Bank capital: the case against Basel

Abstract

Purpose – The purpose of this paper is to focus on the “Basel Illusion”, the belief that a model-driven quantitative approach to capital adequacy can lead to a more robust and shock-proof system. The author analyzes the Basel framework and its role as a major source of systemic risk. Furthermore, the Basel framework is unlikely to enhance the safety of the financial system and prevent future crises. As such, Basel should be scrapped and regulators should revert to a simple tangible common equity (TCE) leverage rule. Design/methodology/approach – The paper aims to review the extensive existing literature and analytic approach to the problem, trying to answer the question: why Basel? The paper looks at the Basel methodology of calculating risk-weighed assets. Findings – The paper looks at the basic reasons underlying the Basel failure: complexity, variations in measurement of risk-weighed assets across banking institutions, ability to game the system and amplification of systemic risk. The research concludes that a simple TCE leverage rule is superior to Basel in controlling systemic risk. Research limitations/implications – Further research will be needed in determining the “optimal” level of capital. Practical implications – Regulators and bankers should seek simplicity in capital rules. The dubious use of quantitative models can only lead to spurious precision. Originality/value – This article synthesizes an extensive body of work on the issue of bank capital to demonstrate the superiority of a simple capital rule.