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FromBaseltoBailouts:

FortyYearsofInternationalAttemptstoBolsterBankSafety*

Christopher Kobrak†

ESCP Europe and Rotman School of Management, University of Toronto

Michael Troege‡

ESCP Europe, Labex Refi

September 14, 2014

Abstract: This paper reinterprets the origin and evolution of the Basel Accords. We argue that the Basel I paradigm was very different from the regulatory approaches that had been successfully applied in most European countries since the Second World War. In particular the stability of b§anking systems had long relied on a multitude tools including entry restrictions, liquidity rules, reserve requirements, deposit rate ceilings, lending and investment restrictions, combined with a hands-on supervision and discretional interventions. Capital adequacy was certainly not perceived as the most important part of these tools.

By focusing exclusively on capital adequacy and credit risk, Basel I shifted attention in a very different and somewhat unexpected direction. The Basel regulations are often understood as a reaction to the bank failures of the 70s and 80s, but in fact Basel I type capital adequacy rules would not have prevented these crises, which were caused by a mixture of interest rate, liquidity and currency risk, none of which was addressed in the Basel I proposals. Indeed, even today, several of these risks are still not addressed by Basel updates, suggesting that the original and current proposals have a rather different raison d’être, placating political constituencies and banking interests. One of the consequences of this fatally flawed tendency is that the smooth functioning of financial markets had and still has to be insured by an implicit government guarantee for larger banks.

* The authors would like to thank Hugo Bänziger, Harold James, Ralf Leiber, Clifford Smout, Daniel Zuberbühler and the author participants at the June EABH seminar on financial risk management hosted in Zurich by Swiss Re. Any errors remain ours. † Corresponding author, Wilson/Currie Chair of Canadian Business and Financial History, Rotman School of Management, University of Toronto, 105 St George Street, Toronto, Canada. Email: cpkobrak@aol.com ‡ ESCP Europe, 79, av. de la République 75543 Paris Cedex 11, Email: troege@escpeurope.eu

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It is not clear that anything would have been different in the 2007-2009 crisis had Basel III

already been in place. (Admati & Hellwig, 2013: 96)

As finance has become more complicated, regulators have tried to keep up by adopting ever more complicated rules. It is an arms race that underfunded government agencies have no

chance to win.

Kenneth Rogoff

The Guardian, Monday 10 September 2012

1 Introduction

This year marks the 40th anniversary of a series of bank failures, the beginning of a

long series of financial disruptions commonly associated with the breakdown of the Bretton

Woods system. In summer 1974, two challenges, which had not plagued western banks for

over a generation, led to the bankruptcy of several banks on both sides of the Atlantic, raising

problems for which financial regulators were ill-prepared and for which there was little or no

positive historical precedence. First, increasing inflation rates and volatile foreign exchange

rates led to demands for financial products to control risk. (Eichengreen, 1996: 142) Second,

inflation and petrol dollars added greatly to bank liquidity and transformed its nature.

This period is often seen as the beginning of the international cooperation of bank

regulators, the birth of the Basel Accords which today have become the principal avenue for

international and national bank regulation. The commonly held view is that after a series of

bank failures in the early 1970s, followed by the Savings and Loan crisis and the huge

sovereign debt crisis of less developed countries (LDC) in the 80s, regulators realized the

necessity of stronger international cooperation and came together in the Basel committee to

set the foundations of a strong and homogenous international framework that would end the

turmoil in financial markets and allow the smooth international exchange of capital and

goods.

However today, five years after the 2008 Banking Panic, few observers are happy with

the extent and quality of bank oversight. Many well informed observers bemoan the slowness

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of deciding and implementing international standards1; some question whether international

standards can supplement national supervision (Levinson, May-June 2010), and others

criticize the timidity of the bank equity standards. (Admati and Hellwig, 2013) and their

increasing complexity (See Kenneth Rogoff’s quote at the beginning of this paper)

This paper focuses on 25 years of banking regulations, the genesis of the Basel

Accords, putting that development into its historic context and trying to understand the

motivations that led to the Basel principles as they stand today. It challenges some of core

tenets of the historical accounts and the efficacy of international attempts to stabilize

international finance. We intend to provide a broader picture of the forces that finally shaped

these rules, in particular the Basel I regulations or Cooke ratio, which continue to provide the

underlying structure for most of today's rules. In particular, we are interested in understanding

why Basel I focused exclusively on capital adequacy and credit risk. We argue that this choice

was somehow surprising, as the bank failures in the 1970s at least, were mostly caused by a

mixture of interest rate, liquidity and currency risk, often in combination with fraud. Finally,

we will suggest that the approach of the Basel Committee contributed to the emergence of the

“too big to fail” issue, which has led to the assumption that governments would protect

creditors and depositors from the risks taken by megabanks. (Haldane and Alessandri, 2009).

By highlighting the political-economic context of the 1970s and 80s, we suggest that

Basel I has not only determined our regulatory paradigm, the failures of this regulation have

also contributed to many problems of the past 25 years and are perhaps even at the root of our

current problems. We take as our starting point that the breakdown of Bretton Woods and the

increase of capital mobility in much of the world shattered older models of national and

international banking. The increased volatility of interest-rate and foreign-exchange

movements coupled with technological developments, greater levels of manufacturing foreign

direct investment, disintermediation, and new banking competition from offshore centers

(Euromarkets), awash with cash, prompted a radical reassessment of banks strategies.

Smaller banks needed to enter a more complicated game than they ever had before and larger

ones to find new activities over a larger geographic area. This new macroeconomic reality,

the privatization of currency risk especially, brought small and large banks more and more

1 Serious financial newspapers and magazines such as The Economist, The Financial Times and Wall Street Journal were rife with skeptical articles about the timing, complexity, and lack of geographic and sector completeness of new regulations. See, for example, “Conflicting signals: Global finance,” Brooke Masters, The Financial Times, April 2, 2012 and almost a year later The Financial Times, “Fund Management,” Philip Stafford, January 28, 2013.

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into the ever-more-complex cross-border lending and derivative businesses, making managing

liquidity and counterparty risk far more complicated.

Unable to win support for dealing with the real issues, central bankers and

international bodies crafted regulations that they themselves knew were only partially

addressing the real structural banking issues. Some of their regulations were designed

specifically to win over important national governments and sufficient buy-in by those

governments to insure that they would underwrite the activity of their banks and perhaps the

wholes system.

Our paper contributes to the small but growing literature trying to understand the

forces that led to the establishment of the Basel regulations. In particular we complement

Goodhart’s (2011) detailed presentation of the history of the “Basel Committee on Banking

Supervision” (BCBS). In contrast to Goodhart, we put the main lines of argument into their

historic context, notably adding facts and data known to committee members but not

necessarily discussed in the (winnowed) official documents on which Goodhart relies.

Our main contribution to these discussions is to weave together several strands of

thought, but with some new twists. Some of the arguments made in our paper are already

contained in the early summary of the process leading to the 1988 capital accord. Kapstein

(1991) traced the process, but his discussion largely leaves out the economic context. Tartullo

(2008) contains a comprehensive and very critical discussion of the earlier Basel regulations,

but mostly focuses on Basel II regulation. Our point that Basel regulations were not well

grounded in economic analysis has been made by several authors, such as Hellwig (1996),

Admati and Hellwig (2008) and Allen and Gale (2003). Even the dependence modern

international banking on implicit government guarantees has been pointed out before by

Haldane and Madouros (2012). What we have done that is rather unique, though, is to

provide ample additional evidence of how inappropriate the Basel measures were at the time

and how subsequent updates did not solve the problems of the first Basel accord.

In the next section, we defend our claim that credit risk as a standalone risk was of

minor importance for the banking failures of the 1970s by reviewing the root causes of the

three principal bank failures from this period. We also complement this analysis with a more

comprehensive overview of the reasons for bank failures during this period and demonstrate

that U.S. regulators, in contrast to some European, were much more concerned to avoid

depositor and bank creditor absorb the losses of failed banks.

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Against this background, we then briefly present in Section 3 the emergence and the

governance of the Basel Committee for Banking Supervision and discuss the problems that

led to a more than decade-long stalemate after some initial success.

Section 4 then follows Kapstein (1991) and Tartullo’s (2008) account of how the 1986

initiative by U.S. and U.K. regulators broke this stalemate and very rapidly led to the

definition of the major features of the Basel I regulations and the implementation of the

capital accord in 1988. We will argue that this choice was driven more by the usefulness of

capital adequacy as a protectionist measure rather than by any empirical evidence about the

potential increase in stability that could be achieved with such a measure.

In Section 5 we reinforce this argument by showing how different the Basel I rules

achieved through this process really were much different from the prevailing approaches to

bank regulation and demonstrate that it must have been obvious that the rules would not

substantially reduce the failure probability of banks.

In Section 6 we argue the flaws in the original approach of Basel I hampered the

committee’s efforts to reform it. Subsequent updates mostly addressed distortions created by

the original Basel I’s, rather than completing the regulation. Indeed many of the first accords

glaring omissions were only addressed after the 2008 crisis and some omissions remain with

us to this day.

We conclude in Section 7 with a discussion of how this incomplete regulatory

framework increased the role of implicit government bank guarantees.

2 The End of Bretton Woods and the Banking Crises of the 1970s

The origins of the Basel Committee on Banking Supervision on bank supervisions do

indeed go back to the early 70s. By the time Nixon took the United States off the Gold

Standard, virtually unregulated Euromarkets, dominated by big U.S. and U.K. banks, had

altered the competitive banking environment. In particular, Euromarkets put great pressure

on the capacities of smaller, more domestically bound, banks of many countries. In contrast to

the larger, internationally active banks, these banks had little ability to escape national

regulation. As a consequence, national authorities, under pressure to respond with lighter

regulation, removed liquidity standards and reserve requirements together with the deposit

rate ceilings. For example, in the fall of 1971, the Bank of England installed the

“Competition and Credit Control,” which replaced direct lending ceilings imposed on

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individual banks with a control of money supply thorough open market operations, reduced

the minimum liquidity requirement for deposit taking banks from 28% to 12.5%, and

eliminated the legal restrictions on deposit rates. (Moran, 1984) Other countries enacted

similar initiatives at the same time.

This deregulation enabled a number of aggressive smaller banks in Europe and the

U.S. to enter new market segments, especially those created by increased macroeconomic

volatility starting in the late 1960s. The first indication that these developments could be

problematic came from the “secondary banking crisis” in the United Kingdom; This crisis had

its roots in an almost classic combination of interest rate risk, correlated with credit risk and

enhanced by fraud and weak liquidity positions The strong increase in interest rates triggered

by the first oil crisis in 1973/74 had led to a drop in real estate values which increase default

rates and quickly caused a decline in profitability of smaller “secondary” or “fringe” banks.

A real crisis was then triggered by the resignation of Donald Bardsley, a recent appointee to

the board of “London and Country Securities,” one of the larger “secondary” banks. This led

to a collapse of trust and a string of additional revelations about the bank’s unsavory business

practices from the newly elected boards. (Capie 2010) The public began to suspect that other

smaller banks might have similar problems and started to withdraw deposits.

Remarkable, during this crisis, the Bank of England did everything to make sure that

depositors did not lose their money. In order to buy more time, it pushed the large clearing

banks, to which depositors had brought the money withdrawn from the secondary banks, to

lend the cash back to the failing banks at a low interest rate. In parallel, the Bank of England

required the trouble banks’ shareholders to recapitalize their institutions or tried to find an

acquirer, a strategy that became known as the “lifeboat concept.” Interestingly, at the same

time, criminal prosecution against key personnel of the trouble banks was commenced, an

effective part of the regulatory tools. One of the directors of London and Country Securities,

for example, went to prison and two others had to pay heavy fines. (Bär, 2004)

The U.K.’s secondary banking crisis was not the only problem. The crisis of two U.S.

banks, National Bank of San Diego in 1973 and then Franklin National, and the German

Herstatt in 1974, followed in short order. Their problems could be traced to similar root

causes: a combination of fraud, currency speculation and classic interest rate risk.

Important lessons were learned by the regulators, however, in these crises. In

particular, the case of the National Bank of San Diego served as a warning to U.S. authorities.

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The bank had failed because of fraudulent activities of its owner C. Arnholt Smith. Crocker

National Bank, which took over the U.S. National Bank of San Diego in conjunction with the

Federal Deposit Insurance Corporation (FDIC). They initially refused to honor some of the

bank’s letters of credit, which had been bought by European banks, claiming that these banks

had been aware of the fraud. (Bär, 2004) Their reluctance led to a general mistrust in smaller

U.S. banks. As a consequence, U.S. banks started to lose foreign deposits, a decline in

business the Federal Reserve Bank (Fed) was determined to head off. Therefore, when

Franklin National went under, Richard A. Debs, the Fed’s Vice president, insisted that another

threat to honor foreign depositors by a U.S. bank would not only lead to a dramatic loss of

confidence in U.S. banks in particular but also in the international currency market in general.

In his memoir, Hans Bär recalled an invitation to the American embassy in Switzerland where

the Ambassador Shelby Collum Davis together with a representative of the Federal Reserve

Bank reassured the leading Swiss bankers that their exposure to Franklin National would be

honored by the Fed. Indeed the Fed injected a total of $1.8 billion into Franklin National

(Edelman-Spero,1999). Franklin was later bought by European American Bank (EAB), a

consortium of European banks, which included Deutsche Bank, in order to get EAB a

foothold into the U.S. retail market. The investment did not end well. (Kobrak, 2007)

The UK reaction to the secondary banking crisis as well as the U.S. reaction to the

Franklin National contrasts sharply with the Bundesbank’s conduct in the Herstatt crisis. I. D.

Herstatt KGaA was a small bank which, in less than 20 years, had grown from 15 employees

to one of the largest private banks in Germany, with 850 employees. Its traditional banking

business, however, generated low profits. The bank tried to compensate with highly

speculative currency trades executed by a group of 6 traders in their twenties, the “Goldjungs”

(the gold boys) under Dany Dattel. Interestingly, the Goldjungs carried out their activities

almost without any control from the banks board or any understanding of their activities by

the directors in charge. This enabled them to fraudulently circumvent the position limits of

$10 million imposed by the bank. In a series of events that closely resembled the recent

Société Générale/ Kerviel debacle, Iwan D. Herstatt claimed that Dattel had manipulated the

bank’s computer system (Herstatt, 1992) in order to be able to temporarily exceed its limit by

up to 750 million marks. Dattel, in contrast, accused management of open connivance. He

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had supposedly asked early on for a transfer to another department because of the activities

and apparently warned the chief auditor of the Herstatt Bank of risks in forex trading.2

Today the bank’s failure is still well known, because it drew the attention to the

existence of a new sort of risk the “Herstatt risk “or settlement risk.” Previously, trading in

spot markets at least had been assumed to be free of counterparty risk. But the Herstatt failure

demonstrated that even spot trades could be dangerous. Indeed, when the bank was closed at

15:30 on 26 June 1974, a range of foreign correspondence banks had already transferred the

Deutsche Mark side of the daily currency deals to Frankfurt. Because of time-zone

differences, however, Herstatt ceased operations before the received the corresponding USD

payments. Interestingly, this risk can be completely avoided by an instantaneous clearing

mechanism, took thirty years to put into place, Continuous Linked System (CLS). (Goodhart,

2011: 4)

More importantly for our purposes, however, was the refusal of the Bundesbank to bail

out any of the creditors. The Bundesbank had always considered that it was not its role to save

failing banks. It also likely profited from this opportunity to calm down what it perceived to

be speculative excesses in the currency markets. In stark contrast to the U.S. regulators, it did

not hesitate to impose severe losses on foreign creditors. Indeed, initial estimates of the

foreign banks’ losses were enormous, only after a surprising court decision which gave

foreign creditors seniority, did the losses of foreign banks become manageable amounts.

(Bär, 2004) This stance contributed to dampening currency markets. It shocked the system of

interbank payments in New York and almost led to the fall of several other institutions.

Herstatt highlighted the systemic risks associated with the internationalization into which

banks were increasingly pushed.

German retail depositors succeeded in getting back around 80% of their deposits, but

only after Hans Gerling, the owner of the Gerling Insurance Company and limited partner in

the bank, had been forced to recapitalize the bank with the proceeds of the sale of 51% of his

company to a group of investors led by Deutsche Bank. (Koch, 2012)

Not surprisingly, given the Bundesbank’s obsession with deterrence of further

excesses, the decision makers at Herstatt were also criminally prosecuted. The leading figures

2 “Herstatt-Bank, Die Bruchlandung der ‚Raumstation Orion‘,“ Frankfurter Allgemeine Zeitung, May 9th 2009.

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in the scandal were all at least condemned to prison terms, although I.D. Herstatt did not serve

his sentence and Dattel, suffering from post-traumatic disorder due to his months in

Auschwitz at age four, was declared unfit to stand trial. (Handelsblatt, 2009)

German bankers, however, learned several lessons. They realized that the Herstatt

Bank debacle had substantially eroded their international standing. As a means of reassuring

creditors, the German banks established a deposit insurance fund to protect depositors from

the consequences of bank insolvency.

The difference between the very cautious treatment of the banks in the United States

and United Kingdom and the brutal, but principled stance of continental European regulators

was still apparent in the early 80s. Take, for example, the different handling in 1982 of Banco

Ambrosiano’s failure in Italy, on the one hand, and that of Continental Illinois in1984, during

the height of the LDC debacle. Continental Illinois was the 8th large largest bank in the

United States. It depended on short-term deposits made by large international investors.

When these creditors started to withdraw their funds, the FDCI and the Fed stepped in. While

management was removed and shareholders wiped out, all depositors and noticeably even

bondholders were bailed out. This created outrage at the time, especially considering that the

FDIC, seeking to encourage depositor discipline, had just announced a pilot program in which

uninsured depositors and other creditors were only reimbursed a part of their investment. The

perceived difference in treatment between large and small banks led to the first popularization

of the term “too big to fail” by Congressmen. (FDIC, 1997)

This bailout of large depositors contrasts greatly with the stance of Italian authorities

in the case of the Banco Ambrosiano failure. Banco Ambrosiano had developed a complex

Enron-like network of subsidiaries, in which stock values were artificially inflated by cross

lending among the different parts of this network. When these artificially increased values

dropped, the bank collapsed. Italian authorities agreed to bail out the creditors of the parent

bank, but refused any help the foreign creditors of the bank’s Luxembourg subsidiary, Banco

Ambrosiano Holdings. Luxembourg authorities did not view the subsidiary as a bank holding

company and refused to give Italian regulators access to information, despite the subsidiary’s

heavy borrowing on the interbank markets and its ownership of two banks. (Vale, 2007)

Ultimately, Banco Ambrosiano’s creditors were saved by a last-minute cash injection of $ 246

million from the IOR (Instituto per le opera di religione), the Vatican bank from which

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Roberto Calvi, Banco Ambrosiano’s CEO, had obtained a “letter of comfort” and which IOR

decided to honor. (Bär, 2004).

In the Appendix, we have constructed a more comprehensive database on bank failures

during the 1970ies and 80ies, trying to identify each time the cause of failure as well as the

origin of the loss absorbing entity. While many bank failures have multiple causes, in many

cases the ultimate reason for credit failures was fraudulent behavior or interest rate changes,

which make it impossible for borrowers to reimburse their loans. As is often the case, though,

fraudulent behavior is part of an effort to cover up losses derived from unexpected volatility

or lack of liquidity. The table also highlights that , given the absence of a deposit insurance

fund, in most European bank failures, private creditors had to take at least some of the losses.

In contrast, since the early 70s (and until the recent crisis), in the United States and United

Kingdom no private creditors were forced to absorb any losses caused by a bank’s failure.

The difference seems to be at least partially be motivated by the importance of petrodollars

for the financing of these countries’ banks and current account deficits. Goodhart (2008, p34),

for example, cites an U.K. briefing note on the Euromarket’s capacity to absorb the

petrodollars: “The Euromoney markets have so far absorbed oil money without serious

mishap (…) But we must not be complacent about the situation. There is a danger that the

failure of one or two banks (…) lead to a general loss of confidence. Government and central

banks must make it crystal clear that they will not stand by and let a major institution

collapse.”

In short, the period witnessed a series of changes that led to experiments with new

business models and consequently higher risk. While credit risk was not absent, it was largely

a consequence of fraud and to risks related to the mismatching of assets and liabilities, i.e.

interest rate and liquidity risk. National regulators employed very different approaches about

oversight and serving as lender of last resort, with UK and US regulators being much more

concerned about depositors than German or Italian ones.

3 The Basel Committee for Banking Supervision (BCBS)

Given its importance to the world economy, the Basel Committee for Banking

Supervision (BCBS) has a curious history. Formed under the auspices of the Bank of

International Settlements (BIS), itself a relic of another financial era (James, 1996), the BCBS

preceded the crises of the early 70s. It began its life as a vehicle to foster communication

among national authorities and to coordinate banking on an international level, with the hope

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of elevating analysis above domestic political debates. Now a standing committee set up by

the bank governors of the G10, BCBS evolved out of the Groupe de Contact, which had been

established in 1972 by a small number of upper/middle-ranking bank supervisors from six

EEC countries, mainly to discuss how to handle the structure of American banking

investments in Europe. The bank failures and turmoil in raw materials markets in 73/74

convinced the G10 that the make-up of the Groupe was too narrow to serve as a place for

central bankers to discuss common approaches to issues, such as liquidity, solvency, and

exposure issues, especially as they included questions beyond the Europe. (Goodhart, 2011)

As discussed above, although neither Franklin National nor Herstatt were major,

money-center banks, their inability to fulfill their contractual foreign exchange obligations led

to blockages in international transfers, just at a time when money was pouring into banks

from petrol producing countries. Smaller banks wanted access and bigger ones wanted to

profit by lending to medium- and small-sized banks. Until the failures of Franklin and

Herstatt, most monetary authorities evidenced little concern. Many of the transactions were

not supervised by any regulatory body. Indeed, the issues were inseparable from the rise of

the Euromarkets. But in the summer of 1974, the practice broke down. Many big banks were

delaying doing business with small American, European and Asian banks for fear that they

were unable to satisfy their counterparty obligations. (Goodhart, 2011: 32-33) Managing the

short-term deposits and exposures in the Euromarkets required seamless movement of funds;

any hesitancy about counterparties added transaction costs.

In particular petrodollars raised the stakes for international banking. The magnitude of

the exposures was extraordinary but the profits were even higher At least on a non-risk

adjusted basis, international lending was much more profitable than national, in 1982, 32% of

all Citibank’s income came from Latin America (only 16% of its assets). (James, 1996). As a

consequence, normal credit evaluation procedures were ignored, even when they were

encouraged by national and international regulators.

From 1974 to 1978, the portion of offshore bank assets that came from oil producing

countries grew from 10 to 25%. About 70% of the $162 billion invested by OPEC countries

went into direct bilateral lending or Eurodeposits, which were recycled in developing country

debt. As the banks of some countries tried to slow down the recycling, the business just

seemed to move to those less concerned. From 1973 to 1978, international lending tripled.

Much of the increase was intrabank, as some banks ran out of borrowers lent to those with

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more opportunities than deposits. Some banks tried to add to their profits by taking

speculating on interest rates, mismatches in sources and uses of funds.3

The BCBS took on these challenges with many disadvantages. During the crucial

period 1974-97, the committee had six chairs, all central bankers, some specialists in

regulation, who devoted approximately 20-25% of their time. The group met four times a

year. As the issues faced by the BCBS became broader and more detailed, the BCBS created

a number of working groups. Neither the chairs nor the other members of the committee had

an official mandate from either their governments or even their central banks. Nevertheless,

despite the absence of a permanent structure and government mandates, during the early 80s

even member central banks came to realize that evoking the BCBS could serve as an antidote

to awkward questions about excessive LDC lending and about what central bankers were

doing to shore up the world’s financial architecture. (Goodhart, 2011: 86) Though a group of

like-minded experts, it required unanimity for its outputs, which were recommendations to the

G10. Until the LDC defaults, virtually no progress had been made in reforming international

finance. Indeed, the BCBS early efforts to create an early warning system (EWS) for

international financial crises produced no warning for the defaults and concerns about foreign

exchange speculation no standards of hedging exposures. The output seems to have been

reports, not standards.

With different procedures and attitudes, as well as conflicting national ambitions,

getting a consensus among the G10 countries on even some vague “best practice” came

slowly. While the participants understood the value of simplicity in capital adequacy,

national interest stood in the way. Debates revolved around risk weighting for investments,

the components of capital, and the number and components of asset categories, but technical

analysis seemed always to play second fiddle to country preferences, which for Europeans

included bank investments in government and quasi-government paper. The increasing

evidence of “shaky” LDC debt compounded the problem. (Goodhart, 2011: 157-160)

4 The U.S. / U.K. capital adequacy proposal and Basel I

In the mid-80s, U.S. officials became increasingly impatient with the pace in Basel.

Mexican, Argentinian, Brazilian and other countries’ actual or threatened defaults revealed

the capital insufficiency of money-centered banks. The Latin American Debt crisis threatened

3 “Lender of last resort to Topsy,” The Economist, 87-88 and “Home truths from Basle”, The Economist, 82-83.

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to force government banking bailouts and increased the political pressure to reign in on its

banks’ speculative excesses. Letting a large bank fail was out of the question, but more

control was the quid pro quo of the implicit government guarantee of multinational banks.

(James, 1996). This led the U.S. Congress to pass in 1983 the International Lending

Supervision Act (ILSA), requiring higher capital standards and greater supervision of U.S.

bank foreign lending.

This was not enough however to convince other regulators that stronger capital

controls were necessary. As demonstrate above, European regulator had less concerns about

depositor bail-ins (Germany, Italy), or less qualms about bailouts (Japan, France) and hence

no interest in burdening their banks with additional regulation. What changed the dynamics of

the decision making process was the rapid increase of market shares for mostly Japanese but

also French banks in international markets. The U.S. Congress put pressure on the chair of

the Fed, Paul Volcker, to find higher, harmonized capital ratios, a pressure which Volcker

passed on to the BCBS via the G10. American leaders first turned to the United Kingdom and

then to the BIS to find palatable international banking standards, which would satisfy both

their general constituencies and banks. After a halfhearted response from the other Basel

committee countries, in 1986, the United States and United Kingdom used a tactic that is well

known from trade negotiations. They went their own way, creating their own CAR, implicitly

threatening other countries with exclusion from their markets, if those countries failed to

apply the same standards. (Kapstein, 1991)

This American and British action put pressure on the BCBS, whose German, Japanese,

and French representatives dissented from tighter CARs and whose complaints had to be

integrated into the outcomes. (Goodhart, 2011: 194-95) Without any legal authority, suddenly

the BCBS seemed forced to shift from merely making recommendations to its Governors to

formulating regulations for the G10 as well as other countries. (Goodhart, 2011: 5). The U.S.

strategy worked: within two years the BCBS agreed on capital adequacy regulation as its

principal tool for international prudential regulation and the “Cooke Ratio” as a common

standard thus creating international standards that mirrored the U.S. capital adequacy

requirements.

The motive for the UK and US initiatives was not only concern about the safety and

stability of the financial system. The rapidity of the implementation and as we want to argue

also the choice of the regulatory tool was certainly influenced by the intention to prevent

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Japanese and to a lesser extend French banks from further expanding their market share in the

Euro markets. American banks had always considered that “Euro-Dollars Are Our

Dollars,” 4 but by the mid-80s Japanese and French banks had captured substantial market

shares. These new entries could offer competitive rates not only with their extraordinarily

low equity ratios (around 2%), but also because they benefitted from an implicit government

guarantee – government and Keiretsu shareholders – whose return requirements were far

lower than those of shareholders of listed U.S. and U.K. banks. Moreover, they drew cheap

deposits from sheltered domestic sources with uncompetitive credit practices. In France, until

2005, banks were legally forbidden to pay interest rates on checking accounts and, in Japan,

the postal savings system tapped into a large portion of a market with very high savings at

extremely low interest rates.

The fact the Basel regulation had a protectionist motive was certainly not hidden. In

fact the text of the accord explicitly states two “fundamental objectives”, the prudential one of

“soundness and stability of the international banking system” and the protectionist one to

“diminishing an existing source of competitive inequality among international banks” (Basel

Committee, 1988 paragraph 3). The relative importance of the two objectives is difficult to

assess but Tarullo (2008) observes that “by the time hearings on the proposed Basel accord

were held by the banking committee of the House of Representatives in April 1988, not a

single member of the committee inquired into whether the proposal was adequate to protect

the safety and soundness of the financial system. Nearly every question was focused on

whether US banks (…) would be competitively disadvantaged”. (Tarullo, 2008:52)

Hence, by political standards, the 1988 capital accord was a success. However from a

prudential view, its imperfections were obvious and much commented upon. We have already

discussed the problems associated with focusing exclusively on credit risk, the following

Section will illustrate that using capital adequacy as the unique regulatory tool was a

remarkable break from the tradition of bank regulation.

5 Judging the effectiveness of capital adequacy

In fact, capital adequacy had only emerged in the 1980s as an important tool for

banking supervision and regulation. Compulsory minimum capital requirements did not exist

in either the United States or in other Basel Committee countries before the 1980s. Until the

4 The Economist, 2 March 1963, 828.

15

late 1970s, the U.S. Office of the Currency (OCC) explicitly emphasized the importance of a

variety of nonfinancial factors in assessing the adequacy of a bank’s capital. (Tarullo, 2008).

For example, the OCC assessed the quality of management, the liquidity of assets and

liabilities, and the earnings histories of banks. With the 1978 establishment of the Federal

Financial Institution Examination Council, this multifaceted approach was formalized and

became the CAMELS framework, with which a bank’s capital level, asset quality,

management, earnings, liquidity and sensitivity to market risk all come together to provide a

reliable assessment of the bank’s stability.

There are a number of reasons for why capital adequacy was not viewed as an useful

concept by many bank regulators. Most importantly the experience of the bank failures of the

1970s and 80s had demonstrated that losses were typically substantially larger than what even

reasonably high capital levels could have absorbed. For example, Continental Illinois had

approximately $40 billion in assets in 1984, but received a total of $5.5 billion of new capital

and $8 billion in emergency loans, implying that an equity ratio of well more than 10% would

have been necessary to prevent a failure, even if the instability had not generated a run by

international creditors. (FDIC, 1998)

These figures are not at all unusual. The FDIC provides loss estimates for 2093 out of

the 2402 bank failures and assistance programs from 1986 to 2000. The average loss during

this period amounted to 24% of the bank’s assets, the median loss was still 19% of assets.

Fig.1 below was generated using information about bank failures in the United States

provided by the FDIC, using all bank failures and assisted banks for which loss estimates are

available.

0

20

40

60

80

100

120

140

160

0,0%

5,0%

10,0%

15,0%

20,0%

25,0%

30,0%

35,0%

40,0%

45,0%

50,0%

55,0%

60,0%

65,0%

70,0%

75,0%

80,0%

85,0%

90,0%

95,0%

100,0%

Nu

mb

er

of

fail

ed

ba

nk

s

Loss as percentage of total assets

16

Fig. 1: Distribution of losses for failed US banks 1986-2000

Only 15% of the losses are below 5% of assets and 20% below 8% which implies that

only a very small fraction of failures could have been prevented with Basel I type capital

adequacy. Obviously it can be argued that some of a bank’s total losses might only have been

produced after the bank has become financially distressed, implying that lower equity ratios

would have been sufficient to keep the bank healthy. Precise information on the origin and

timing of the losses are difficult to obtain for a larger sample of banks, but for banks such as

Continental Illinois or Herstatt, analyzed above in detail, this is clearly wrong. Losses that

largely exceeded the bank’s capital preceded financial distress.

Another major shortcoming of the Basel I regulations is the focus on book equity.

Regulators had long known that banks can manipulate this measure. This became apparent

during the 1990s, when the Japanese, in particular, used a large range of techniques to

produce high capital adequacy ratios, while remaining economically insolvent. These

included: under-reserving against recognized bad loans (Fukao 2003), underreporting the

number of bad loans (Hoshi and Kashyap, 2004), evergreening loans to underperforming

companies (Peek and Rosengren, 2005), including deferred taxes in capital, even though

deferred tax assets cannot be used as a buffer against failure, and finally “double gearing,” a

practice where banks lend money to other institutions, which then in turn reinvest these funds

as Tier 1 or Tier 2 capital.

Part of the reason for why this evidence does not seem to have deterred regulators

from relying on capital adequacy regulation was a shift in the argumentation in the early 80s.

The classic textbook explanation of capital as a “buffer” in case of losses was complemented

or even substituted by a more theoretical one that argued that well capitalized banks had fewer

incentives to take high risk. The 1988 Basel Accord explicitly stated that banks with high

equity would be less prone to risk-taking behavior, in current jargon, because they would have

more “skin in the game.” In other words, while it was obvious that high equity levels would

not be sufficient to save a bank that taken excessive risk, the high capital levels thwarted

excessive risk taking, a view that only receives little or no theoretical and empirical evidence

in the academic literature. In fact, there is some evidence that the relationship between capital

levels and risk taking is not straightforward. Sheldon (1996) reports that capital to asset ratios

correlate inversely with Moody’s ratings and other measure of the default probability of

banks. This relationship is likely due to a reversed causality: banks with a more risky strategy

17

finding it necessary to hold more capital. The result still shows, however, that the disciplining

effect of high capital ratios is likely to be small.

The actual numbers of 4 per cent for Tier 1 and 8 per cent overall capital on which the

BCBS finally agreed, were not based on any empirical evidence on what should be the

optimal capital ratios, but rather simply reflected a modest increase in capital compared to

what most international banks were doing. (Goodhart, 2011: 195) Interestingly, although the

Cooke ratio of 8% seemed to be rather on the high end of capital ratios used by several

regulators in the mid-80s, with the introduction of Tier 2 capital, the possibility of including

perpetual preferred stock in Tier 1 and the generous “risk” weighting scheme actually watered

down the regulation substantially. Still, the Basel 1 standards were mostly tighter than

existing capital adequacy standards. In fact, before the advent of the Basel regulations a

number of countries had no capital ratios. Goodhart (2008: 197) lists an internal document

showing that even among the BCBS countries France, Italy as the US and the UK had no

regulatory capital ratios in the early 80s. Therefore, the Basel rules probably cannot be made

directly responsible for a weakening of banking regulation. However there certainly was an

indirect effect. With the newly implemented Basel regulations, existingmulti-criteria

approaches were perceived as outdated, inefficient and were successively wound down.

6 Fixing Basel I?

To its credit, from the beginning, the BCBS recognized the severe limits of the rules

that it had proposed. The official 1988 document clearly acknowledged that Basel I was a

highly imperfect set of rules, covering only a small part of bank risks:

“It should also be emphasized that capital adequacy as measured by the present framework, though important, is one of a number of factors to be taken into account when assessing the strength of banks. The framework in this document is mainly directed towards assessing capital in relation to credit risk (the risk of counterparty failure) but other risks, notably interest rate risk and the investment risk on securities, need to be taken into account by supervisors in assessing overall capital adequacy. The Committee is examining possible approaches in relation to these risks. Furthermore, and more generally, capital ratios, judged in isolation, may provide a misleading guide to relative strength.”

Goodhart (2008, p.191) cites a note of the BCBS secretariat from 1988 stating

explicitly that “if further work made it possible to develop a satisfactory method of

measurement of interest rate risk for the business as a whole consideration should be given to

18

applying some appropriate control alongside the credit risk framework.” Remarkably,

however, further updates of the Basel framework did not focus on interest rate risk nor

liquidity risk, which both had been recognized as essential during the earlier years of the

committee. Extensions concerned market and operational risk which were certainly important

but arguable less central to banking than the risks identified earlier on by the committee. Note

that the 1996 Amendment includes only interest rate risk for debt securities in the trading

book, but not on the general banking book which are predominant in a universal or

commercial bank. In addition the implementation of these extensions entailed extensive

compromises to gain political acceptance and major concessions to the banking sector.

Overall, these extensions seem to have weakened rather than strengthened he regulatory

framework.5 Hence, although the Basel committees had initiated a broad process bent on

increasing international capital market safety and reducing monitoring costs, its

recommendations remained narrow and ill focused. Despite the limits of capital adequacy as

a tool for reducing system risk, the capital adequacy ratio continued to serve as a blueprint

and core for future efforts.

The following table lists the key features of the original Basel I framework and the

most important additions. Some effort has been made in the Basel II regulations to enlarge

the framework beyond its focus on capital adequacy and add two additional “pillars.”

However, the resulting construction was still very heavily imbalanced towards capital

adequacy. Pillar II was supposed to take care of important risks, such as interest rate and

liquidity risk left, but did not go much beyond the formulation of principles and objectives.

The task to develop concrete tools to measures to limit these risks was left to national

regulators, much as before.

Pillar III forced banks to disclose useful information, however, this information did

not, as expected, trigger market discipline. Here as with the argument that more equity will

lead to more prudent behavior, regulator seem to have relied on an overly simple economic

5 For example Zuberbühler (1996, p 769) states that “Compared with the present Swiss capital adequacy ratios for market risks, however primitive and incomplete they may be, the implementation of the Basle standard approach, let alone the models approach, would bring about a. further erosion of the once tough capital requirements. Every adaptation to the international minimum standards since 1989 has decreased the amount of required capital in Switzerland. The amendment of the Banking Ordinance of December 12th, 1994 resulted in a reduction from 81 to 72 billion for the entire Swiss banking system between 1994 and 1995 (Swiss National Bank, The Swiss Banking System in the Year of 1995 (Nr. 80), p. 45 and Tables 44.0 and 44.a.). Nobody can claim that the risks were reduced accordingly within one year. Our patience as regulators is running out, if the ongoing implementation exercise is moving into in the same direction.”

19

reasoning. While it is certainly true that shareholders can lose their money if the bank take

high risk, it is well understood that their losses are limited to their investment whereas their

potential gains are unlimited. This implies that shareholders actually have incentives to

increase the bank’s risk taking rather than incite the bank to prudency.

Basel I (Cooke Ratio) Market Risk Amendement

Basel II (McDonoughRatio) Basel III

Date of proposal 1988 1996 2004 2010

Date of final implementation (EU) 1992 1998 2007 2019

Capital Definition Tier 1 and Tier 2

Tier 1, Tier 2

and Tier 3

Tier 1, Tier 2

and Tier 3 Tier 1, Tier 2

Risk Credit Risk Market Risk Credit, Market and Operational risk

Credit, Market, Operational and Liquidity risk

Non Capital Adequacy Components

Supervisory review (Pillar 2) and Market Discipline (Pillar 3)

Supervisory review (Pillar 2), Market Discipline (Pillar 3) and Liquidity ratios

Risk Measurement External Internal Internal

Internal (except leverage ratio)

There is much evidence that the BCBS spent a great deal of time, not on including

risks that had been omitted by the Basel I regulations, but rather on mitigating negative side

effects created by its first attempt at international regulation. The risk weightings under Basle

1 were based on a pragmatic grouping of assets that were “ad hoc and broad-brush, based on

subjective (and political) judgment, not on any empirical studies.” (Goodhart, 2011: 195)

This led to serious distortions in bank asset portfolios, a consequence of the Basel Iaccord

that was apparently not discussed at the time. Finer risk weightings were supposed to decrease

the economic distortions created by regulatory arbitrage. However, the attempt to make

20

capital adequacy requirement more risk sensitive led the regulators as well as the industry into

a quagmire of complexity.

Essentially the BCBS started to integrate a set of risk assessment techniques developed

in the 80s and 90s by Banker’s Trust, a mid-sized US commercial bank, interestingly initially

without major academic input except for rudimentary portfolio theory. The responsibility of

these tools for the demise of Banker’s Trust after a period of high profitability and rapid

growth remains subject to some controversy, but unlike the BCBS techniques, these methods

at least had some theory and empirical evidence to bolster their credibility. However, neither

all the banks nor even the BCBS itself proved capable of employing these models without

major assumptions about the future, yielding very disparate results about values and many

control glitches (Goodhart, 2011: 248-251).

Despite the use of historical data, the methods require judgments and assumptions,

not the least of which is the assumption that historical patterns and relationships will continue

into the future, especially during traumatic times. Although the methodology is core to

regulatory consistency risk assessment and is an attempt to evaluate mismatching of assets

and liabilities, sadly they have demonstrated that portfolios of loans and trading assets still

lead to very different risk assessments, in part because they are dealing with assets and

liabilities whose underlying (notional values) are so large and in part because they are not

always really identical. Their ostensible matching (offsetting) is based on statistical analysis,

the results of which may be limited in time. (Troege and Kobrak, 2013)

As a consequence, since the first Basel Accord was formulated, the complexity of

international banking regulations has increased exponentially. The Basel I contained 30

pages; Basel II, 347, Basel III, 616 pages. But the length of the pronouncements is neither

sufficient for grasping the increase in their complexity nor answering the question whether the

increase is commensurate with the complexity of the transactions they are designed to

regulate. Just defining the quality of capital has been tough. Basel I divided capital into two

categories, paid in capital and retained earnings (Tier I), were allowed 100% as equity capital;

limits were placed on Tier II, hidden reserves, perpetuals, subordinate debt, for example.

Basel II expanded its original emphasis on credit risk by adding operational and market risk.

Finally Basel II tried to move away from the exclusive focus on capital adequacy by

introducing Pillars II (regulatory oversight) and III (disclosure). Despite the impressive

21

“pillar” rhetoric, the whole regulatory building remained heavily lopsided, with Pillar II and

III representing not more than stunted appendix to capital adequacy.

Understandably, the work of the BCBS required close, long-lasting working

relationships with several outside professional bodies. Derivatives posed special problems.

The size of the market and pace of innovation stymied both national and international

regulators. Controlling them seemed to be a game of catch-up that regulators were losing to

markets. Because of the importance of investment houses to this area, the BCBS worked

extensively, for example, with the International Organisation of Securities Commissions

(IOSCO). Jointly, committees of various groups of regulators tried to come up with prudent

rules for securization, derivatives pricing, and the risk of contagion. (Goodhart, 2011: 479-

481) Derivatives also strained existing accounting rules. Many new derivative contracts were

not traded on markets and were highly illiquid, testing existing rules about marking to market.

Whereas accounting rules long held that “marketable” securities needed to be held at their

market value, many products defied standard pricing. By the early years of the new century,

accountants and others had signed off on the banks themselves using their own models to

price the derivatives that they were carrying on their books.

7 Conclusion

In light of nearly three decades of increasing international financial regulation, it is hard to

know whether the glass is half full or half empty. By some measures and among some

constituencies, Basel I and II were great successes. For 20 years, regulators made many

strides in codify and harmonizing national regulations. G-10 central bankers seem committed

to greater coordination of finance. The decision to allow banks to use their own models to

price instruments and assess market risk was generally applauded, especially by the banks and

among some academics. The IMF and WB took on the responsibility for verifying

implementation of the new rules via the Financial Sector Assessment Programmes. (FSAP)

(Goodhart, 2011: 6) Nevertheless, while Basel rules have become less voluntary, the lack of

enforcement mechanisms still limits implementation and deep-seated convergence, leaving a

very heterogeneous system. (Bernauer, 2000)

Despite the adoption of their own models, bankers may have been the actors most

critical of the system. The introduction of new products and currencies coupled with the

added complexity of dealing with different national bank standards have led to distortions in

competition and added costs, which are particularly hard for smaller banks to bear. (Busch,

22

2009) Meanwhile, the vast increase in the volumes and complexity of financial transactions

have augmented the opportunities and dangers of mismatching, which older and even current

versions of Basel Accords hardly address. Although we agree with the Harold James’

observation that financial innovation, like all innovation, may breed fear, which takes the

form of charges of hubris and opportunism among those with new ideas, history also counsels

that “paranoia” is sometimes justified. (James, 1996)

Our analysis suggests that international attempts at bank regulation over the past 30

years smack of too much complacency at best or worse still a willingness to ignore some

obvious consequences of the new rules and a lack of will to tackle more difficult, but

necessary, measures. Far from consolidating and strengthening banking regulation, the Basel

framework might better be conceived as part of the general movement towards deregulation

that was initiated in the 1980s, some of which contributed to the 2008 Bankers’ Panic.

Rather than setting limits on bank activities and stabilizing international finance, its focus on

capital as principal regulatory variable is an historical accident, motivated in part by a desire

to protect one banking business model against others. Perhaps unavoidable in international

negotiation, Basel I appears as a race to the bottom. Instead of completing the Basel rules

with stricter national rules as some such as the United States did, the Basel framework

became the de facto norm which resulted in a major deregulation of regulatory standards.

In fairness to the Basel Committee, it had a “tiger by the tail.” By the time Basel I

capital and leverage ratios as well as reporting requirements were agreed and more

importantly implemented, a veritable revolution in organizational and product structure of

banks was well under way. Led by American and British banks anxious to harness the vast

growing amounts of Eurodeposits, the participants in these offshore markets became

increasingly clever at attracting and lending across borders. The lightly regulated

Euromarkets not only became centers of innovation but more importantly of attracting funds

for banks incorporated in countries whose investment demands and business plans

outweighed domestic sources of financing.

On several occasions, the banking system went through a new round of crisis before

the new standards derived from the old could be implemented. In general, from 1974 to the

present, both domestic and international regulators seemed consistently behind the curve in

their attempts to control the new financial architecture. Only as a reaction to further crises

and banking failures did market and operational risk come on the agenda, for example. Even

before Basel I was implemented several money center banks perceived that they were better

23

off shifting their business model from risky loans to providing advice, designing new

products, and making markets for complex derivatives. New negotiations started in 1999,

lasted to 2004, and were released in 2006. The world of finance had changed enormously in

the interim. Basel II, agreed in 2004, sought to adapt capital and adequacy rules principally

to derivative instruments, whose volumes as measured by notional value had already climbed

by that time to nearly ten times Gross World Output ($300 trillion), 85% of which was traded

outside of organized exchanges. (Erturk, 2008) The complexity of financial instruments

continued to contribute to growth of banks and transactions, which required greater sources of

capital as well as costly international and IT investment, which in turn created greater

competition and demands for higher volumes.

Whereas some observers complain about a lack of bank regulation, the new regulation

may have spawned conditions that increased risk taking and contributed to (or at least did

little to avert) several crises, including the Asian Debt Crisis and LTCM bankruptcy.

Encouraging banks to move from risky loans, covered by Basel I regulations, to find a new

business model, one that emphasized the design, sale of complex instruments and making

internal markets for those instruments (only lightly covered by Basel II) serves as an excellent

example of the Law of Unintended Consequences. When Bear Stearns fell, most major

American banks were considered reasonably well capitalized by Basel II requirements.

(Cathcart, et al, 2013) Indeed, the very existence of the standards may breed over confidence.

(Engelen, et al., 2011)

Building on existing organizations and techniques, created for different purposes,

for nearly 40 years, the world financial community experimented with an ambitious project

of coordinating, leveling, and solidifying the financial playing field, in a quest not only to

increase stability but also competitive equality. Those efforts mix technology of very recent

vintage with institutions and organizations from earlier periods, augmenting the risk of

conflicting signals or worse still significant holes in supervision. Even though the financial

sector has become much larger and complex over the past 40 years, the process of adaption

has not included a wholesale rethinking and perhaps restructuring of our current business and

regulatory models, such as that which accompanied the Bretton Woods System. Accounting

rules and bank annual reports, for example, never completely adequate for simpler businesses,

have expanded greatly, ostensibly to give users of financial information more direct access to

valuing complex bank positions. Nevertheless, banking activities probably remain less

transparent today than they were 40 years ago. Even noted experts in derivative instruments,

24

for example, cannot evaluate the banks’ positions, which continue to make up major parts of

money-center bank activity. Even after 2008, many megabanks still trade and house what

were deemed “toxic assets” (liabilities) before they were bailed out, with historical low

amounts of real equity capital, rather than lending funds that require them to engage more

capital under the Basel rules.

This historical argument suggests that Basel III will be plagued by the same

difficulties as its two earlier versions. Little in the rules deal with mismatching of currencies

and complex derivatives, the carry trade, hedge fund counterparty risk, and other activities

and institutions that had grown immensely in just the seven years before release. Moreover,

the regulations failed to deal with many other causes of the crisis: lax monetary policies, trade

imbalances, over-reliance on rating agencies, and political decisions to ward off the effects of

globalization with new subsidies and debts, which formed the political-economic context of

the 2008 Panic. While some of those contexts have been eased and central banks have

pumped more capital and liquidity into banks, little has been done to stop banks from rolling

out a plethora of new, very risky products.

The Basel Accords and the processes which led to them point to an even more several

general weaknesses in international and national financial regulation. Adapting rules to an

ever-changing series of specific product and organization innovations may be flawed in that it

does not address management and shareholder incentives as well as the imbalance of

resources between the public and private sectors. (Rajan, 2008) These problems are

compounded by regulatory competition (and private arbitrage) between the countries fixing

the rules. Moreover, international standards still need national approval and application, a

highly charged political process. Continued reliance of dubious book values of equity, stress

tests based on statistical assumptions, and flawed accounting standards facilitates dangerous

reliance on misleading aggregate numbers. This was well understood by German and

Japanese banks (and their regulators) that held huge "hidden reserves," against uncertainty

rather than risk. (Barth et al., 2012)

There are many facets to the weakness of regulators vis-à-vis their charges. Although

regulators in many countries seem to recognize the limits of the system that evolved before

the 2008 Panic, there was and is little consensus about new approaches. Some of the problem

seems to lie in the unwillingness of regulators to take on the principals (and principles) of

megabanks, for fear of destabilizing the system, or worse still for fear of threatening

profitable exchanges between the private and public sectors. They seem blithely to disregard

25

Paul Volcker’s famous maxim: "save the banks but not the bankers." Often regulators are just

out gunned by the banks’ ability to marshal resources to defend their actions.

We would add another explanation: a consensus among regulated and regulators, a

shared new ideology, convenient for both, which entails faith in neat automated, mathematic

models for assessing and managing risk, based on assumptions about the identity of

instruments and changes in their variances and co-variances, the bedrock of value-at-risk

assessment and stress tests. While the modeling is not assessable to even the well-informed

observer, the shared assumptions, precision, and elegance of the formulas, appeals to those

who cannot afford the time and energy to examine banking activities in more detail.

Moreover, the approach to regulatory reform included, indeed perhaps required as a

necessary precondition, commitments to massive central bank and direct government bailouts

of ailing financial organizations for “the public good.” Ironically, the international regulation

has contributed to just the “unfair” governmental subsidies that American and British banking

systems disliked with Japanese and French competitors, and to aggressive competition

involving reckless risk taking by “too-big-to-fail” mega-financial organizations.

26

27

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Wilmarth Jr., Arthur E. (2002) “The Transformation of the U.S. Financial Services Industry, 1975-2000: Competition, Consolidation and Increased Risks,” University of Illinois Law Review, Vol. 2002, No. 2, 2002.

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Appendix A

Bank failures 1970-1900. Cause and resolution. In this table we have extracted the likely reason for the bank’s failure and the origin of the compensation for the bank’s losses from a number of sources (Goodhart 1995, Gup, 1998, FDIC, 1997, OECD 1993, Perez, 1997, Sprague 1986, Thompson 1991, Vale 2006, Vives 1990). We have tried to classify the reasons for bank failures into four categories 1) Credit risk 2) Fraud) Market risk 4) Liquidity risk. We define fraud broadly, including for example related party and intra-group lending. Often the sources indicate fraud together with other types of risk as the reason for a bank’s failure. In this case we assume that fraud was the principal source of risk.

Europe

Year Bank Type of Risk

Private sector bail in

1974 Bankhaus I.D. Herstatt (Germany) Market yes

1975 Allgemeine Wirtschaftsbank (Austria) Fraud yes

1976 Banque pour l'Amérique du Sud (Belgium) Fraud no

1977 ATS Bank für Teilzahlungskredite (Austria) Fraud yes

1978-83 Spanish Banking Crisis Fraud yes

1978 La Banque Van Loo (Belgium) Fraud no

1979 Banque Belgo-Centrade (Belgium) Fraud no

1980 Banque Andes (Belgium) Liquidity yes

1981 Amsterdam American Bank (Netherlands) Liquidity yes

1981 Banca Steinhauslin SpA (Italy) Fraud yes

1982 Banque Copine (Belgium) Credit no

1982 Banco Ambrosiano (Italy) Fraud yes

1983 Schröderm Münchmeyer, Hengst & Co (Germany) Credit yes

1983 Tillburgsche Hypotheekbank (Netherlands) Credit yes

1983 Fiskernes Bank (Norway) Credit yes

1984 Johnson Matthey Bankers (GBR) Market yes

1985 Kronebanken (Denmark) Credit yes

1987 6. juli Banken (Denmark) Credit yes

1987 C&G Banken (Denmark) Credit no

1988 Banque Internationale pour l'Afrique Occidentale Market yes

1988-1991 Norwegian Bank Crisis Credit yes

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1988 Sunnmorsbanken (Norway) Credit no

1989 Banque de Participations et de Placements (France) Fraud no

no

Canada no

1985 Candian Commercial Bank Credit yes

1985 Northland Bank Credit no

1985-86 Continental Bank of Canada Liquidity no

1985-86 Bank of British Columbia Fraud no

no

United States no

1971 Unity Bank Credit yes

1972 Bank of the Commonwealth Fraud no

1974 Franklin National Bank Fraud no

1979 First Pennsylvania Bank Liquidity no

1980s Saving and Loans Crisis Market no

1982 Penn Square Bank Credit no

1983 First National Bank of Midland Credit no

1984 Continental Illinois Bank Credit no

1986 First Oklahoma Credit no

1987 BancTexas Group Credit no

1987 First City Bancorporation of Dallas Credit no

1988 First Republic Bank Credit no

1989 Mcorp of Houston Credit no

1989 Texas American Credit no

1981-1985 Mutual Savings Bank Crisis Market no

1980-1990 Agricultural Bank Failures (Midwest) Credit no