indirect Benefits 222Conclusion 2237 Alternatives to Basel II 225Retaining a Standardized Approach 226Market Discipline: Mandatory Subordinated Debt 231Precommitment Approach 246Establishing an International Supervisory Role 251Eliminating International Cooperation on Safety and Soundness 255Conclusion 2568 Conclusions and Recommendations 259Recommendations 262Implications Beyond Capital Regulation 279References 285Index 299TablesTable 2.1 US bank capital ratios, 1970–81 32Table 3.1 The world’s 10 largest banks, 1974, 1981, and 1988 47Table 3.2 Capital ratios of selected large banks, 1981 and 1988 48Table 3.3 Credit conversion factors for off-balance-sheet items in Basel I 60Table 3.4 Capital charges for debt instrument market risks in the Basel Committee 1993 proposal 62vich00_FM_15092_Peterson_Basel 9/4/08 8:26 PM Page vi Table 4.1 External agency ratings and risk weights in the first consultative paper 95Table 4.2 Results of second quantitative impact study change in capital requirements under second consultative paper proposals 112Table 5.1 Capital ratios for 10 largest US banks as of December 31, 2003 147Table 5A.1 Risk-weighted capital (RWC) ratios of 10 largest US banks, 1992–2006 191FigureFigure 2.1 Equity as a percent of assets for all insured commercial banks, 1840–1989 31BoxesBox 1.1 Basel Committee on Banking Supervision 2Box 1.2 Bank for International Settlements 4Box 3.1 Definition of capital in Basel I 57Box 3.2 Risk-weight categories in Basel I 58Box 4.1 Basel Committee proposals in the first consultative paper 94Box 4.2 Changes proposed in the second consultative paper 106Box 4.3 Key principles of supervisory review in the second consultative paper 109Box 4.4 Areas of public disclosure by banks in the second consultative paper 110Box 4.5 Proposals issued between the second and third consultative papers 115Box 4.6 Basel Committee proposals between the third consultative paper and the final revised framework 122Box 4.7 Outline of revised framework (Basel II) 124Box 4.8 Proposed changes to Basel II following the subprime crisis 134Box 6.1 High-level principles for Basel II implementation 220viich00_FM_15092_Peterson_Basel 9/4/08 8:26 PM Page vii ch00_FM_15092_Peterson_Basel 9/4/08 8:26 PM Page viii ixPrefaceThe financial distress that followed the implosion of markets for securi-tized mortgages in 2007 has raised profound doubts about the adequacyof supervision of financial markets—in the United States and in othercountries. One question in the ensuing public policy debate has beenwhether financial institutions would have been in sounder condition hadthe capital regulations agreed upon internationally in the Basel II accord,negotiated between 1999 and 2004, already been in place. Basel II marks adramatic change in capital regulation of large banks in the countries rep-resented on the Basel Committee on Banking Supervision, composed of13 of the most important financial centers, by using banks’ own credit riskmodels in setting minimum capital requirements.In this book Daniel Tarullo considers the Basel II approach both as aparadigm for domestic banking regulation and as the basis for an interna-tional cooperative arrangement. While highly skeptical of Basel II as a do-mestic regulatory system, he does not definitively reject some use ofbanks’ own risk models in setting minimum capital requirements. Al-though he is troubled by the theoretical and practical problems in relyingon the value-at-risk credit models used by large banks, he finds no clearlysuperior alternative approach to capital regulation.As to the Basel II agreement that each participating country imple-ment the same “internal ratings” method of minimum capital regulationfor its large banks, however, Tarullo is unequivocal in his criticism. Heconcludes that the shortcomings of this method as the foundation for do-mestic regulation will only be magnified at the international level. The de-tails of this very complicated set of regulations are unlikely to be appro-priate for the different circumstances of participating countries. Yet thech00_FM_15092_Peterson_Basel 9/4/08 8:26 PM Page ix [...]... the IRB approach is a hybrid form of regulation Development of a satisfactory proposal for using internal ratings was not easy Two comprehensive drafts and numerous discrete modifications produced progressively more complexity, as the Basel Committee attempted to respond to objections from many quarters, most importantly including banks in their countries In its attempts to respond to problems in successive... approach as such, the Basel II formulas appear to produce this result The chapter then turns to the potential advantages of the IRB approaches, with emphasis on the A-IRB approach applicable to the very largest banks These include greater risk sensitivity; the prod given to large and complex banks to improve their internal risk management systems; and the creation of a “common language” of risk profiles... shifted to the promotion of international financial cooperation and monetary stability These goals were initially pursued through regular meetings of central bank officials and economic experts directed toward promoting discussion and facilitating decision-making processes, as well as through the development of a research staff to compile and distribute financial statistics The BIS also played a role in implementing... other changes but maintain the basic 1988 approach, as contemplated in the original 1999 proposal; permit larger, sophisticated banks to base their minimum capital requirements on inputs from their own internal credit risk models through the use of either a “foundational” internal ratings–based approach (F-IRB) or an “advanced” internal ratings–based approach (A-IRB); require certain disclosures by... sought from an IRB approach is the increased risk sensitivity of regulatory capital requirements, to be achieved through the use of the sophisticated risk assessment techniques of major banks Unlike the regulatory methods and rules resulting from most exercises in international convergence, the IRB approaches were developed entirely during the international negotiation itself, rather than adapted from... participating country From the standpoint of any one country, then, the key question is whether the gains from having other countries subscribe to the Basel II rules will offset the losses from following rules different from those that would have been generated in a purely domestic process.4 Specifying the gains from cooperation is considerably less straightforward than it might first appear One familiar difficulty... depart from the basic risk-bucket approach of Basel I It proposed using external credit ratings, such as those developed by Moody’s or Standard & Poor’s, as the basis for defining risk categories Widespread dissatisfaction among large banks with the failure to incorporate up-to-date risk management ideas in the proposal sent the committee back to the drawing board Attention was redirected toward an approach... specific policymakers For example, any policymaker in the European Union—whether in a member state or in the Commission—will consider how an arrangement like Basel II will affect a broader set of policy dynamics within the European Union INTRODUCTION 5 ch01_15092_Peterson_Basel 9/4/08 8:29 PM Page 6 Basel II’s internal ratings–based (IRB) approaches to capital regulation will allow large banks to use... basic Basel II approach has promise as a paradigm for domestic regulation, is the effort at extensive international harmonization of capital rules and supervisory practices useful and appropriate? This book provides extended and, on balance, reasonably negative answers to both questions Summary of Argument The core policy issue is whether an international effort at regulatory convergence around Basel II’s... scheme; augment the supervisory process; and require capital set-asides for operational risk Of these elements, the proposal for using banks’ internal ratings was, by a substantial margin, both the most difficult and the most controversial, with operational risk a clear second INTRODUCTION 9 ch01_15092_Peterson_Basel 9/4/08 8:29 PM Page 10 The revised framework was controversial even before it was issued . II with me. I also profitedenormously from two peer review sessions organized at the Peterson In-stitute and from comments received from participants at. 87Launching the Review Process 87Curious Release of the First Consultative Paper 93Shift to an Internal Ratings–Based Approach 104Process of Continuous Revision