NCPA - National Center for Policy Analysis

The Dismal Failure of the Basel Regime of Bank Capital Regulation

August 2, 2011

The Basel regime is an international system of capital adequacy regulation designed to strengthen banks' financial health and the safety and soundness of the financial system as a whole.  It originated with the 1988 Basel Accord, now known as Basel I, and was then overhauled.  Basel II had still not been implemented in the United States when the financial crisis struck, and in the wake of the banking system collapse, regulators rushed out Basel III, says Kevin Dowd, an adjunct scholar at the Cato Institute, Martin Hutchinson, a former investment banker, Simon Ashby, a senior lecturer at Plymouth Business School in the United Kingdom, and Jimi M. Hinchliffe, an investment banker based in London.

In this paper, Dowd et al., provide a reassessment of the Basel regime and focus on its most ambitious feature: the principle of "risk-based regulation."  The Basel system suffers from three fundamental weaknesses:

  • First, financial risk modeling provides the flimsiest basis for any system of regulatory capital requirements.
  • The second weakness consists of the incentives it creates for regulatory arbitrage.
  • The third weakness is regulatory capture.

The Basel regime is powerless against the endemic incentives to excessive risk taking that permeate the modern financial system, particularly those associated with government-subsidized risk taking.  The financial system can be fixed, but it requires radical reform, including the abolition of central banking and deposit insurance, the repudiation of "too big to fail," and reforms to extend the personal liability of key decision makers -- in effect, reverting back to a system similar to that which existed a century ago.

Source: Kevin Dowd, Martin Hutchinson, Simon Ashby and Jimi Hinchliffe, "Capital Inadequacies: The Dismal Failure of the Basel Regime of Bank Capital Regulation," Cato Institute, July 29, 2011.

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