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1. An essay on bank regulation and Basel III
Written in May 2013 by Torbjørn Bull Jenssen
Introduction
“The provision of financial services in general, and banking in particular, is closely regulated and
supervised in most countries” (Goodhart, 1989,p.194). There can be several different motives behind
the regulation of banks. Political, distributional, and other moral considerations are often cited as
legitimate grounds for government intervention in the sector. However, from an economic
perspective, the main driver behind regulation is often a desire to ensure Pareto efficiency. Along
these lines, most of the economic literature related to banking focuses on three principal motivations
to regulate (ibid.); (i) the existence of natural monopolies, (ii) the existence of externalities, and (iii)
the existence of information asymmetries. This essay seeks to provide some theoretical arguments
supporting regulatory constraints on capital-adequacy ratios (CARs) and liquidity ratios. Furthermore,
the principal innovations regarding CARs in the Basel II framework will be discussed. Particular
attention will be drawn to the pitfalls made evident by the financial crisis of 2007, and fixes proposed
in Basel III. However, it is not clear that the suggested framework will be sufficiently robust or
comprehensive to achieve this elusive goal, a critical evaluation of which will be presented at the end
of this essay.
Why regulate banks?
There are many different instruments used to make the banking system sounder (Freixas and Rochet,
2008). However, the main focus of this essay will be the regulation of CARs and liquidity ratios.
Bank capital is not in the form of real capital such as plant and machinery, but rather a bookkeeping
construction; the total value of assets, minus nominal claims on the bank. Thus, the regulation of
minimum levels of bank capital puts a cap on financial gearing, and affects a banks capacity to absorb
unforeseen losses (Atik, 2011). Further, in the same way a leverage ratio regulates the size of a loss
that a bank can absorb, CARs regulate the probability of losses by limiting the riskiness of bank

2. assets, given leverage. A CAR therefore directly regulates the risks originating from changes in the
bank’s assets. However, banks also face risks deriving from changes in the liability side of the balance
sheet. By also imposing a liquidity ratio, demanding banks to hold a certain fraction of highly liquid
assets, regulators improve the bank’s ability to accommodate a sudden shift in access to credit.
Regulations like those mentioned above aim at reducing the probability of bank failure. If the
regulator decides to target the probability of bank failure, optimal regulation can in theory be derived
by the application of the Merton Method (Herring, 2002). This approach would then necessitate the
creation of Value-at-Risk models which would approximate the “risk adjusted return to capital”,
consistent with current regulation under the Basel framework. However, this is based on the premise
that banks need to be regulated differently than other capitalistic firms. To understand why, one must
analyse what it is that is special about banks.
Micro economic considerations:
Banks are often thought of as an institution that naturally emerges as a tool to reduce the transaction
cost problem of asymmetric information between borrowers and lenders, utilizing returns to scale in
monitoring. In practise however, no institution emerges out of thin air just because it is efficient.
Banks came into existence because there was a profit to be made, a rent to capture (Collins, 2012). Be
that as it may, functionalistic theories are useful as they enable us to analyse how banks operate. By
serving as maturity transformers, backing short term liabilities by long term assets, banks provide an
important function in the economy (Goodhart, 1989). Banks are able to do this because their assets are
diversified, and their liabilities have acquired moneyness, (i.e. are kept as a store of wealth, accepted
as means of payment, and used as unit of account). Further, the moneyness of bank liabilities is
important to keep the system running by ensuring high redeposit rates (Dow, 1996).
In 1983, Diamond and Dybyg highlighted the fragility of the maturity transformation process. By
creating a model where banks are viewed as efficient providers of liquidity insurance, in a world of
incomplete contracting, they were able to illustrate the existence of two equilibriums: One good
equilibrium, and one bad, bank-run equilibrium. This problem could be mitigated by introducing a

3. lender of last resort (LOLR), able to provide liquidity during shocks. But, the separation of a solvency
problem from a liquidity problem is an almost impossible task (Goodhart, 1989). In Diamond and
Dybig (1983) it is instead showed how deposit insurance could secure the no bank run equilibrium; a
sufficient solution because there is no asset risk in the model. When one introduces asset risk another
asymmetric information and related moral hazard problem arises. Bank creditors, mainly depositors,
are unprofessional, and have very limited capacity to monitor the banks activity and exert control
rights (Dewatripont and Tirole, 1994). As a result, banks may take too much risk from the depositors’
point of view. The depositors’ risk aversion and lack of control rights therefore result in a demand for
deposit insurance and stabilising regulations to avert severe losses of monetary savings.
When depositors are unable and therefore not monitoring the activities of the bank, the question of:
Who are, and who should, naturally arises. Jensen and Mecling (1976) argue that mangers tend to take
too much risk. Moreover, it can be shown by applying a simple model that unregulated banks,
maximising profit, will choose risky projects (Freixas and Rochet, 2008, p.314). Due to limited
liability, equity can be viewed as a call option on the banks assets with bounded losses and unbounded
potential gains (Nuño and Thomas, 2013). This makes the profit function convex in risk, in contrast to
the concave return function of debt holders. To reduce the moral hazard between the deposit insurer or
bank creditors, and equity holders, arising as a result of this difference, regulation is needed. The goal
of the regulation will then be to reduce the risks faced by the insurer and creditors. As showed by
Rochet (1992), a CAR may reduce the excessive risk-taking associated with leveraged finance, and
should therefore be imposed. A leverage and/or liquidity ratio would also mitigate the costs of the
moral hazard. In theory an optimisation problem weighting the costs of bank failure against the costs
of different regulations, maximising the values of deposits could be constructed, and used to find the
optimal level and scope of regulation (Dewatripont and Tirole, 2012). When deciding how to regulate,
the aim should be to align managerial incentives with those that would have occurred with complete
contracting between creditors and equity holders. CARs can therefore be rationalised along these
lines, given the absence of macroeconomic shocks (Dewatripont and Tirole 2012). However, it is
important to notice the potential offsetting dynamic effects of a stringent CAR. While a CAR today

4. makes risk more costly, the anticipation of tomorrow’s capital requirements may motivate excessive
risk taking today (Blum and Hellwig, 1995). Since it is the return on today’s investment that is
becoming regulatory capital tomorrow, “the overall effect of a uniform requirement today and
tomorrow is unclear”(p.741).
Macroeconomic considerations
The purely microeconomic viewpoint with respect to regulation espoused above focused on
asymmetric information between depositors and managers. However, there are also other important
micro and macroeconomic reasons to regulate banks due to negative externalities that arise from the
normal conduct of banking. Financial activities tend to be pro-cyclical, as modelled in the financial
accelerator model (Bernanke et al., 1996), and the reduction of macroeconomic volatility, and
especially avoiding deep recessions, is welfare enhancing (Gali et al., 2007).
The moneyness of short term bank liabilities can be viewed as a public good (Dow, 1996), and a part
of the economic infrastructure. It is the risk free character of deposits, supported by prudential
regulation, which provides deposits with the ability to buy (ibid.). Because it eases the costs of
transacting, private money creation can be viewed as generally beneficial for society. However, the
incentives of banks lead them to excess due to the fact that negative externalities such as economic
instability and fire sale costs are not internalised (Stein, 2011). Furthermore, as providers of liquidity
banks operate the payment system, and bank failures can impose a severe negative shock to the
economy, should it break down.
While a CAR can be applied to reduce the overall availability of credit in the economy, it must be
countercyclical to limit the build-up of credit bubbles and their tendency to amplify economic output
over the cycle. When assets appreciate during a boom, banks’ assets (marked-to-market) increase
relative to nominal liabilities. This generates higher levels of regulatory capital, extending the scope
of credit creation, and puts further upward pressure on asset prices (Atik, 2011). This feedback loop

5. accelerates credit creation, and works the other way round during a downturn. Moreover, the self-
enhancing stability during a boom may destabilise the banking sector as a whole, and in turn bring
about or intensify fluctuations in the real sector (Minsky, 1982). As a result, higher levels of capital
must be required during booms, so banks have a buffer to draw down on during a bust.
Another set of externalities that are often considered in the literature are the contagion effects of bank
failure. The failure of one bank may impose problems and costs on other banks due to
interconnectedness. Such effects can be modelled even in the absence of asymmetric information
(Allen and Gale, 2000). Moreover, without full information, the contagion effect may be even greater.
The failure of one bank may result in a Bayesian reassessment of the riskiness of other banks and
widespread deposit withdrawals. If the LOLR does not prop up the system by supplying liquidity, a
potential solvency crisis may occur caused by the aforementioned maturity mismatch. The complexity
of and counterparty risk within the financial system may therefore result in fire sales (Caballero and
Simsek, 2010). By imposing a liquidity ratio, the costs of a sharp fall in deposit rates are reduced.
Together with a CAR, the likelihood of contagion can therefore be mitigated; “greater resilience at
the individual bank level reduces the risk of system wide shocks” (BCBS, 2011,p.2). However, given a
failure, bank creditors may still rationally question the effectiveness of the regulation in place, and
withdraw funds from other banks.
Why harmonisation?
Perhaps the most important driver behind the Basel regulations is the desire to harmonise the
regulation of banks operating internationally. The failure of a bank operating in one jurisdiction may
quickly spread to banks operating under another completely different jurisdiction through
international interconnectedness. Furthermore, banks operating under more lax regulation will have
lower operation costs and the possibility to expand faster. This might result in a regulatory race to the
bottom between countries wanting to stimulate financial competitiveness. A unified regulatory
framework with a common CAR reduces international counterparty risk and motivates international

6. risk sharing. However, it is important to bear in mind that when increased interconnectedness does not
increase the opportunities of diversification, systemic risk becomes strictly increasing in
interconnectedness (Lagunoff and Schreft, 2001).
The evolution of capital requirements under Basel I-III
In 1988, the Basel Accord (Basel I) was released as a guideline of how banks operating internationally
should be regulated. It consisted of three core elements (King and Tarbert, 2011). First, banks were
obliged to hold at least 8% regulatory capital against their assets. Second, regulatory capital was
defined and divided into two tiers. Tier 1 capital represented high quality capital like common equity,
while Tier 2 capital represented lower quality capital like subordinated term debt. Under Basel I,
banks were required to hold half of its capital as Tier 1 capital. Third, banks were required to calculate
the ratio of regulatory capital in a uniform way based on crude risk weights.
In 1996 the “Amendment to the Capital Accord to Incorporate Market Risk” was added to the Basel
framework. To better capture market risks, banks were required to hold capital against their trading
book, marked-to-market. In addition, banks were allowed to employ internal models to calculate the
market risk capital charge. However, even with modifications the Basel I framework was viewed to be
inadequate. The crude categorisation of risk groups under Basel 1 had led to opportunities of
regulatory arbitrage, and some of the capital defined under Tier 2 was of questionable quality (King
and Tarbet, 2011). Thus, a new framework was developed, and resulted in the publishing of Basel II
in 2004. Basel II was organised along three core pillars: (i) minimum capital requirements, (ii) the
supervisory review process, and (iii) market discipline, with the first as the mainstay. In Basel II the
methods of risk assessment and calculation of capital requirements, was drastically changed. Capital
requirements against operational risk were introduced, and the crude risk categorisation under Basel I
was replaced with much more fine-tuned risk assessment and weighting. The methods included one
standardised, and two internal-based ratings. In the standardised approach, external agencies were
used in the calculation of risk-weighted-assets, while the internal-based regulation motivated banks to

7. develop and apply sophisticated risk management models to calculate their own capital requirement
(King and Tarbert, 2010). This was supposed to reduce the opportunities of regulatory arbitrage.
However, issues of systemic risk and correlation between bank assets were not addressed properly,
and the opportunities of arbitrage were only moved, not removed. Trough securitisation, assets were
moved from the banking book to the trading book, allowing banks to use value-at-risk models, leaving
them with lower capital requirements. Thus, banks became able to reorganise to receive a lower
capital requirement without any real shift in risk exposure (Achary and Richardson 2009). Banks
could in this way increase their gearing because there was no leverage ratio in the Basel II framework.
To address this problem Basel III supplements the CAR with a liquidity ratio imposed as a back
stopper. Banks will be required to hold at least 3% Tier 1 capital against “total exposure”. However,
the details of how to calculate “total exposure” are still to be determined (King and Tarbert, 2010).
Moreover, Basel III seeks to improve the CAR. The 8% of risk weighted assets capital charge is kept
unchanged, but the quality of capital is enhanced. Banks will now be required to hold 75% Tier one
capital and at least 4,5% common equity. However, low quality capital was not the only problem
Basel II faced in relation to the crisis. Lack of transparency in the over-the-counter market led to a
sudden withdrawal of liquidity from the market as the crisis hit, and made it virtually impossible to
evaluate assets marked-to-market. Basel III therefore seeks to stimulate the development of central
counter parties (CCP) operating as clearing houses by requiring less capital against CCP exposure
together with other measures to reduce counterparty risk.
A large problem of Basel II was its reliance on risk weights that were badly calculated. Lack of data
for many new products, no consideration of systemic risk and possible moral hazard resulted in
several financial products of questionable quality receiving AAA ratings (Coval et al. 2008). The
downgrade of these products during the crisis meant that banks had to increase their regulatory
capital. Due to the systemic character of these products this happened exactly as assets were least
liquid and capital most costly to replace. Basel III keeps the risk weighting, but encourages banks to
supplement external rating with internal calculations. Moreover, external ratings must be improved,

8. and rating agencies are now obliged to comply with IOSCO’s “Code of Conduct Fundamentals for
Credit Rating Agencies.
To address the problem of liquidity Basel III imposes two new ratios: a Liquidity Coverage Ratio and
a Net Stable Funding Ratio. The coverage ratio requires internationally active banks to hold a large
enough quantity of highly liquid assets to offset cash outflows during a month long stress period. The
Net Stable Funding Ratio on the other hand, aims at stabilising medium and long term funding. The
required ratio of highly liquid assets will depend on the asset composition of the bank and include off-
balance sheet commitments.
Requiring banks to hold more liquid assets in a way requires banks to do less of what banking is
about, which is maturity transformation. One could therefore disagree with such regulation, and point
to the LOLR as a liquidity insurer or provider during periods of stress. However, the LOLR (usually)
only accepts collateral of high quality, which is likely to stay liquid during periods of stress if it truly
is safe.
The most striking difference between Basel III and its predecessor is the inclusion of macro-
prudential considerations. Some banks continued to award staff bonuses and hand out dividends
during the early stages of the crises (King and Tarbert, 2010), arguably in part to avoid sending
negative signals to the market. However, the reduction in banks’ capital buffer limited the banks’
ability to absorb losses (ibid.). To avoid capital reductions during periods of stress, and to address the
problems of pro-cyclicality, two new capital buffers are introduced. The first is a capital conservation
buffer requiring banks to hold additional 2,5% of risk weighted assets as common equity. Banks are
allowed to draw down on this buffer when needed, but must seek to rebuild it as soon as possible. If
they fail to do so regulators should constrain the banks opportunity to distribute dividends, pay
bonuses and buy back shares (ibid.). The second buffer is meant to be a counter-cyclical one by
reducing the self-reinforcing effects of credit growth/crunch. National authorities are supposed to

9. measure the level of credit growth and impose a buffer during periods of excess credit creation. This
can later be removed, and banks can draw down on the buffer when credit creation is viewed to be too
low.
Will Basel III succeed?
The motivation behind the development of Basel III is to cope with changes in the functioning of the
system, and fix weaknesses in the former version. However, fully predicting the implications of Basel
III is an impossible task, both due to the complexity of the financial system, and the complexity of the
regulation itself. Still, the proposed design of Basel III raises some key concerns, and “rather than
pushing through a flawed Basel III, we need to take the time to do it right so we do not have to do it
over” (Hoenig, 2012), or end up overdoing it.
Haldane (2012) points to the complexity of the rules under Basel II and III as a fundamental problem.
Simple models are better at forecasting out-of-sample observations, and the amount of data needed to
make complex models robust is enormous (ibid.). Furthermore, the more complex the regulation is,
the more difficult it is to monitor and identify weaknesses. The new Basel regulation is rules-based,
and resting on the premise that “making crises a thing of the past” is achievable, as long as everything
is accounted for. To my understanding, this is fundamentally the wrong way to cope with financial
instability for several reasons. First, as pointed out by Minsky (1981) “Economic administration in a
capitalist economy cannot be reduced to a routine such as can be programmed in a computer” (p.20).
This is because there is too much information to include and because “Goodhart’s law” applies. The
market forces are explosive, and banks will find ways to work their way around regulations (Wray,
2007). Further, if they fail at doing so, different institutions may emerge. An example is the
substantial part of private money creation now done outside the regulated banking sector by the so
called “shadow banks” (Gorton, 2010). Second, by fine-tuning banking regulation, you may end up
with a more homogenous banking sector. The system may look more stable during a boom, since no

10. banks are failing. This was the situation under Basel II, taken together with inflation targeting
monetary policy (Atik, 2011). Politicians, central bankers, regulators and private agents were all lulled
into a false sense of security, clinging on to the belief that the Great Moderation could continue
forever. However, as the current crisis revealed; if everyone is encouraged to buy or sell at the same
time, regulation becomes pro-cyclical. What is needed to reduce systemic risk are banks bucking the
trend.
In Basel III regulators are encouraged to operate a counter-cyclical capital buffer based on discretion.
I generally believe that discretion accompanied with some few simple rules, could be efficient for
micro-prudential regulation. However, I fear that rules must be dominant in macro-prudential
regulations for several reasons. First, discretion undermines the idea of international harmonising as a
way to reduce competitive deregulation. Second, it is not obvious that regulators (or the market) can
objectively measure and identify excess amounts of aggregate credit creation before it is too late1
.
Third, as a result, political pressure and regulatory capture may lead to problems of time
inconsistency. Instead countercyclical measures should be mandatory, e.g. requiring banks to
subscribe to a capital insurance scheme offered by the government as suggested by Dewatripont and
Tirole (2012). Removing macro shocks from the decision scheme of bank management and stabilising
credit creation over the cycle would be efficient both from a micro and macro-prudential point of
view. However, regulation such as this will require that the government have the financial muscle to
inject cash into the system when a shock occurs. This may not always be the case, but to my mind it
seems unlikely that any other institution generally would be in a better position to do this.
1
It is difficult to imagine that the current crisis would have been as severe, had destabilising credit creation
been easily observable ex-ante.

11. Conclusion
Banks are qualitative different than most other capitalistic firms. The general acceptance of bank
liabilities, backed by a diversified portfolio of assets and insurances, make them circulate as money in
the economy. This puts banks in a special situation where they are able to fund long term assets by
issuing short term liabilities. The maturity mismatch and high levels of leverage associated with banks
make them fragile and prone to runs. Thus, regulation such as liquidity ratios and CARs are used to
enhance the soundness of banks and increase their ability to cope with risks originating both on the
asset and liability side of the balance sheet. Moreover, reducing the riskiness of banks can be
rationalised along the lines of both moral hazard and from an externality perspective.
To ensure the stability of the global financial system, the different versions of the Basel Accord seek
to harmonise and set some minimum regulatory requirements. Basel II sought to reduce the
opportunities of regulatory arbitrage by introducing fine-tuned risk weights, but the result was
devastating. Basel II was unable to eliminate opportunities of regulatory arbitrage. Manipulation and
modelling failures resulted in highly leveraged banks, and contributed to the severity of the current
financial crisis. Furthermore, the pro-cyclicality of a CAR became evident as the credit crunch
reinforced itself through the downgrading and depreciation of asset values.
To fix the problems of Basel II, Basel III was presented in 2010. By addressing systemic risk and
introducing a macro-prudential perspective, Basel III moves banking regulation in the right direction.
However, by being even more complex than its predecessor, it is impossible to predict its effect on the
economy. Systemic risk will be increased if banks operate in a uniform manner, and complexity
makes it costly to monitor its implementation. Moreover, the regulation of the counter-cyclical buffer
seems to be inadequate due to political considerations. I thus fear that Basel III will be both costly and
ineffective. Admitting the limitations of complex rule based regulation, and alternatively using simple
and robust requirements accompanied by discretionary action may serve us better. Market forces are
explosive, and there will be another financial crisis in the future no matter how we regulate, as long as

12. we have a capitalist system. Very complex regulation today may at best provide a false sense of
security, and remove focus from how to minimise the social costs and distributional effects when the
next crisis hits.

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