The Basel Process, Financial Stability,
and the Age of Turbulence ?
David S. Bieri a,∗
a School
of Public & International Affairs, Virginia Tech, Blacksburg, VA 24061, USA
Abstract
The Basel Process is a key element of the global financial system and a critical force that
has been shaping the international financial architecture over the last 80 years. As such it
plays an important role in co-ordinating the multilateral efforts of central banks, regulators,
supervisors and market participants alike and is thus uniquely geared towards fostering and
maintaining financial stability. Giving rise to current global financial turbulence, the recent
subprime crisis has subjected the Basel Process to intense internal and external scrutiny. This
episode of financial instability might yet prove be one of the most challenging tests for the Basel
Process as authorities strive to improve their regulatory frameworks in search of incentives for
prudent behaviour.
Key words: Basel Process, international financial architecture, financial stability, Basel II
JEL codes: G18, G28, E50
“The objects of the Bank are: to promote the co-operation of central banks and to
provide additional facilities for international financial operations.”
Article 3, Statutes of the Bank for International Settlements (20 January 1930)
1. Introduction
Although drafted more than three quarters of a century ago, Article 3 of the BIS
Statutes has lost none of its relevance for the process of fostering a stable global financial
? A first version of this short article was written in late 2004 while the author was working at the Bank
for International Settlements in Basel, Switzerland. The opinions expressed are personal and do not
reflect the views of the Bank for International Settlements.
∗ I am grateful to Claudio Borio, Eli Remolona and Philip Wooldridge for their valuable comments and
suggestions.
Email address: [email protected] (David S. Bieri).
Preliminary version -- please do not cite without permission
10 April 2008
system. Strengthening both monetary and financial stability is the traditional remit of
central banks and other monetary agencies, but achieving these twin objectives may not
be possible without the close co-operation of other regulatory and supervisory bodies.
In addition, the various components and players of the global financial system – namely
the financial markets themselves, institutions and the associated infrastructure – may
not all be subject to the same sources of concern and threats. This requires different
policy approaches and measures in order to achieve the stability of the financial system
as a whole. Because the stability of the financial system depends so critically on the
institutions, structures and governance arrangements that comprise it, continued policy
coordination and cooperation is paramount. The so-called Basel Process plays a key role
in providing the necessary policy framework. It is explicitly designed to strengthen the
stability and resilience of the global financial system.
However, the recent subprime crisis is one example of how financial innovation can
give rise to global financial turmoil. This might yet prove be one of the most challenging
tests for the Basel Process as authorities strive to improve their regulatory frameworks
such that they give the right incentives for prudent behaviour.
2. Promoting monetary and financial stability
Promoting both monetary and fiscal stability are key goals for the authorities, but
while there is broad agreement on the definition of the former, this is much less the case
for the latter.
2.A. Definitions matter
Consensus with regard to the definition of monetary stability has emerged over the last
ten years and permits various notions ranging from stability of the (anticipated) value of
money to price level stability or even low levels of inflation. Indeed, there is also broad
agreement that monetary stability is a vital ingredient for sustainable economic growth,
that there is unique institutional responsibility for it (i.e. the central bank), and that the
authorities need to be engaged in continuous efforts to achieve it. The story for financial
stability, however, is somewhat different; there is a much broader spectrum of definitions
and consensus only seems to exist in so far as financial stability is deemed a “good thing”
and that it is mostly noticed by its absence. 1
Broadly speaking, one can distinguish between a systems approach – primarily linking
financial stability to a well-functioning financial system 2 – and a more narrow definition
relating to the (excess) volatility of an observable financial variable, such as asset price
volatility or interest rate smoothness. The debate around finding a suitable definition is
1 One of the earliest definitions of financial stability is given by Bagehot (1873): “[It is . . .] not a situation
when the Bank of England is the only institution in which people have confidence.” More recently, at
the 1997 Jackson Hole conference dedicated to “Maintaining Financial Stability in a Global Economy”,
Crockett (1997) introduced the distinction between two types of financial instability: that of institutions
and that of markets.
2 Mishkin (1992) offers a systems-based definition, describing a stable financial system as one which
ensures “[. . . ] without major disruptions an efficient allocation of savings to investment decisions”.
2
more than a semantic one, particularly since any given definition predetermines the role
assigned to monetary policy in contributing to financial stability.
2.B. A trade-off between monetary and financial stability?
In the sense of Tinbergen (1956), if the monetary authorities only have control over one
policy instrument, namely monetary policy, they can only achieve one independent goal,
e.g. price stability. By delegating the broader objective of financial stability to a financial
regulatory authority, time inconsistency complications of a direct trade-off between the
two goals can be avoided. In turn, this raises the challenge for policy makers to identify
suitable trade-offs between monetary and financial stability. 3
The conventional view is highly skeptical concerning the existence of such a trade-off.
According to this view, monetary instability is regarded as the main threat to financial
stability, because inflation distorts perceptions about future return possibilities. Price
stability is thus a sufficient condition for financial stability. In this sense, central banks
should not focus on gauging the effects of asset price inflation on core inflation, but
instead they should place their focus on capital requirements that increase with the
growth of credit and are collateralised by inflated assets. 4
More recently, as inflation rates have reached historic lows in most industrialised
economies, a new school of thought has emerged which suggests that low and stable
inflation can make financial system even more vulnerable due to the threat of asset price
bubbles and the associated “irrational exuberance” of market participants. 5
In an attempt to reconcile these conflicting views, Issing (2003) concludes that the strict
systems-based definition of financial stability excludes any trade-off between monetary
and financial stability, by definition. The key to solving this apparent contradiction lies
in shifting the focus to the role of the policy horizon: In this context, a short-term conflict
between monetary and financial stability may indeed be possible, as long as it is optimal
for the authorities to deviate from desired rate of inflation to maintain price stability
over medium run. With the clear definition of an appropriate horizon to which policy
objectives should apply, the conflict disappears. In a more radical interpretation of the
issue, Laidler (2004) argues that the authorities should stick to basic task of targeting
inflation, while holding the lender of last resort (LOLR) powers in reserve. Consequently,
policy makers should not be tempted by any form of trade-off, simply for the sake of
achieving financial stability.
The institutional responsibilities for financial stability are traditionally shared across
different institutions, namely finance ministries, the central bank and regulators. While
clearly defined accountabilities for each of the institutions involved is a sine-qua-non, the
actual goal of financial stability can only be brought about by an effective coordination
of these efforts. This is the role of the Basel Process.
3
If financial stability is indeed defined as interest rate smoothness, a trade-off with price stability
immediately follows from the result of Poole (1970) whereby in the face of an aggregate demand shock
monetary authorities need to choose the degree to which they want to stabilise interest rates or output
and inflation.
4 See Schwartz (1995, 2002) for one of the most vociferous proponents of this school of thought.
5 Borio, English, and Filardo (2003) provide an overview of this so-called new environment hypothesis.
3
3. The Basel Process
In light of the increasing globalization of financial markets in the post-Bretton Woods
era, central banks and regulatory authorities have recognised the growing need for a central vehicle for coordinating their efforts. With their various regulatory and supervisory
initiatives and by providing the institutional building blocks, the Basel-based committees
form the natural home for such a global coordination exercise. Collectively, this interaction of the committees and their working groups is referred to as the Basel Process.
As such, it encompasses a global framework aimed at harmonising regulatory and supervisory processes and standards. Despite its global focus, one of the unique features
of the Basel Process is its ability to incorporate regional elements without necessitating
separate regional channels for cooperation. A wide-ranging treatment of the various aspects of regional harmonisation, particularly in Asia, and the Basel Process is provided
by Yoshikuni (2002).
3.A. Basel II
One of the most prominent recent initiatives arising out of the Basel Process is the
new capital adequacy framework, commonly referred to as Basel II (BCBS, 2004). After
almost four years of intense consultation, Basel II was endorsed by central bank governors
and the heads of bank supervisory authorities of the G-10 in June 2004. Himino (2004)
offers a comprehensive overview of the Basel II framework, arguing that it provides a
common language which improves communication about risk exposures among banks,
supervisors and investors. The full text of Basel II and supplementary documentation
can be found on the BIS website at this link.
Similarly, the Basel Process has served as the core infrastructure to facilitate the
creation of such standards as the twenty-five Core Principles for Effective Banking Supervision (BCBS, 1997) or Basel II.
3.B. Components of the Basel Process
There are four main Basel-based committees that are at the very centre of the Basel
Process. The Basel Committee on Banking Supervision (BCBS), established by the G-10
central banks in 1974, deals with the activities of commercial banks. It is this committee
(including its roughly thirty technical working groups) which is responsible for the new
capital adequacy framework.
The Markets Committee together with the Committee on the Global Financial System
(CGFS), established in 1963 and 1971 respectively, broadly cover issues related to the
functioning of foreign exchange and related financial markets. 6 Whilst both committees
focus on recent financial market developments, possible future trends, and considerations
of the short-run implications of particular current events, discussions in the Markets
Committee are informal and are not released to the public. Discussions and deliberations
6
Unlike the CGFS, the Markets Committee does not have a formal policy mandate from the G-10
governors. It mainly serves as a forum for an open and informal exchanges of views amongst senior
officials responsible for market operations in the G-10 central banks.
4
in the CGFS, on the other hand, are conducted with a view to formulate appropriate
policy recommendations for central banks. The topics monitored by the CGFS are also
often referred to as ‘macroprudential issues’. 7
The Committee on Payment and Settlement Systems (CPSS), established in 1990, focuses on market infrastructure issues and therefore monitors and analyses developments
in domestic and cross-border payment, settlement and clearing systems. The International Association of Insurance Supervisors (IAIS), established in 1994, deals with various
aspect of insurance companies.
III THE BASEL PROCESS
7
Fig. 1. The Basel
Processa
MARKETS & INFRASTRUCTURE
Macro-prudence
Banks
Insurance
companies
CGFS
BCBS
IAIS
Micro-prudence
Securities
companies
CPSS
IOSCO
JOINT FORUM
INSTITUTIONS
a
BCBS: Basel Committee on Banking Supervision; CGFS: Committee on the Global Financial System;
CPSS: Committee on Payment and Settlement Systems; IAIS: International Association of Insurance
Supervisors; IOSCO: International Organisation of Securities Commissions.
Figure 1: The Basel Process
BCBS: Basel Committee on Banking Supervision; CGFS: Committee on the Global Financial System; CPSS: Committee on Payment and Settlement Systems; IAIS: International
Given
the complexity
linkagesIOSCO:
between
the various
relevant topics
that form
Association
of Insurance and
Supervisors;
International
Organisation
of Securities
Com-the
area
of
competence
of
the
Basel-based
committees,
successful
international
cooperation
missions
is only possible as long as there exists a clear division of labour between the individual
committees and their secretariats. Regular meetings at either the committee- or working group-level form the main mechanism that drives the process. However, a common
criticism levered at meeting-based efforts driven by other international bodies is that
across markets, participants and borders, coordination of activities amongst
such processes are overly bureaucratic, cumbersome. Furthermore, it is often argued that
such
a free
and open exchange
of views
and discussions,
not at least
thecommittees
committeeslack
is also
of paramount
importance.
Yoshikuni
(2002) summarises
because of an alleged heavy influence through the opinions and beliefs of the organizing
the key function of the Basel Process as one of
7
See Borio, English, and Lowe (2003) for a detailed description of this concept and how it relates to
other aspects
regulatory and
arrangements.
A schematic
overview
of such
arrangements
“[. . of
. providing]
thesupervisory
international
financial
community
with
the opis provided in figure A.1 in the appendix.
portunity to explore good governance in various regulatory and su5
pervisory issues in forums that allow a frank exchange of views with
the support of highly sophisticated analysis.” (p.5)
Figure 1 gives a schematic overview of the specialised ‘division of labour’ between the various committees involved in the Basel Process.
body. The informal nature of the Basel Process avoids many of these pitfalls, despite a
considerable amount of ‘behind-the-scenes activities’. 8
With many of the key issues pertaining to the stability of the global financial system
becoming increasingly integrated across markets, participants and borders, the diligent
coordination of activities amongst the committees is paramount importance. In this vein,
(Yoshikuni, 2002, p.5) summarises the function of the Basel Process as one of
“[. . . providing] the international financial community with the opportunity to explore
good governance in various regulatory and supervisory issues in forums that allow a
frank exchange of views with the support of highly sophisticated analysis.”
Figure 1 gives a schematic overview of the specialised division of labour between the
various committees involved in the Basel Process.
3.C. Evolution and Increasing Co-operation
The influence of market participants has rendered the Basel Process more transparent
and market oriented. The inclusion of this new element into the process is probably best
illustrated in the context of Basel II with the decision to allow banks to use their internal
models to assess risks. Furthermore, financial innovations evolving at increasing speed
and stronger global linkages between markets have called for the closer cooperation of
the various Basel-based committees at different levels and intensities.
The deregulation, liberalisation and globalisation of financial markets during the 1990s
led to an increasing erosion of the dividing lines between banks, securities companies and
insurance companies. As a result, closer cooperation between the regulatory and supervisory bodies dealing with the specific segments of the market became a pressing priority.
In response to this challenge, the International Organisation of Securities Commissions
(IOSCO) became involved more actively in the Basel Process with the explicit aim of
staying in closer contact with the BCBS and IAIS. In 1996, a Joint Forum of these three
committees was established.
Progressing globalisation also called for closer cooperation between those elements
of the Basel Process which are responsible for the overall functioning and stability of
the financial system. This has lead to a strengthening of ties of the CGFS and the
CPSS with the other committees, respectively monitoring macro and micro aspects of
the infrastructure of the international financial system. In addition, the BIS and the
BCBS jointly established the Financial Stability Institute (FSI) in order to promote
cooperation amongst supervisors, primarily through sharing experiences in workshops
and seminars. The FSI’s objectives are:
(i) To promote sound supervisory standards and practices globally, and to support full
implementation of these standards in all countries.
(ii) To provide supervisors with the latest information on market products, practices
and techniques to help them adapt to rapid innovations in the financial sector.
8
E.g. the multi-year effort in the context of the review of the 1988 Accord on capital adequacy involved
more than forty working groups, including many ad-hoc and temporary ones that were coordinated under
the umbrella of the BCBS.
6
III THE BASEL PROCESS
9
other international standard setting bodies and the institutions entrusted with
(iii) To help supervisors develop solutions to their multiple challenges by sharing expe-
monitoringriences
theseinstandards,
primarily
and the Word Bank. In 1999,
seminars, discussion
forumsthe
andIMF
conferences.
(iv) To assist supervisors in employing the practices and tools that will allow them to
the establishment
of ademands
more comprehensive
framework
meet everyday
and tackle more ambitious
goals. for coordinating these
As the convergence of global best practices continued, the need for more coordination
and
also became
more apparent
at the
level of various
other international
efforts wascooperation
placed under
the umbrella
of the
Financial
Stability
Forum (FSF),
standard setting bodies and the institutions entrusted with monitoring these standards,
and the Word Bank. In 1999, the establishment of a more comprewhich primarily
is hoststhe
itsIMF
secretariat
at the BIS, but is operationally independent for
hensive framework for coordinating these efforts was placed under the umbrella of the
Financial Stability Forum (FSF), which is hosts its secretariat at the BIS, but is operathe BIS
and independent
only reports
tionally
fromto
theits
BISmembers.
and only reports to its members.
Fig. 2. The Pillars of Sound Financial Systems
Institutional and
Market Infrastructure
Financial Regulation
and Supervision
Macroeconomic Policy
and Data Transparency
Financial Stability
The FSF is the main international body orchestrating financial stability efforts, bringing together national financial authorities, international financial institutions, international regulatory and supervisory groupings as well as committees of central bank ex-
Figure 2: The Pillars of Sound
Financial Systems
7
The FSF is the main international body orchestrating financial stability
efforts, bringing together national financial authorities, international finan-
perts. It seeks to co-ordinate the efforts of these various bodies in order to promote
international financial stability, improve the functioning of markets, and reduce systemic
risk. In an attempt to improve the architectural blue-print for the global international
financial system, the FSF designated twelve main standard areas as key for sound financial systems and deserving of priority implementation, depending on individual countries’
circumstances.
As is shown in figure 2, these areas can loosely be grouped into three categories, which
in turn form the pillars that constitute the basis of sound financial systems.
(i) Macroeconomic policy and data transparency forms the first pillar of sound financial systems; defining standards for transparency with regards to monetary and
financial policy, fiscal policy and data dissemination, this is almost exclusively the
responsibility of the IMF. 9
(ii) The second element focuses on financial regulation and supervision, in particular
the principles and objectives that fall under the auspices of the Joint Forum with
regard to banking and insurance supervision and securities regulation.
(iii) The third pillar covers all issues related to institutional and market infrastructure,
stretching from corporate governance, international accounting standards and auditing to payments and settlements. Both the BCBS (through the aspect of market
discipline under Basel II) and, more directly, the CPSS through its Core Principles form Basel Process-related elements of this third element of global financial
stability.
3.D. The Age of Turbulence: Current Threats to Financial Stability
Similar to its monetary equivalent, achieving financial stability is not a one-off effort, but rather a continuous quest by the various bodies involved in the process. In
this context, the identification of potential threats is a key ingredient for a consistent
strengthening of the stability of both national and global financial systems, the boundaries of which have become increasingly blurred due to increasing inter-market linkages.
Put differently, the separation between national and global aspects of financial stability
look increasingly artificial, not at least because of the incessant threat of contagion.
[PARAGRAPH on Greenspan (2007)]
At present, there are a number of issues on the radar screens of the different bodies
involved in the Basel Process (listed in no particular order of significance or preference):
– Resilience of financial markets and institutions: As historically low global growth rates
lead to sharp corrections in market valuations, the balance sheets of many financial
institutions are exposed to immense strain (skyrocketing default rates, collapsing equity
markets and widening credit spreads). Unlike in previous comparable periods, the
financial systems seem to have endured the recent slowdown remarkably well. Whilst
there is ample evidence that markets currently perceive the system as stable and
improving, there may be impending systemic risks that have built up in the process.
Could there be a threat to future financial resilience, if the macro environment does
not improve further?
9
See the IMF’s Code of Good Practices on Monetary and Financial Policies, Code of Good Practices
in Fiscal Transparency and the Data Dissemination System (GDDS, SDDS).
8
– Excess global liquidity: Accommodative monetary policy in many industrial economies
has supported a revival of the global economy after several major adverse shocks.
However, the associated strong growth in liquidity has raised some concern, including
accelerated inflation, financial imbalances and spillovers from the G-3 to other smaller
economies.
– Concentration risk : Advances in financial innovation have lead to a redistribution of
risks within the global economy. Recent events in CDO markets have highlighted that
new financial instruments can lead to a concentration, rather than a diversification of
risks among market participants. [to be expanded]
– Role of the central bank as LOLR vs. risks emanating from non-bank institutions (e.g.
hedge funds) [to be expanded]
4. Outlook
The Basel Process plays a key role in the context of promoting financial stability.
The various committees engaged in this process provide a unique platform or forum for
discussing and analysing current sources of concern or threats to stability. All of which
– in isolation or combination with each other, both short term and longer term – need
diligent monitoring and a close consideration of the appropriate steps in order to ensure
further progress in the respective fields.
4.A. Basel II and the current financial markets crisis
What are the implications of the recent financial upheavals in the U.S. sub-prime
market for the Basel Process and for the supervisory and regulatory aspects of the international financial architecture? What lessons can be learnt? Did international standards,
like Basel II, actually aggravate the situation, or even provoke it (e.g. the value-at-risk
argument of increased correlations across markets during a financial crisis)? [to be expanded]
In the context of the current financial market upheavals, the CDO-related multi-billion
asset write-downs and credit losses of investments banks 10 seem to confirm many of the
long-standing concerns and criticism by some of the most vociferous critics of Basel II.
According to this view, Basel II harmonises investment decisions during a crisis, and
regulation becomes destabilising instead of stabilising as a consequence.
Danielsson et al. (2001) argue that Basel II fails to address many key deficiencies of
the global regulatory system. They also maintain that Basel II is creating the potential
for new sources of instability.
(i) In addition, Basel II fails to recognise that risk is endogenous (VaR-related risk
measures can reinforce crises)
(ii) Statistical models are inconsistent and biased, frequently unterestimating downside
of risk.
(iii) Problematic heavy reliance on credit rating agencies due to lack of regulation and
unobservable risk estimates
10 By
end-February 2008, the FT estimates total losses to exceed $181 billion.
9
(iv) Basel II does not incorporate a meaningful definition of operational risk, no adequate data or models
(v) Financial regulation is inherently procyclical. Basel II increases this tendency significantly, thus increasing the risk of a systemic financial crisis (financial instability).
In a related argument, Danielsson (2002) emphsises that since market data is endogenous to market behavior, statistical analysis made in times of stability does not provide
much guidance in times of crisis. For regulatory use such as Basel II, the model and
market-price risk measures may give misleading information about risk, and in some
cases may actually increase both idiosyncratic and systemic risk.
4.A.1. “Without Basel II things would be worse . . .”
– Basel II is not to blame, but rather the “Balkanisation of regulation”. Thus the institutional fragmentation across market segments, across national jurisdictions within a
global financial system is the main culprit for the current crisis. 11
– Different treatment of on- and off-balance sheet assets in much of historic regulation.
Thus, goal in future was for “regulation to be more consistent so the same risks get
treated in the same way irrespective of who is holding them”.
– If implementation Basel II proceeded faster, banks would have had much less overleveraging.
– Basel II’s significant reliance on the scores from credit ratings agencies might have to
be re-assessed.
4.A.2. “Basel II deepened the crisis . . .”
– Regulators around the world have spent an unseemly mountain of money on Basel II,
creating an industry using financial analytics and an army of consultants.
– Basel II’s main thrust on solvency might be a fallacy of misplaced emphasis, since it
ignores the golden rule of banking. Most banks fail because of a lack of liquidity, not
a lack of capital (e.g. Northern Rock).
– Basel II contributed to the current financial crisis by providing incentives for regulatory
capital arbitrage in the form of securitisation.
4.B. Tentative Conclusions
(i) Greater openness in economic policy making and dissemination of data on economic
and financial developments as key to financial stability. [to be expanded]
(ii) Transparency promotes efficient functioning of markets. It also reduces the likelihood of shocks and enhances accountability of policy makers. [to be expanded]
(iii) International efforts of development of standards and codes of good practice are
built on commitment to greater transparency. [to be expanded]
11 Recent
speech by BIS General Manager Malcolm Knight at World Economic Forum. Financial Times,
January 26, 2008
10
4.C. Open Questions
(i) Can there be too much of a good thing? Are there side effects from too much
stability or being too transparent? “Le mieux est l’ennemi du bien”. Anecdotal
evidence of moral hazard from the recent sub-prime mortgage crisis and from central
bank reserve management. [to be expanded]
(ii) How do market structure and technology (financial innovation) affect the regulatory
framework? Sovereign Wealth Funds to the rescue, but who regulates them? [to be
expanded]
11
Appendix A. Macroprudential Regulation
A New Framework for Policy Action
Fig. A.1. A New Framework for Policy Actiona
a Source:
Borio, English, and Lowe (2003).
12
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13