edward j. kane, boston college 1 the dialectics of basel ii edward j. kane boston college keynote...

Edward J. Kane, Boston CollegeEdward J. Kane, Boston College11

The Dialectics of Basel IIThe Dialectics of Basel II

Edward J. KaneEdward J. Kane

Boston CollegeBoston College

Keynote AddressTaiwan Finance AssociationTaichung, TaiwanJune 9, 2007


Purpose and Shortcomings of Basel IPurpose and Shortcomings of Basel I

PurposePurpose: To get regulators in all major countries : To get regulators in all major countries of the world to define and of the world to define and enforce minimum enforce minimum capital standardscapital standards for their banks that would for their banks that would align each bank’s Tier I and Tier 2 capital with align each bank’s Tier I and Tier 2 capital with the extent of its the extent of its risk exposurerisk exposure. .

ShortcomingsShortcomings: Banks and policymakers know : Banks and policymakers know that the measures of bank risk and bank capital, that the measures of bank risk and bank capital, as well as the numerical standards that Basel I as well as the numerical standards that Basel I promulgates are conceptually flawed and easy promulgates are conceptually flawed and easy for opportunistic bankers to arbitrage. for opportunistic bankers to arbitrage.


Basel I and II Illustrate the Workings of An Basel I and II Illustrate the Workings of An Endless Regulatory DialecticEndless Regulatory Dialectic

Changes in regulatory systems deliver Changes in regulatory systems deliver benefitsbenefits and and burdensburdens to regulated parties (“ to regulated parties (“regulateesregulatees”).”).

To maximize the net benefits they receive from To maximize the net benefits they receive from regulation, regulatees have an incentive to regulation, regulatees have an incentive to reduce the burdens by undertaking low-cost reduce the burdens by undertaking low-cost structural innovations (“structural innovations (“Regulatory ArbitrageRegulatory Arbitrage”). ”).

After lags for recognition and response, After lags for recognition and response, regulation-induced and other innovations induce regulation-induced and other innovations induce Re-RegulationRe-Regulation. .


Each 3-part dialectic combines alternating Each 3-part dialectic combines alternating sequences of action and reaction: sequences of action and reaction:

1. Regulation-Avoidance Sequences1. Regulation-Avoidance Sequences

2. Avoidance-Reregulation Sequences2. Avoidance-Reregulation Sequences


BASEL II IS RE-REGULATION


My GoalsMy GoalsTo Show That The Dialectics of Sequential Contracting Explains: To Show That The Dialectics of Sequential Contracting Explains:

1. Why Basel II has so many loose ends (i.e., “national options”). 1. Why Basel II has so many loose ends (i.e., “national options”).

2. Why the attempt to implement Basel II in the U.S. has been 2. Why the attempt to implement Basel II in the U.S. has been roiled by continuing doubts, controversy, and delays that have roiled by continuing doubts, controversy, and delays that have put the country further and further out of phase with planned put the country further and further out of phase with planned implementation by Europe and Canada. implementation by Europe and Canada.

3. Why the debate among U.S. banks and U.S. regulators has 3. Why the debate among U.S. banks and U.S. regulators has proved fractious and intractable. proved fractious and intractable.

a. Largest banks a. Largest banks vsvs. other financial institutions.. other financial institutions.b. Federal Reserve b. Federal Reserve vsvs. other financial regulators. . other financial regulators.


REGULATORY DEBATE REFLECTS INDUSTRY DOUBTS ABOUT BASEL II

Source: American Banker (11-17-06)/Insight Express Executive Forum 3Q 2006 (Online survey of over 400 leaders of FSFs).


A country’s financial safety net is a social A country’s financial safety net is a social contract whose counterparties are government contract whose counterparties are government entities and the major sectors of the national entities and the major sectors of the national

economy.economy.

Government SubsectorsGovernment Subsectors

Financial SubsectorsFinancial Subsectors

Subsectors of the Real EconomySubsectors of the Real Economy


CONTRACTING THEORY SEEKS TO CONTRACTING THEORY SEEKS TO IDENTIFY AND EXPLAIN DELAYS AND IDENTIFY AND EXPLAIN DELAYS AND

GAPS IN ANY DEALGAPS IN ANY DEAL CONTRACTCONTRACT: Any commitment by: Any commitment by two or more two or more

parties to exchange a mix of reciprocal rights parties to exchange a mix of reciprocal rights and obligations: a “deal”and obligations: a “deal” which creates an which creates an incremental balance sheet. incremental balance sheet.

COUNTERPARTIESCOUNTERPARTIES: Serve as both principals : Serve as both principals and agents.and agents.

STAKESSTAKES: Value of contract : Value of contract performanceperformance or or breachbreach to stakeholders to stakeholders

STAKEHOLDERSSTAKEHOLDERS: Negotiators need to establish : Negotiators need to establish who the stakeholders are and what each seeks who the stakeholders are and what each seeks from the agreement.from the agreement.


COORDINATING SAFETY NETS ACROSS COUNTRIES COORDINATING SAFETY NETS ACROSS COUNTRIES MEANS REWRITING INDIVIDUAL-COUNTRY SOCIAL MEANS REWRITING INDIVIDUAL-COUNTRY SOCIAL

CONTRACTSCONTRACTSCounterparties Counterparties are Major Sectors of an identifiable political or are Major Sectors of an identifiable political or

economic Communityeconomic CommunityThree Contract Segments:Three Contract Segments:

1. “Clauses” that define and assign 1. “Clauses” that define and assign responsibilitiesresponsibilities for for preventingpreventing disruptive financial-institution insolvencies.disruptive financial-institution insolvencies.

2. Clauses that define a range of 2. Clauses that define a range of tax-transfertax-transfer techniquestechniques for for financing this supervisory activity and losses it fails to prevent.financing this supervisory activity and losses it fails to prevent.

3. Clauses that dictate the political and economic 3. Clauses that dictate the political and economic incentivesincentives under which operators discharge their responsibilities.under which operators discharge their responsibilities.

Incompleteness of ContractIncompleteness of Contract::1. Goal Variables (Financial Stability and Cross-Country 1. Goal Variables (Financial Stability and Cross-Country

Integration) are not operationally “describable.”Integration) are not operationally “describable.”2. Operational Triggers 2. Operational Triggers and remedies for breaches are specified and remedies for breaches are specified

only in the U.S.only in the U.S.3. Optionality of Supervisory Actions: Operators of National Nets 3. Optionality of Supervisory Actions: Operators of National Nets

are authorized to make decisions about their actions are authorized to make decisions about their actions improvisationallyimprovisationally and under great and under great time pressuretime pressure..


Model of U.S. Stakeholders and ClientelesModel of U.S. Stakeholders and ClientelesI. Federal Reserve Board and NY Fed (lead negotiators for the U.S.)I. Federal Reserve Board and NY Fed (lead negotiators for the U.S.)

a. Quantitative Staff at Fed (stake = advancement & “street creds”: e.g., John Mingo)a. Quantitative Staff at Fed (stake = advancement & “street creds”: e.g., John Mingo)b. Successive Leaders of Basel II pushb. Successive Leaders of Basel II push

William McDonough and Larry Meyer (Greenspan in background)William McDonough and Larry Meyer (Greenspan in background) Roger Ferguson, Susan Bies, and Randy KrosznerRoger Ferguson, Susan Bies, and Randy Kroszner● ● Roger Cole at staff levelRoger Cole at staff level

c. c. Broad Stability MissionBroad Stability Mission: Stabilize Liquidity; Oversee Domestic and International : Stabilize Liquidity; Oversee Domestic and International Value of the Dollar; Promote Systemic StabilityValue of the Dollar; Promote Systemic Stability

d. d. Special ClienteleSpecial Clientele: Larger Financial Holding Cos. and Their Quant. Staffs: Larger Financial Holding Cos. and Their Quant. Staffs

II. Other Federal Regulators: The “FDIC+” II. Other Federal Regulators: The “FDIC+” a. FDICa. FDIC MissionMission: Resolve Insolvencies and Protect the Integrity of the DI fund. : Resolve Insolvencies and Protect the Integrity of the DI fund. Special ClienteleSpecial Clientele: Community Banks; Conference of State Bank Supervisors : Community Banks; Conference of State Bank Supervisors b. OCCb. OCC MissionMission: Supervise National Banks and Strengthen Their Charter: Supervise National Banks and Strengthen Their Charter Special ClienteleSpecial Clientele: Money-Center and Regional Banks: Money-Center and Regional Banksc. OTSc. OTS MissionMission: Support mortgage market (i.e., keep Basel risk weight for mortgages low), : Support mortgage market (i.e., keep Basel risk weight for mortgages low),

Strengthen S&L charter, and supervise S&Ls Strengthen S&L charter, and supervise S&Ls Special ClienteleSpecial Clientele: S&Ls & Building Industry: S&Ls & Building IndustryIII. Congress & Administration (Treasury)III. Congress & Administration (Treasury)IV. Voter-TaxpayersIV. Voter-Taxpayers


Stakeholders in Europe Had Simpler GoalsStakeholders in Europe Had Simpler Goals

I. CHANGING MIX OF CENTRAL BANKS AND FINANCIAL SUPERVISORY I. CHANGING MIX OF CENTRAL BANKS AND FINANCIAL SUPERVISORY AUTHORITIESAUTHORITIES

a. Mission of Central Banks: Stability of Every Kinda. Mission of Central Banks: Stability of Every Kindb. Mission of FSAs: Application of Basel Across Countries and b. Mission of FSAs: Application of Basel Across Countries and Institution Types (Uniformity Rather Than Financial Institution Types (Uniformity Rather Than Financial Stability) Stability)c. IOSCO c. IOSCO et al.et al. d. Clienteles: Systemically Important Institutions d. Clienteles: Systemically Important Institutions (Trend is for European central banks to transfer responsibility (Trend is for European central banks to transfer responsibility

for for fin. stability to FSAs.) fin. stability to FSAs.)II. ECB and Other Authorities in European UnionII. ECB and Other Authorities in European Union

a. Mission: To promote pol. and econ. integration (uniform a. Mission: To promote pol. and econ. integration (uniform rules) rules)b. Clientele: Sponsors of political and economic b. Clientele: Sponsors of political and economic integration in Brussels and elsewhere. integration in Brussels and elsewhere.

III. Elected Officials in National GovernmentsIII. Elected Officials in National GovernmentsIV. Voter-TaxpayersIV. Voter-Taxpayers


MY CONTRACTING MODELMY CONTRACTING MODEL

Assumptions: First-Order Stake of U.S. Negotiators is Assumptions: First-Order Stake of U.S. Negotiators is Enhancing Enhancing Financial-StabilityFinancial-Stability; First-Order Stake of ; First-Order Stake of EU Negotiators is Enhancing EU Negotiators is Enhancing Financial IntegrationFinancial Integration..

Objective Function for Objective Function for RegulatorsRegulators

Mission FulfillmentMission Fulfillment Reputational Standing of their Reputational Standing of their

OrganizationOrganizationa. With clienteleb. With National Politiciansc. With Foreign Regulatorsd. With Taxpayer-Voters

Personal and Career Personal and Career Rewards to Staff and LeadersRewards to Staff and Leaders

Objective Function for Objective Function for Regulated InstitutionsRegulated Institutions

Competitive Advantages, Competitive Advantages, Including Loyalty of Clients and Including Loyalty of Clients and Broader Reputational Standing Broader Reputational Standing of Firmof Firm

Regulatory ForbearancesRegulatory Forbearances Personal Rewards to Staff & Personal Rewards to Staff &

Leaders (Incentive Bonuses; Leaders (Incentive Bonuses; Career Trophies and Career Trophies and Opportunities) Opportunities)


Elements of a “Good Contract”Elements of a “Good Contract”1.1. Easy to Understand (Interpretation Costs and Adverse Easy to Understand (Interpretation Costs and Adverse

Options are Imbedded in “fine print”)Options are Imbedded in “fine print”)2.2. Creates incentives for its fulfillmentCreates incentives for its fulfillment

IMPLICATIONS OF BAD CONTRACTINGIMPLICATIONS OF BAD CONTRACTING: : 1. Regulatory Dialectic tells us fine print will be 1. Regulatory Dialectic tells us fine print will be

exploited to the disadvantage of taxpayers. exploited to the disadvantage of taxpayers. 2. When and as a bank weakens, Use of Total Assets 2. When and as a bank weakens, Use of Total Assets

in the Denominator of Insolvency-Avoidance in the Denominator of Insolvency-Avoidance Leverage Tests Outscores Basel II’s Complicated Leverage Tests Outscores Basel II’s Complicated Risk-Weighting Procedures on Both Counts. Risk-Weighting Procedures on Both Counts.

3. Technical staffs at Fed and large banks are not 3. Technical staffs at Fed and large banks are not accountable for “overselling” higher-ups about accountable for “overselling” higher-ups about reliability reliability of models and of data on which of models and of data on which estimation must rest. estimation must rest.


How Older Quants Mentor New Recruits


Loose Ends and Fractiousness Occur in U.S. Loose Ends and Fractiousness Occur in U.S. Because Dealmaking is Sequential: Three PhasesBecause Dealmaking is Sequential: Three Phases

1.1. ““Predeal understandings”: Recognizing that “a stitch in Predeal understandings”: Recognizing that “a stitch in time” might “save nine,” prior consultation with time” might “save nine,” prior consultation with constituencies develops a prior consensus that constituencies develops a prior consensus that imposes a mix of hard and soft constraints on contract imposes a mix of hard and soft constraints on contract terms that U.S. officials could negotiate in Basel.terms that U.S. officials could negotiate in Basel.

• Understandings are less Understandings are less sharply wordedsharply worded, and less , and less enforceableenforceable than a contract.than a contract.

• Because understandings are Because understandings are largely privatelargely private communicationscommunications, , particular constituencies can interpret their understandings in particular constituencies can interpret their understandings in ways that might be ways that might be inconsistentinconsistent with understandings given to with understandings given to another sector.another sector.

2.2. Dealmaking in BaselDealmaking in Basel3.3. Postdeal Reconciliation of Individual-Country Postdeal Reconciliation of Individual-Country

Regulatory Options allowed by Basel with Sectoral Regulatory Options allowed by Basel with Sectoral Understandings: Undertaken in public and backroom Understandings: Undertaken in public and backroom dialogues between industry segments and regulators. dialogues between industry segments and regulators.


Inconsistencies in Prior Inconsistencies in Prior Understandings and GoalsUnderstandings and Goals

US regulators eliminated the Foundational US regulators eliminated the Foundational approach and specified that very large US banks approach and specified that very large US banks would be required to use the AIRB approach.would be required to use the AIRB approach.

Individual banks that designed and operated Individual banks that designed and operated state-of-the-art risk-management systems would state-of-the-art risk-management systems would be rewarded with lower levels of capital be rewarded with lower levels of capital (presumption that PCA “leverage ratios” could (presumption that PCA “leverage ratios” could be over-ridden).be over-ridden).

FDIC+ was assured that overall level of US bank FDIC+ was assured that overall level of US bank capital would not be allowed to decrease much capital would not be allowed to decrease much under Basel II, in line with their under Basel II, in line with their accountabilityaccountability for complying with FDICIA’s anti-forbearance for complying with FDICIA’s anti-forbearance PCA requirements.PCA requirements.


How Does Recognizing These Phases How Does Recognizing These Phases Improve our Understanding of Basel II?Improve our Understanding of Basel II?

When seen as part of a Regulatory Dialectic, this perspective When seen as part of a Regulatory Dialectic, this perspective helps us to see that the Value of Basel II Lies in the focus the helps us to see that the Value of Basel II Lies in the focus the Forum Creates for Better-Informed and More Timely Forum Creates for Better-Informed and More Timely Re-Re-RegulationRegulation

Continuing negotiations demonstrate Continuing negotiations demonstrate commitmentcommitment to to monitor changes in financial monitor changes in financial contracting technologycontracting technology and and to respond to to respond to regulatory arbitrageregulatory arbitrage in a relatively prompt in a relatively prompt and coordinated way.and coordinated way.

Dialectical perspective also helps to explain Dialectical perspective also helps to explain ComplexityComplexity and and IncompletenessIncompleteness of the Evolving Deal of the Evolving Deal

Why have negotiations been so protracted?Why have negotiations been so protracted? Because Because so so many counterpartiesmany counterparties are involved and the number in are involved and the number in Europe kept expanding. Europe kept expanding.

Why is deal so full of loose ends?Why is deal so full of loose ends? Because hard-to- Because hard-to-understand options must be conveyed to national regulators understand options must be conveyed to national regulators and banks to enable them to rework and banks to enable them to rework predeal predeal understandingsunderstandings with major sectors so as to sell the deal to with major sectors so as to sell the deal to competing constituencies in their home countries.competing constituencies in their home countries.


QIS4 (AND QIS5) NEARLY DERAILED QIS4 (AND QIS5) NEARLY DERAILED THE PROCESS IN 2006THE PROCESS IN 2006

Source: FDIC


Quantitative Impact StudiesQuantitative Impact Studies QIS4 surveyed 26 US bank holding companies QIS4 surveyed 26 US bank holding companies

expected to use the AIRB methods. Showed great expected to use the AIRB methods. Showed great variation in effects. If these BHCs met only their Basel variation in effects. If these BHCs met only their Basel II capital requirements, 17 of them would be classified II capital requirements, 17 of them would be classified as as undercapitalized by PCA standards undercapitalized by PCA standards (a few others (a few others may have lied).may have lied).

Surprising in that it seems as if bank quant staff filled Surprising in that it seems as if bank quant staff filled out the survey to demonstrate benefits to their out the survey to demonstrate benefits to their superiors (i.e., to generate evidence that “risk” could superiors (i.e., to generate evidence that “risk” could be removed from the system), without recognizing the be removed from the system), without recognizing the contradictory organizational need to quiet the fears of contradictory organizational need to quiet the fears of the FDIC+. the FDIC+.

Supports hypothesis that Supports hypothesis that quantsquants at large banks and at large banks and the Fedthe Fed are the engine driving the Basel IIare the engine driving the Basel II train. train.


QIS4 showed that large-bank and FDIC+ predeal QIS4 showed that large-bank and FDIC+ predeal understandings about individual-bank and system capital understandings about individual-bank and system capital were inconsistent and that their subdeals had to be were inconsistent and that their subdeals had to be renegotiatedrenegotiated..

FDIC+ has firmed up their understandings about the FDIC+ has firmed up their understandings about the leverage leverage ratioratio and and capital reductionscapital reductions for FDIC+ clienteles (Basel IA), for FDIC+ clienteles (Basel IA), with consequence that giant banks are now asking that their with consequence that giant banks are now asking that their deal be revisited. deal be revisited.

Large banks want more options to use either a more-flexible Large banks want more options to use either a more-flexible AIRB or a standardized approach that is specifically tailored AIRB or a standardized approach that is specifically tailored to the activities of large complex banking organizations. to the activities of large complex banking organizations.

Fed personnel evidence impatience. Staff is embarrassed Fed personnel evidence impatience. Staff is embarrassed about continuing to fall further and further behind Europe and about continuing to fall further and further behind Europe and Canada. Canada.

Where is the U.S. Today?


Stages in Finalizing Basel II in U.S.: Four Stages in Finalizing Basel II in U.S.: Four Layers of Dealmaking Have to be Completed Layers of Dealmaking Have to be Completed

Before ImplementationBefore Implementation1.1. International Layer of DealmakingInternational Layer of Dealmaking: Between U.S. : Between U.S.

delegates and other members of the Basel Committee delegates and other members of the Basel Committee on Banking Supervision on Banking Supervision (Done)(Done)

2.2. Interregulator Layer of DealmakingInterregulator Layer of Dealmaking: Between Fed : Between Fed and Leaders of “FDIC-Plus”and Leaders of “FDIC-Plus”

a.a. PreBasel UnderstandingsPreBasel Understandingsb.b. PostBasel Process of Reconciling Contradictory PostBasel Process of Reconciling Contradictory

Understandings Understandings (Nearly Done)(Nearly Done)

3.3. Industry-Regulator Layer of DealmakingIndustry-Regulator Layer of Dealmaking: Between : Between Regulators and their Clienteles, PreBasel and Regulators and their Clienteles, PreBasel and PostBasel PostBasel (Hang-Up Today)(Hang-Up Today)

4.4. Political Layer of DealmakingPolitical Layer of Dealmaking: Regulators have to : Regulators have to Sell Deals that clear first three levels to Politicians and Sell Deals that clear first three levels to Politicians and Taxpayer/Voters Taxpayer/Voters (Eager to Take Any Deal)(Eager to Take Any Deal)

(similar layers exist in the EU)(similar layers exist in the EU)


Post-Basel Negotiations are realigning the Post-Basel Negotiations are realigning the original goals: focusing on equalizing original goals: focusing on equalizing competitive effectscompetitive effects of potential reductions of of potential reductions of minimum capital across U.S. regulatory minimum capital across U.S. regulatory clienteles rather than on rewarding clienteles rather than on rewarding improvements in improvements in risk management risk management made by made by individual institutions. individual institutions.

Political pressures are likely to push minima Political pressures are likely to push minima generated by final version of Basel IA for generated by final version of Basel IA for community banks and still-to-be-determined community banks and still-to-be-determined large-bank options to be calibrated close to the large-bank options to be calibrated close to the U.S. regulators’ stated 10 percent threshold for U.S. regulators’ stated 10 percent threshold for redesigning the IRB option. redesigning the IRB option.


Value of Taking One’s Time to Get a Value of Taking One’s Time to Get a Deal Right: Well Begun is Half DoneDeal Right: Well Begun is Half Done

Post-Basel Contracting Forum

Large Banks


Few Cross-Country Commitments made by Regulatory Few Cross-Country Commitments made by Regulatory Bodies are Explicit; Most Are ImplicitBodies are Explicit; Most Are Implicit

Selective Implementation Will Occur: Looseness in Selective Implementation Will Occur: Looseness in Methods by which performance of regulators’ Methods by which performance of regulators’ supervisory and disclosure obligations are to be supervisory and disclosure obligations are to be triggered, monitored, and enforcedtriggered, monitored, and enforced

Weaknesses in defining or observing triggers or Weaknesses in defining or observing triggers or enforcing obligations convey enforcing obligations convey adverse implicit optionsadverse implicit options to one’s counterparties. [D. Carrullo of Georgetown Law to one’s counterparties. [D. Carrullo of Georgetown Law claims that Basel II offers 82 opportunities for exercising claims that Basel II offers 82 opportunities for exercising “national discretion.”]“national discretion.”]

At bank level, risk management depends on melding At bank level, risk management depends on melding clearing and settlement networks with portfolio-offset clearing and settlement networks with portfolio-offset valuation models that cannot easily be standardized. valuation models that cannot easily be standardized.

What Next?: Confronting Cross-Country Loose Ends in Basel II Dealmaking Will Generate Many Higher-Numbered Versions of Basel


APPENDIX: REALISTICALLY, TBTFU TELLS GIANT BANKS THAT THEY NEED LESS ENTERPRISE-CONTRIBUTED

CAPITAL THAN SMALLER BANKS

Source: American Banker (3/7/07)

edward j. kane, boston college 1 the dialectics of basel ii edward j. kane boston college keynote...

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