Harvard University

Harvard Extension School

Independent Research Project

(INDR)

Understanding and Regulating Banks: A New Paradigm

Alfredo B. Roisenzvit
 Introduction and Brief Summary

This paper is about Bank Capital. More concretely, about how Bank Capital is

understood, explained, and regulated in practice. I will present arguments that support the

idea that the main and core functioning of banking activity has not been historically defined

and communicated in a manner such that it could be clearly understood by all stakeholders. I

will present a stylized explanation of the function of banks, and their intrinsic problems and

risks, especially to the economy in general. With this particular explanation focus, I propose

that there is a more practical way to offer stakeholders the ability to grasp a deeper

understanding of the peculiarities of banking. I shall caution the expert reader, in the sense

that the proposed solutions –in terms of concrete regulations- of this work are not original

developments, as the latest advancement of international standards, issued by the Basel

Committee focuses concretely on “bank capital and its relationship with the risk management

process”. (Basel Committee, Revisions to the Basel Capital Accord, known as Basel III).

Rather, what intends to be original is an elaborated re-thinking of the pivotal point for

regulation, intended to drill down to the most relevant elements of fundamental bank

regulation, and a different presentation of the functions, relevance and intrinsic problematic

of banks, along with the way they are explained in traditional textbooks.

These differences should not be trivial, as they affect –in my proposed schema- the

mere foundations of how regulation and supervision of banking activity should be

constructed. To this end, J. Santos, in the introduction to the BIS Working Paper on “Bank

Capital Regulation in Contemporary Banking Theory” starts by presenting precisely that

point: “Banking is undoubtedly one of the most regulated industries in the world, and the

rules on bank capital are one of the most prominent aspects of such regulation. This

2
prominence results from the central role that banks play in financial intermediation, the

importance of bank capital for bank soundness and the efforts of the international community

to adopt common bank capital standards” (Santos, 1).

To the layman reader, hopefully this will present a framework that will help

understand how banks work and their intrinsic risks and dangers, in a manner that is

somewhat original and much easier to grasp. Even if it appears to the reader as a bold claim,

my proposal is that one of the reasons for the relative and pendular effectiveness over the

long run of the banking regulatory system in general is that most of the stakeholders in the

banking business cannot attain a programmatic and thorough understanding of how the

particular and many times counterintuitive mechanics of banking activity affect them

individually and collectively as stakeholders. Unfortunately, the span of this paper does not

allow me to intend to prove this last point, but I find it very relevant to leave it for discussion,

as it hopefully notes during my presentation. It is my proposal that this way of presenting and

understanding the relevance of capital regulation, and the intrinsic problems of banks, which

in my research efforts, I have not been able to see explained this way, will enable all relevant

stakeholders to better understand the whole process, and will contribute to a clearer

regulation of banking activities, centering such regulation in “risk based capital

requirements” (Basel Committee, Core Principles, Principle 17), hence fostering the growth

of the banking system in general, which in turn fosters economic development, as I show in

the following sections.

In light of the clarifications just offered, I propose the reinforcement of the new

regulatory paradigm undergone by the Basel Committee, via the reformulation of how the

communication process for these regulations is put out, in favor of all stakeholders to banking

activity, especially policy makers in the broad sense. My claim is that this paradigm change

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has not been thoroughly communicated, as the main communicational focus was not placed

in the importance of managing risks and controlling excessive leverage via risk based capital

requirements, but in the mechanics of the calculations behind the particular models. Hence,

the effectiveness of the main changes that explain this new paradigm stay diluted in less

important technicalities. As I will discuss in further sections, there has been a paradigm

change in regulation, going form a reactive approach, based merely on capital requirements

emerging form fixed ratios, that led to a very particular regulatory compliance approach,

towards a new paradigm of proactive regulation, based on requirements emerging from the

individual risk management processes, that requires active participation of banks and

regulators, and are not centered in a compliance approach, but in technical arguments.

In my view, many stakeholders still interpret banking activity controls and regulations

via the old paradigm of fixed basic limits and percentages, that turns out to be reactive and

ineffective, and therefore are naturally led to misinterpret how banking regulation works and

should work.

The use of Bounded Rationality as a means to “understand and explain”

What is known today as “Behavioral Economics” has produced a good number of

Nobel Prizes in the last few years. Perhaps one of the clearer cases of original development

in this light, and surely the Nobel Prize winner that helped put these judgment biases on the

table was Prof Daniel Kahneman1. Likewise, the logic of bounded rationality has been

worked on and developed for quite some time, as Bazerman describes: ¨In his Nobel Prize–

winning work, Herbert Simon (March & Simon, 1958; Simon, 1957) suggested that

individual judgment is bounded in its rationality and that we can better understand decision

1
For a detail of decisión making and bounded rationality, please see Bazerman, Ch. 1. Also, See Kahneman´s
Nobel Prize Lecture in Works Cited.

4
making by describing and explaining actual decisions, rather than by focusing solely on

prescriptive (what would rationally be done) decision analysis” (Bazerman, 5). The work of

Stanovich and West (2000) has helped Kahneman and others make a useful distinction

between two specific ways that humans use to make decisions: They called them System 1

and System 2. As explained by Bazerman, ¨System 1 thinking refers to our intuitive system,

which is typically fast, automatic, effortless, implicit, and emotional. We make most

decisions in life using System 1 thinking. By contrast, System 2 refers to reasoning that is

slower, conscious, effortful, explicit, and logical” (Kahneman, 2003; as cited by Bazerman,

3). In short, most of our decisions are led by System 1, which is based mainly on heuristics.

As Harvard Professor Joseph Henrich explains in The secret of our Success (Princeton

University Press, 2014) These heuristics are one of the ways humans have been able to

accumulate knowledge, by cultural transference, in what he calls ¨Cultural Learning¨. This

very important feature of our humanity, which, according to Henrich has helped us develop

further that any other species, is very useful to resolve immediate threats and problems, such

as “fight or flight” in a dangerous situation, by resolving quickly using heuristics, before

being eaten by a beast. Now, when it comes to understanding more complex financial

operations, these heuristics can play against our judgment: “Specifically, researchers have

found that people rely on a number of simplifying strategies, or rules of thumb, when making

decisions. These simplifying strategies are called heuristics. As the standard rules that

implicitly direct our judgment, heuristics serve as a mechanism for coping with the complex

environment surrounding our decisions. In general, heuristics are helpful, but their use can

sometimes lead to severe errors” (Bazerman, 6). These errors can come naturally by the logic

of interpreting complex situations with System 1 heuristics, that come naturally, as they are

5
 usually known as “common sense”. Now, the problem arises when these complex elements

cannot be explained or solved by System 1 heuristics.

In using the analogy of Kahneman´s terms, it would be necessary for stakeholders in

the banking system, to relate to banks´ functioning and banking regulation through a “System

2” framework, where the specific elements and motivations of bank capital regulation and the

structure of stakeholder incentive is very clearly understood. Initially, and by literal virtue of

Kahneman´s distinction between frameworks, System 2 will appear counterintuitive, if

reasoned through System 1 heuristics.

Box I: Combining Kahneman´s and Bazerman´s explanations of Systems

1 / 2 Judgment and Decision Making

“The perceptual system and the intuitive operations of System 1 generate impressions of the

attributes of objects of perception and thought. These impressions are not voluntary and need not

be verbally explicit. System 2 is involved in all judgments, whether they originate in impressions

or in deliberate reasoning. As in several other dual-process models, one of the functions of System

2 is to monitor the quality of both mental operations and overt behavior. Kahneman and Frederick

(2002) suggested that the monitoring is normally quite lax, and allows many intuitive judgments to

be expressed, including some that are erroneous.”

Box 1: System 1 / System 2 in Bounded Rationality

Thus, we face the first problem to identify and understand: we should find a way to

define and explain how banks work, from a system 2 perspective, meaning a more

profound reasoning of the structure of incentives and results of the interactions between

stakeholders, and explain how these incentives collide. In short, the correct and clear

identification of what I define later in this document as the “intrinsic problems of banking”,

will allow regulatory stakeholders to better define the clear problematic, as a necessary step

6
in order to better support intelligent capital regulation, which in turn will contribute to

financial stability. As a necessary note of clarification, I refer to banks in general, as the

understanding of traditional commercial banking. There are, however, many different classes

of banks, with particularities and concentration in certain activities, such as investment banks,

second tier banks, and specific activity banks. There are also many different regulators for

banks, not only within countries, as the case of the US, with many regulators, but also among

countries, with each one having their own regulatory regime. As I will show in further

sections, banking regulation has been mostly standardized by the emergence of the Basel

Committee standards, and virtually every country has adopted at least the main and most

important regulatory standards, namely capital regulation. As regards to kinds of banks, in

order to simplify the general propositions of this work, I refer to a traditional commercial

bank, although these principles should apply equally -or with minor specific differences- to

any enterprise that intervenes in banking business, that is, leveraging third party funds in

financial intermediation.

Re-thinking how the underlying mechanics of banking work

A perspective on the role of Banks

In particular studies2 and some regular interviews, people are asked what banks do,

and basically they say that banks lend money. Furthermore, financial officials in banks, and

seasoned managers in the financial system answer more technically to the same question:

They explain banks´ role as: efficiently intermediating between the supply and demand of

2
The most complete study I could find on this subject is: Public Attitudes to Banking. A student consultancy
project by ESCP Europe for The Cobden Centre. June 2010.

7
financial resources. Furthest, Scholars, as treated in most Textbooks3, define the main role of

banks as the best and most efficient way to intermediate transaction costs between savings

and loans. For example, Mishkin and Eakins define the basics of banking activity as follows:

“In general terms, banks make profits by selling liabilities with one set of characteristics (a

particular combination of liquidity, risk, size, and return) and using the proceeds to buy assets

with a different set of characteristics. This process is often referred to as asset transformation.

For example, a savings deposit held by one person can provide the funds that enable the bank

to make a mortgage loan to another person. The bank has, in effect, transformed the savings

deposit (an asset held by the depositor) into a mortgage loan (an asset held by the bank)” (

Mishkin and Eakins Ch. 17, 403). Furthermore, they continue: ”another way this process of

asset transformation is described is to say that the bank ‘borrows short and lends long’

because it makes long-term loans and funds them by issuing short-dated deposits. The

process of transforming assets and providing a set of services (check clearing, record

keeping, credit analysis, and so forth) is like any other production process in a firm like any

other production process in a firm” (Mishkin and Eakins Ch. 17, 403). Now, one of my

strongly proposed points is that the re-thinking of banking activity, in terms of its

understanding, in fact requires the clear comprehension that banking is not “like any other

production process in a firm” as stated by Mishkin. In fact, banks are quite unique, as

explained below.

As relating to the matters on to what extent people understand –with a System 2 logic-

what banks do, a fairly recent study performed by The Cobden Centre, in the United

3
I use Mishkin and Eakins as a representative typical textbook on the subject of Banking and Finance, since it is
one of the popular books in Schools and academic circles, with numerous editions (See chapter 7). Also, in
chapter 5 of Modern Banking, cited in references, I use a recent and specific publication to show the same point
about how banking and its regulation is explained.

8
Kingdom, found the following main conclusions, after a comprehensive survey: “According

to our survey: 74% of people think that they are the legal owner of the money in their current

account, as opposed to the bank • 66% of respondents answered ´don’t know´ when asked

what proportion of their current account was used in various ways by their bank • 33% of the

population oppose the fact that banks lend out some of the money in their current

account as loans” (Cobden Centre Survey, 2). One of the conclusions of the survey that

most called my attention, is, in my understanding, the manifestation of a System 2 logic when

discovered through system 1 heuristics. Furthermore, I think this particular point of the

survey serves the point I try to make when saying that normal people seem to fail to

understand the complexities of bank functioning with a System 2 logic: The study concludes

that “By leveraging an average of 34 times its reserves, banks are behaving in a way that

would not be considered legal in any other business” (Cobden Centre Survey, 2). In fact, as I

will post later, banks are the only business that in practical terms can have so much leverage,

and that is why they must be properly regulated, with a focus on containing excessive

leverage. Under the same logic, another conclusion of the survey shows that “A healthy

solvency ratio is typically seen as about 20%. Of the 6 high street banks that we analysed the

average is just 0.18%”. In regular industry standards, the solvency ratio indicates whether a

company’s cash flow is sufficient to meet its short-term and long-term liabilities. However,

the particularities in the functioning of banks, need for a good system 2 explanatory

framework in order to be able to understand why this happens. Otherwise, as I propose, a

legislator with “System 1 common sense” would impose limiting regulations, that will in turn

hamper the development of banks, and therefore of the economy, and as I show in the next

few sections, this has happened repeatedly in history. The conclusion of the study, shows my

point regarding the general understanding on how banks work and how they should be

9
regulated: “the British population seems to be largely unaware of how the system actually

operates. Overall there is widespread public support for bringing the legal status of banks into

line with other businesses.” (Cobden Centre Survey, 12).

The question then remains, as the subject of the cited study is “regular people”, would

politicians, public officials, congressmen and congresswomen be considered as part of this

sample? In my experience, they are4. One of my points is that as banking activity in general,

and regulation in particular, is not properly explained at many different levels of

interlocution: they are missing a very important part in the functioning of banks, which is the

intrinsic internal unstable equilibrium that any bank has, by means of the particular

clash of incentives in their agency problem description, but worsened by the fact that

only one stakeholder group has the power to manage the bank. All of this, coupled with

the fact that banks are the only business that operates with incomparable high leverage.

How banks create money and wealth

So far in, my modest but extensive research effort over many years of interest in this

particular subject, also as an industry practitioner5, I have not been able to find any textbooks

and formal publications that concentrate in what, in my judgment, is the most relevant reason

for the importance of the mere existence of banks, and furthermore, the paramount reason for

the need of proper regulation of banks: In layman´s terms, Banks “make” most of the

4
I understand this is a difficult claim to make, evidence has not been formally gathered, other than the large
recollection of publications reviewed. In my years interested in these topics, even in my participations at the
Basel Committee, and in my years as a Regulator, I have informally interviewed a good number of banking
professionals and officials, including senior regulators. As part of my evolving research for this subject, a
comprehensive research work on these claims will be very positive, However, at the time I lack the resources to
conduct it.
5
As an Official for the Central Bank of Argentina, I participated in many Basel Committee Meetings at the time
of the initial discussions of Basel II, and in different international fora where these regulations were being
discussed.

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money we actually use in our economy. This is known as the Money Multiplier effect.

This effect has been widely explained in terms of macroeconomic implications, yet I have

failed to find a comprehensive argument where this multiplicator effect is utilized to sustain

the intrinsic need for proper banking regulation. With this logic in place, and according to

data collected by Ahrensdorf (17) banks are responsible for roughly 65% of the money

creation across the globe6. This created money, under normal conditions, turns into capital

investments and wealth, which in turn fosters economic growth and development.

In line with the multiplier effect, but not as clearly centered on why banks are so important to

the economy, Shelagh Heffernan, in Modern Banking, shows the effect and importance of the

participation of banks, from the traditional perspective of banks in the economy. Heffernan

intends to back the idea that banks play a key role in the economy, and therefore should be

protected: “Additional problems arise because of the macroeconomic role played by banks;

they help to implement government monetary policy. For example, the government may use

the banks (changing a reserve ratio or setting a base rate) to achieve certain inflation and/or

monetary growth targets. If the banking system collapses, there may be a dramatic reduction

in the money supply, with the usual macroeconomic implications. “…Thus, bank failures can

create substantial negative externalities or social costs, in addition to the obvious private

costs of failure. So in most countries, to minimise the chance of governments having to

rescue a bank or banks, the national banking systems are singled out for special regulation,

known as prudential regulation, which is typically more comprehensive than regulation of

other sectors of the economy,” (Heffernan, Ch 1). One correction that we would suggest to

make, even though this is an academic work is that prudential regulation, via capital

6
According to Ahrensdorf´s work, the average defined multiplier across a good sample of countries was around
three times.

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requirements, is not one more kind of regulation, but, as we propose, it should be taught as

the centerpiece of the regulatory process.

In Figure 1 below, I depict a simplified approach to the multiplier effect that banks

provide to the economy. For simplicity of the explanation, I did not include the concept of

reserves, which are a percentage of deposits that the bank must hold and cannot lend. When

reserves are taken into consideration, the multiplier effect goes diminishing in every round,

up to a point where there is no more lending ability. In our simplified example, the cycle

Figure 1: The simplified multiplier effect. Source: own

could

continue constantly. This is not the case in real application, but the simplification helps make

the fundamental point of the effect. If we imagine a new country in Robinson Crusoe´s

Island, with a Government and a Bank, we can start the example by establishing that the

Government issues $100 (step 1 in Figure 1). As the money is in the economy, we suppose it

entirely goes through the bank as a deposit (step 2). The bank then lends this money to

Citizen A (step 3), which in turn, deposits the same $100 in his current account (step 4), in

12
order to facilitate his production business functioning (pay bills, salaries, etc). The Bank then

lends the $100 again, this time to Citizen B (step 5), which in turn is used to produce other

goods, and is then deposited in Citizen´s B current account. The process can repeat itself as

indicated. By the end of the cycle, Citizens A, B, C, D, and E will have $100 each, plus the

$100 that the government printed, the whole economy of the island is now worth $600 as

indicated by the green checkmarks in Figure 1. In short, if the Island had no banks, they

would all be worth $100. But with banks, and thanks to the Multiplying effect they favor,

they are all worth $600, and can spend and trade worth of $600. Now, as we will see, banks

are in a permanent unstable equilibrium. If they are not controlled and properly regulated,

this unstable equilibrium will break, as explained in the further sections of this study. If it

breaks, in what is usually called a banking crisis, the process would be as if we could literally

remove banks from the list in Picture 1. If this were to happen, the whole economy would go

very quickly from being worth $600, to being worth $100. This effect, as anyone could

determine, would be completely destabilizing for the whole economy, in fact for the whole

organization of society. Therefore, the explanation of the need for bank regulation should

rest mainly on this particularity of the banking system. Hence, a well regulated and

efficient banking system will foster economic development via the expansion of money

and subsequently the creation of wealth. On the other hand, an unstable financial system,

especially if not properly regulated, can be a serious threat to the economy, via the

opposite effect, which would lead to the rapid and distressful destruction of wealth. With this

logic, we should consider effective banking regulation as a cornerstone of any economic

system for any society or country.

The Challenge of really understanding banks

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 As I tried to show in the previous section, the way banks work is mostly understood

through common sense, via a System 1 logic, as most –if not all- other instances of daily life.

However, there are some particularities that make banks especially difficult to

understand through common heuristics. Yet, banks seem to have been regulated based

on those common heuristics, leading to some disastrous results time after time. The

misconceptions people usually have about banks are perhaps one of the best examples of the

System 1 / System 2 differences explained by Kahneman in his Nobel prize lecture on

prospect theory and heuristics. I find two distinctively relevant reasons why understanding

how banks really work is paramount. First because this understanding will lead to proper

regulation, which, as explained above, is determinant for the soundness of the economy of

any society, and second because the traditional common-sense / system 1 vision of banking

has led many efforts to communicate and actually teach the way banks work in a manner that

is not necessarily consistent with the most important and relevant role banks play and ought

to play in the economy. I will expand this logic further in a later section, under the belief that

the way banking is taught and understood has also a preponderant deterministic part in how

banking has evolved –and many times failed to provide and maintain its role. This logic of

introducing banks to students and stakeholders in general also has played its part on how

banks are regulated and run, which in turn carves deeply in economic development, with

domestic and global implications. This latter point focuses on the broader vision of

regulation. In fairness, we should not neglect the negative effects that lobbying and some

doubtful practices known to banking, as with many other industries with very high stakes at

play and high levels of regulation.

So, how difficult could it be to regulate banks properly? In the traditional theoretical

framework banks take deposits from people who have excess funds and loan them efficiently

14
to people who need them. This explanation is both evidently and intrinsically present in most

textbooks that treat banking as a subject7. It also sounds very straight forward, and viewed

from an observer´s viewpoint, it is. The problem lies in incentives. The way banks work

determines colliding incentives between the three main stakeholder groups involved,

which I will identify and define shortly ahead. These colliding incentives determine, in turn,

that banks are constantly in an unstable equilibrium, with tensions to scale up these

instabilities which sometimes actually happen, into what we know as bank failures, or if they

are generalized, banking crises. These stakeholder incentives are widely known as agency

problems, and are present in any industry. But agency problems are rather particular in

Banks. To this point, the Basel committee has issued a document with guidelines with

principles for sound Corporate Governance for Banks. The Basel Committee, in such

document, defines Corporate Governance as “A set of relationships between a company’s

management, its board, its shareholders and other stakeholders which provides the structure

through which the objectives of the company are set, and the means of attaining those

objectives and monitoring performance. It helps define the way authority and responsibility

are allocated and how corporate decisions are made” (Basel Committee. Principles of

Corporate Governance for banks, 1).

Box 2 below, shows the main definitions from the cited Principles document, stating

why the focus on Corporate Governance is of such importance for banks:

7
I use Mishkin and Eakins as a representative textbook on the subject of Banking and Finance, since it is one of
the popular books in Schools and academic circles, with numerous editions (See chapter 7).

15

Box 2 - Principles Of Corporate Governance for Banks. Source: Basel Committee on Banking Supervision

Agency problems are particular in banks, because one of the stakeholder groups

concentrate all of the decision making power, and the majority of the economic benefits of

the business, but are intrinsically exempt from facing the bad decisions they could make, as

they could –if not properly regulated, pass on the losses to other less powerful stakeholders.

In order to better present the identification of stakeholder groups, and the schematics of the

functioning of banking activity, I will use a simple graph, depicting a T Balance Sheet

representation of a simple hypothetical bank:

16
Figure 2: The Classic Bank´s T Balance Sheet. Source: own

In this example of a typical bank, as we see in Figure 2, and for simplification purposes, I

will define “Bankers” as only one stakeholder group, comprised of Shareholders, Owners,

Directors and Management. As recognized in the above cited Principles document, these

stakeholder groups have their own tensions, and concrete agency problems. However, these

are not of the essence of the point I intend to make in this paper, and therefore, in light of

simplicity to present the points I do want to make, I refer to them as the “Banker”, in the

traditional sense, as if it were a bank owned and operated by one person. Once the point I

intend to make about colliding incentives among the three main groups of stakeholders in the

following lines is clear, we could consider the complexities of the agency problems within

owners, shareholders and management, but this discussion escapes the span of this paper. In

our simplified example of figure 2, the bank loans out $100, made up basically from deposits

($90 in our example) and Bank Capital ($10 in our example). This scheme allows us to see

the three different stakeholder groups present, and the study of traditional banking operations

will let us analyze their colliding incentives. The three groups are: Depositors, Loan Holders,

17
and the explained “Bankers”. As in any economic relationship, they all want to maximize

economic results. The particularity in banks, is that they can only do this at the expense

of the other ones. Let´s see each group: Depositors maximize when they get as high an

interest rate as possible. For this to happen, Bankers need to diminish their profit, via

lowering their interest rate spread, and Loan holders need to pay higher interest, which goes

directly against their maximization objectives. On the other hand, Loan Holders maximize

when they pay as low an interest rate as possible. Regardless of their individual situation, as

a group, they could maximize by minimizing interest paid to depositors and by minimizing

spread – and results- for Bankers. So far, these colliding interests could describe the

constraints of supply and demand of any industry, and the zero sum game of opposing

interests. But it is with the incentives of what we have simplified in “Bankers” that make this

–intrinsically- a particularly unstable equilibrium that needs proper regulation in order to stay

in equilibrium beyond the short term. “Bankers” maximize utilities when they charge as high

an interest rate as possible to Loan Holders, and when they pay as little an interest rate as

possible to Depositors. Exactly opposite of what each other group wants, in order to

maximize. The problem starts because these Stakeholder groups that have colliding

interests, have also very uneven power to act upon their interests, and furthermore, and

most importantly, if not properly regulated, “bankers” have no accountability over

their decisions and the emerging economic results of such decisions. In light of these

powers, Depositors can either choose to stay or leave, as they have absolutely no saying in

the administration of their monies, even though they provide (in our example) for 90% of the

money being used to generate profit. Loan Holders can choose to take the loan or not, as

they have no say in how much to pay depositors, or how to segment loans in terms of risk, or

how much they pay for such loans, even though they provide for most of the profits the bank

18
makes, as it collects interest from the loans. Finally, Bankers hold all the power to decide

what to do with the money of depositors, what to pay them, what to charge for loans, and

eventually what to do with all the Depositor´s money.

Under this logic, Banks, in their natural state –and if not properly regulated- are

the only particular business where “Bankers” can do business worth $100, with only

$10 being their own (in reality it´s even much much less). But on top of that, all the profits

stay with them, instead of being shared with the real investors (Depositors), and most

remarkably, in absence of proper regulation, all the possible losses go to Depositors. In

fact, one of the main reasons for deposit insurance is the fact that, even with the existence of

regulation, often times “Bankers” find a way around those regulations, and these intrinsic

instabilities actually break the system. In other words: in their natural state, if not properly

regulated, Bankers have all the upside, as they keep all the profits regardless of the risk

they take to get the profits, and in absence of regulation, they have none of the

downside, because virtually all the money they risk is not theirs. In this light, Banking is,

and has to be, perhaps the best business ever. If you can open a bank under these

circumstances, you can do business worth well over ten-fold your capital, you get to keep all

the profits, and you get to pass on all the losses, and if you are not regulated, you don´t have

to give explanations to anyone on how you use other people´s money. Moreover, if you are

big enough, and should you lose all the Depositor´s money, the Government will bail you

out, so you don’t have to close down, as a measure to protect the rest of the economy and the

payment system. This makes Banks the best business ever! It also explains the main reason

why Banks must be properly regulated.

A condensed history of regulation

19
 By this logic of the permanent tensions and unstable equilibrium among the main

three stakeholder groups, it is rather clear that regulation is necessary when it comes to

banking. If banks are not regulated, they can exploit their very sharp incentives to maximize

risk taking, and try to keep all the profits as they pass on the losses to depositors. This, of

course, has been proven very harmful not only to the affected depositors, but to the economy

as a whole, because of the expansionary role of banks that I have explained in the previous

sections with the example of the Multiplier. Historically, there is evidence of a sort of formal

banking activity as early as in Mesopotamia (around 1800 BC), on to the Roman Empire, the

Renaissance, the Pre-industrial Europe, and of course through modern times. The business

has quite evolved, but not as unevenly in time as one may think. For example, during the

tulip bubble in 1637, there was long evidence of the existence of future and derivatives

trading8. Moreover, in Hammurabi´s Mesopotamia, the “bankers” of the time (a sort of

temple priests) performed banking activity very similar to what the typical banking book is

today. Regulation, conversely, did not evolve along with activity, as there are records as

recent as the late 1800s where bankers were heavily persecuted after the effects of what we

know today as a banking crisis emerged: The cases of John Law and and Johan Palmstruch

are of particular amusement (Mc Kay. Ch 1). Not until the 1980´s the most advanced

countries in the world (namely the G8) all agreed on minimum capital requirements

regulation, and not until the late 1990´s that other countries went along. Moreover, the great

paradigm change of banking regulation is still being discussed, as it goes from a reactive

approach to a proactive approach, trying to anticipate problems instead of penalizing them. In

particular, practical regulations moved from an asset size and quality-based fixed percentages

(which describes the old paradigm), towards a capital requirement and allocation focused on

8
See Charles Mc Kay Ch. 3 for a brilliant recollection of colorful anecdotes of the Tulip Bubble and other
events of the sort.

20
risk measurement and management abilities, bank by bank (which describes the new

paradigm)

But regulation itself is not the right answer. Proper regulation is, along with effective

supervision. Of course, there has been much debate about what proper regulation is and

entails. In a comprehensive study, J. Santos takes on a wide-ranging review of banking

regulation literature. In it, he relates how “researchers have already made significant

progress explaining, for example, the parallel existence of financial intermediaries and

markets, the differences between bank–based systems and market–based systems and the role

of various financial intermediaries”. “As for the research on financial intermediaries, it

focused initially on the development of theories to explain commercial banks but has more

recently been extended its goals to a study of the implications of broadening the scope of

these intermediaries to include activities such as investment banking, insurance and

commerce. Notwithstanding all this progress, the research on bank capital regulation

continues to focus on intermediaries that combine lending with deposit taking” (Santos, 3)

Perhaps, the first academic discussion on the need of proper regulation was largely

introduced by Bagehot in his book Lombard Street, published in 1873, and becoming one of

the cornerstones of banking regulation. Possibly, the main discovery emerging from

Bagehot´s work is the figure of Lender of Last Resort, emergent from his paramount analysis

of the intrinsic problems of banks in 19th Century England, as the financial epicenter of the

known world. But even after the widespread introduction of lenders of last resort, as

proposed by Bagehot, banking failures and crises grew in volume and complexity, along with

banking activity. A much deeper sort of regulation after the Big Depression of the 1930´s

emerged in the US, as a counter-measure of the excessive risk taking that led to the crisis.

This was a clear example of the Bankers utilizing their dominant position within the

21
stakeholder groups described in previous sections, and pocketing gains while passing on

losses. One of the main reforms then was the Glass Steagall Banking Act of 1933. The bill

was designed “to provide for the safer and more effective use of the assets of banks, to

regulate interbank control, to prevent the undue diversion of funds into speculative

operations, and for other purposes.”9 (As cited by Maues, 2). An important motivation for

the act was the desire to restrict the use of bank credit for speculation and to direct bank

credit into what Glass and others thought to be more productive uses, such as industry,

commerce, and agriculture. (Maues, 1). Prior to the passage of the act, there were no

restrictions on the right of a bank officer of a member bank to borrow from that bank.

Excessive loans to bank officers and directors became a concern to bank regulators. In

response, the act prohibited Federal Reserve member bank loans to their executive officers

and required the repayment of outstanding loans. the main provisions of the Banking Act of

1933 effectively separated commercial banking from investment banking. Basically,

commercial banks, which took in deposits and made loans, were no longer allowed to

underwrite or deal in securities. In addition, the act introduced what later became known as

Regulation Q, which mandated that interest could not be paid on checking accounts. The

view was that payment of interest on deposits led to “excessive” competition among banks,

causing them to engage in unduly risky investment and lending policies so that they could

earn enough income to pay the interest (Maues). As we can propose, these regulations came

as logical reactions of what we know to be the unstable equilibrium of stakeholders in

banks, and the materialization of the ability for bankers to take advantage of their

power position, in dismay of the rest of the stakeholders, not only in the bank, but in the

whole economy, as the big depression has shown. These were, arguably, not the exclusive

9
See Julia Maues, Federal Reserve Bank of St. Louis: Banking Act of 1933, commonly called Glass-Steagall

22
cause, as other relevant problems include the inaccurate pricing of risk and the described

distorted incentives. Yet, as the next subsequent crises of the 1970´s, 80´s and then the big

crisis of 2008 have shown, these regulations have not solved the problem. By 2008 most of

the regulations were either gone or were subverted by the shadow banking system. Even

more, some propose they have aggravated the problem. As Dr. Andreas Dombret, Member

of the Executive Board of the Deutsche Bundesbank, states in a passage of his Speech at the

Bundesbank Regional Office in Hamburg, very recently in April 2016: “Let us not forget the

repeated instances in the past in which credit bubbles have led to financial crises – and on

each occasion we were told that ´this time is different´ and ´this time it’s not a bubble´ But

every bubble has ended up bursting, and the costs have had to be socialised in most cases¨

(Dombret, 5). In the recent, and not so recent, past a big movement and strong lobbies,

arguably mobilized by the big and traditional banks on wall street, with strong ties to political

power started advocating for de-regulation. It is worth mentioning that this was expanded

from the particular case of the US. Although most of the other relevant countries in the

world had their own problems and misunderstandings regarding bank regulation, the industry

was not as heavily regulated as the US was, mainly because of the strong regulatory stance

generated by the perhaps much needed strong regulatory response to the big crash of the

1930s. So some (including many key members of the Republican Party) actually believed

that one of the problems against growth of the economy when most needed after the Oil price

crisis of the 1970´s was pinned on the heavy regulation still imposed on the financial sector.

There lies most of the support towards the logic of de-regulation, mostly applicable to the

United States by design. To some extent, efficient de-regulation could have occurred in some

aspects of the Glass Steagall act, as in fact it later did. But, perhaps for the reasons we

propose in this paper about key players and policy makers not fully comprehending the

23
interplay of banking activity, reforms were not focused on effective capital requirements, that

foster in time the reduction of speculative activity, and if properly applied, the reduction of

moral hazard. In fact, many of the further reforms ended up allowing for regulatory

arbitrages in order to avoid capital regulations, for instance in off-balance sheet instruments,

and relationships with investment vehicles, that it turn facilitated the skyrocketing of leverage

that was observed during the crisis of 2008. In fact the system evolved into a complex set of

many overlapping regulations, that perhaps inadvertently allowed for many instances of

regulatory arbitrage, that in turn allowed bankers to leverage tremendously, facilitated by the

complexities of the same regulatory framework. As star economist Raghuram Rajan puts it:

“Deregulation has removed artificial barriers preventing entry, or competition between

products, institutions, markets, and jurisdictions. Finally, the process of institutional change

has created new entities within the financial sector such as private equity firms and hedge

funds, as well as new political, legal, and regulatory arrangements” (Rajan, 2). And, as we

have proposed, as a consequence of the unstable stakeholder equilibrium of forces, when

bankers can leverage excessively, they will, and the system will then suffer the consequences

almost surely.

Proper Regulation: Incentives, risk taking, and capital requirements.

In turn, proper regulation is a function of the accurate identification of

stakeholder incentives, in combination with adequate risk management and stringent

limits to specific activities that can´t be ordained merely through incentives. Hence, a

new paradigm of banking regulation based on these elements, whilst impossible to prevent

crises or recurring bank failures, will guarantee better managed crises and failures. Part of

the incursion of modern regulation, especially after the Basel II and III standards, there has

24
been a paradigm change in regulation, going form a reactive approach, based merely on

capital requirements emerging form fixed ratios, that led to a very particular regulatory

compliance approach, towards a new paradigm of proactive regulation, based on

requirements emerging from the individual risk management processes, that requires active

participation of banks and regulators, and are not centered in a compliance approach, but in

technical arguments. The new paradigm recognizes the structure of incentives that we have

presented in the previous sections.

In this light, there is already a key regulation that takes care of these incentives, and

tends to equate them, if properly applied: Minimum Capital Requirements. We will

analyze how these work in a further section. However, I will anticipate that this regulation

makes the complete difference in terms of a system being properly and adequately regulated,

versus one that is not. Arguably, although impossible for me to capture in the span of this

work, we could relate most of the biggest financial crises in history to excessive leverage

(See Mc Kay CH 1,2 and Rajan), which is another way to say absence of real capital

requirements, as explained here. Moreover, if we had to remove all regulations, any banking

system could probably operate under just one rule: Risk Based Minimum Capital

Requirements. I will explain why this is in the section about capital requirements. But it

will suffice to say that capital requirements are the tool that resolves the incentive

disengagement that I have presented while introducing this paper. This is because a

proportional part of assets (loans) are in fact funds from the stakeholder group we refer to as

“Bankers”, and since in modern Basel-based regulation they are risk-weighted, then this

aligns the incentives of the bankers with those of the Depositors, because the “Bankers”

would not want to lose their part, even if it´s only a portion. The dynamic notion of the

25
regulation makes for a very strong incentive base for this stakeholder group. I will expand

this logic in the Capital Requirement section below.

Grow a Heart…

Another important point relating to proper regulation, in line with my thesis that

banking activity is not properly and thoroughly understood by all stakeholders, whereby most

of them will react with a system 2 logic, is explained by the interpretation and prerogatives of

bank’s behavior. We take the case of legislators, for instance. In many countries, there are

legislations that in fact set maximums to credit card interest rates, or set lending targets to

SME’s, or even in some cultures, they prohibit any enterprise from charging interest rates.

This, in my thesis, is the materialization of the wrong understanding of what banks do and

how banks work and should work. One of the most common system 1 mistakes towards

banks is to ask them to “have a heart”. People in general commonly react with a moral

prerogative on banks, as if they were a person, or a traditional public service charged with the

natural demands to aid the community. By system 2 logic, banks cannot have a heart. It will

be a paramount mistake to regulate that banks should make decisions favoring the moral well

being of particular individuals. This is not to say that banks, with their earned money, i.ee

with their earnings from their activity, instead of paying shareholders benefits could actually

do charity, as many of them actually do. The mistake is to have them do charitable or similar

operations as part of their activities of intermediation, that is to say, to have a heart with

depositor’s money. As humane and good as this may sound through common sense, this

would be catastrophic for banks and for the economy as a whole. Yet, many common sense

driven stakeholders, some in a position to regulate banking activity, do claim that banks must

have wholehearted decision making processes, to favor the lesser graced. If banks had a

26
heart, they would lend very cheap to people who really needed the funds, but had little

chance of paying them back. Therefore, they would lose the depositor’s money, and also if

they do, they would set in motion the same process as shown with the multiplier, but in the

opposite direction, withdrawing money from the economy and creating a grave recession. If

regulation picks up these common sense traits, as in many times it does, then the same

regulation is setting on incentives, and many times rules (as shown in many underdeveloped

countries policies) that actually negatively affect banking in particular and the economy as a

whole. It is my view that this is a problem of merely understanding how banks work,

especially stakeholder incentives. And that proper understanding of this logic by other key

stakeholders, will foster much better regulation and supervision of modern banking activity.

Having said this, this is no Carte Blanche for banks to act recklessly, or even immorally, as

has been the case recently before and after the crisis of 2008, as can be seen in the heavy

fines imposed to major banks by regulators.

The Intrinsic Problems of Banking

We can establish as a central part of our statement, that banking has always had, and

most probably will ever have, two intrinsic problems. I have defined these as the Intrinsic

Problems of Banking. One is establishing the real value of assets. And the other is the

natural incentives toward excessive leverage. These two problems define the whole scope

of bottom line problems for banks, and therefore also the way we should focus on their

regulation. On a next layer, there are the traditional risks bank face, identified by the Basel

Committee (Basel Committee, Capital Accord, Pillar I and II, and Core Principles 15 - 19)

But we can claim that these risks are secondary to the intrinsic problems identified. In the

27
sense that these “Basel defined” risks usually generate losses, that affect either or both, the

real value of assets and the real leverage ratio, which in turn is a function of bank capital.

Explaining these two intrinsic problems is paramount, and understanding these

intrinsic problems is central to bank regulation and supervision. In my thesis, I maintain

that the way banks are explained and studied, provide for an imperfect understanding of the

main problems driving the activity, or in other words, miss the point of the two intrinsic

problems of banking (see chapter 7 of Mishkin and Eakins and chapter 5 of Modern Banking

for a clearer explanation of how banks are understood and taught). In their chapters dedicated

to banking and Banking regulation, Mishkin and Eakins (Ch. 17, 18) for example, define

banking with the traditional functioning and associated risks of asset transformation, agency

problems and moral hazard. However, they don’t establish capital requirements as the main

took for regulation, as proposed in this work. Conversely, they just present bank capital as

the traditional solvency measure and cushion, in line with the traditional view of textbooks.

As we can see in Picture 1 below, the authors list capital requirements as one of many tools

regulators have, but don’t define a preponderance of such instrument over others, in the way I

propose that should be understood and regulated.

28

Picture 1 - Source : Financial Markets and Institutions 7th Ed.

In older times, as regulations were incomplete, excessive leverage was easily

exploded. It is worth noticing that formal and generalized capital requirements based on risk

weighted assets only came to be with the First Capital Accord (known as Basel I) issued by

the Basel Committee, recently in 1994. Although there is historic regulatory evidence of

many sorts of capital requirements, these were many times based on the liabilities side of the

balance sheet (which does not relate to banking leverage as we have defined it). Other times,

it was a fixed amount as an entry barrier, and it would not evolve with asset size or risk, so in

practice as the banking activity grew bigger and more complex, so did its leverage, and hence

it´s potential for crises.

29
The proposed simple answer: Risk Based minimum capital requirements

So far, we have anticipated that banks have two main intrinsic problems, and a

structure of colliding incentives that bring them into a constant unstable equilibrium of forces

among stakeholders. We have therefore proposed that their correct understanding mandates

for necessary proper regulation of banking activity. We have also proposed that said

regulation has been, up until very recently, missing the spot in terms of directly attacking and

intending to solve the concrete intrinsic problems identified. One of the main reasons we

have proposed to sustain this point, is that banking activity cannot be understood and

therefore explained via a traditional system 1 heuristics approach. Moreover, a proper system

2 approach will lead us to some counter intuitive conclusions, as presented in previous

sections of this work. Henceforth, regulations must be reasoned within this system 2 logic,

where the first thing that regulation must try to resolve is the outset of the intrinsic problems

described, along with the structure of colliding incentives presented. If regulation can tackle

these elements in an efficient manner, it will foster the sound growth of the financial system,

and by addition, it will foster economic development. We mean regulation is efficient when

it is easy to communicate, easy to understand, easy to implement, and easy to supervise. If

we judge by history, usual regulations across the globe have almost harmoniously lacked

these qualities. In many occasions, on the contrary, they have impeded banking activity to

develop, adding costs, limits, prohibitions, and inefficiencies. It is my thesis that regulations

have done so, because –as explained along this work- banks are rather difficult, or confusing

to understand in their deep true functioning, if not focused via a system 2 approach, as

described in the introduction. I have proposed such approach, and along with it, I have

identified the existing instrument that can provide for efficient and effective regulation. This

instrument is “Risk Based Minimum Capital Requirements”.

30
 Capital requirements are no novelty. Although risk based capital requirements are.

Also, capital requirements may be an old and widespread instrument, but Capital

requirements as the true center of banking regulation is more of a novel concept. Moreover,

capital requirements in traditional regulation, usually are established across the board for all

banks, defined by regulators as an arbitrary percentage of assets. On the contrary, risk based

economic capital is a measure mostly driven by risk, and aimed to actually accompany risk

levels in order to define the most appropriate capital requirement level. This means that the

actual level or segment of required capital is clearly sensitive to measurable risk levels. In

order to better define the instrument, I will decompose it into its different attributes: First, as

a capital requirement, it is basically a percentage of assets that has to be integrated in cash, or

in an allowed instrument, by the ”Bankers” as defined in our simplified example. If we go

back to Figure 2, we can see how out of $100 of assets, $10 are bank capital. So, in this

example, the simple capital requirement would be 10% of assets. This means that out of

every $100 the bank loans out, $10 of those must be their own money (usually the rest is

depositor´s money).

What is the regulatory benefit of capital requirements? The best way to answer the

question, is to relate the instrument to the problem we need to solve. This is, how this

instrument relates to the intrinsic problems of banks, and to instability due to colliding

incentives of stakeholders. In terms of the intrinsic problems, especially leverage, capital

requirements are the inverse calculation of leverage. If in our example of Figure 2, Capital

requirement is 10%, and leverage, which is calculated as assets over bank capital, is then 10

times, then the level of required bank capital determines the limit to leverage. The more

required capital, the less leverage banks can exercise. Additionally, capital requirements are

a very effective tool to equalize the uneven positions regarding incentives of stakeholders. If

31
we go back to the case analyzed over figure 2, we had shown that bank owners have a strong

incentive to leverage on depositor´s money, and to take higher risks, as they naturally have all

the upside from the assets, but very little of the downside from the operations they choose to

execute –using depositor´s funds. Capital requirements tend to balance out these incentives,

since they are calculated as a ratio. So if the bank loses money from its operations, in the

more abstract conceptual definition, it would be the capital of the bankers that they will be

losing first, because in order to recompose the ratio, the banker has to replace that lost capital,

and cannot assign the loss to depositors. In this light, the most basic form of capital

requirements tackles the two main problems of banking activity, since it functions as a limit

to leverage, and as a balance for uneven agency powers among stakeholders, in favor of

depositors, who are the ones that provide the greatest part of the funds. As advised, these are

no novel concepts, and have been part of regulation for many years. However, as many

crises have shown, these basic functions were in many cases overtaken by other more

complacent de-regulations, that allowed for some severe cases of regulatory arbitrage, or

even the avoidance of capital requirements. To this point Minsky, a very critical observer of

the process of the recent regulatory process, has proposed that “the problem is money

manager capitalism – a system characterized by highly leveraged funds seeking maximum

returns and systematically under-pricing risk” In tnis light, “if banks know that government

will provide liquidity, there is a moral hazard. Hence, financial system has to be strictly

regulated” (Minsky, The Financial Instability Hypothesis).

Here is when Risk Based minimum capital requirements come into play, along with

the new paradigm of regulation, with a proactive stance, instead of the said reactive

measures. As we have established, capital requirements should be at the center of regulatory

policy. These requirements are not to be in a form of a previously set percentage or fixed

32
amount, but rather a concept, in the sense, that it has to be a portion of the particular assets, in

terms of the specific risks that are being analyzed, in line with the Basel Committee

definitions and requirements (See Figure 3 in the next section for a deeper conceptualization

of this logic). Moreover, in order to improve its effectiveness, the instrument of capital

requirements can be risk weighted. This means it would bear a relationship with the risks

that are being taken as the assets of the bank are invested. In theory, the rationale of risk

based capital requirements is that: as risk increases in the asset side of the balance sheet, so

should capital requirements, in order to keep balancing the incentives of bankers and

depositors, as shown in the explanation to figure 2. In this light, instead of being a simple

measure of a given percentage over total assets, or even certain asset kinds (as was

determined by the Basel Committee in 1988 in what is known as Basel I), risk based capital

requirements must be calculated separately for each relevant risk the bank faces, and also for

every business line or differentiated product the bank offers. In this light, instead of having

different capital requirements in asset type categories – which were historically the base for

basic credit risk capital requirements, as established by the Basel I capital accord (Basel

Committee, Capital Accord, known as Basel I), Capital requirements are to be categorized by

risk type (See figure 3 for a possible categorization). Requirement levels, for each risk type,

emerge from either regulatory definitions, or validated internal models, that have proven to

be able to measure risk accordingly. This means that the capital adequacy process is much

more granular, in terms of detail and scope of the regulatory reach, and therefore much more

effective.

In essence, based on the fundamentals just exposed, risk based minimum capital

requirements offer a very effective way to cope with the intrinsic problems of banks,

especially the incentive towards excessive leverage. This is so because if “bankers” decided

33
 to explode leverage, they have to accompany asset growth with the injection of their own

capital. More so, if these assets were risky, then capital requirements would augment

proportionally. These simple mechanics also serve the important purpose of aligning

incentives, and therefore contribute to stabilize the unstable equilibrium we described in the

introductory sections. This is so because when capital requirements grow with risk, then

what also grows is the risk “bankers” take on their own money. In this sense, they will then

have clear incentives to take good care of the depositor´s money, because in essence they are

also taking care of their own. Making this simple mechanism the center and key to

banking regulation will tend to foster more effective regulation, because it will be in line

with the proper understanding of the risks that banks face, especially those that are intrinsic

to banking activity.

How the Basel Committee is in fact running the long road towards more effective regulation

The Basel Committee has already attended to this logic. However, it has not been able

to communicate the importance of Risk Based Minimum Capital Requirements as the central

piece of banking regulation. Proof of this are the pressures known in present day 2016 in

Basel I: Extracted from: A brief history of the Basel Committee, BIS 2015

With the foundations for supervision of internationally active banks laid, capital adequacy soon became the
main focus of the Committee’s activities. There was strong recognition within the Committee of the
overriding need for a multinational accord to strengthen the stability of the international banking system and
to remove a source of competitive inequality arising from differences in national capital requirements.
Following comments on a consultative paper published in December 1987, a capital measurement system
commonly referred to as the Basel Capital Accord (1988 Accord) was approved by the G10 Governors and
released to banks in July 1988.The 1988 Accord called for a minimum capital ratio of capital to risk-
weighted assets of 8% to be implemented by the end of 1992. Ultimately, this framework was introduced not
only in member countries but also in virtually all other countries with active international banks. In
September 1993, the Committee issued a statement confirming that G10 countries’ banks with material

international 34 requirements set out in the Accord.
banking business were meeting the minimum

Box 3- A Basel I
 order to de-regulate the newer elements of Basel III, which mainly incorporate the lessons

from the 2008 crisis. (See next section for a brief discussion on this point). Before 1988,

there were no international standards, and no agreed or established practices regarding the

regulation of bank capital. In many cases bank capital was just an initial entry barrier, or an

upfront one-time disbursement requirement, as with a regular unregulated business. In Box

2, I present a brief excerpt that describes the main characteristics and evolution of the Basel

Committee´s capital standards, known as Basel I, Basel II, and Basel III.

Basel II: Extracted from: A brief history of the Basel Committee, BIS 2015

In June 1999, the Committee issued a proposal for a new capital adequacy framework to replace the
1988 Accord. This led to the release of the Revised Capital Framework in June 2004. Generally known
as ‟Basel II”, the revised framework comprised three pillars, namely:
I. minimum capital requirements, which sought to develop and expand the standardised rules set
out in the 1988 Accord;
II. supervisory review of an institution’s capital adequacy and internal assessment process; and
III. effective use of disclosure as a lever to strengthen market discipline and encourage sound
banking practices.
The new framework was designed to improve the way regulatory capital requirements reflect
underlying risks and to better address the financial innovation that had occurred in recent years. The
changes aimed at rewarding and encouraging continued improvements in risk measurement and
control.
The framework’s publication in June 2004 followed almost six years of intensive preparation. During
this period, the Basel Committee consulted extensively with banking sector representatives, supervisory
agencies, central banks and outside observers in an attempt to develop significantly more risk-sensitive
capital requirements.

Box 4- B Basel II

35
 36
 Basel III: Extracted from: A brief history of the Basel Committee, BIS 2015

Even before Lehman Brothers collapsed in September 2008, the need for a fundamental strengthening
of the Basel II framework had become apparent. The banking sector had entered the financial crisis
with too much leverage and inadequate liquidity buffers. These defects were accompanied by poor
governance and risk management, as well as inappropriate incentive structures. The dangerous
combination of these factors was demonstrated by the mispricing of credit and liquidity risk, and excess
credit growth.
Responding to these risk factors, the Basel Committee issued Principles for sound liquidity risk
management and supervision in the same month that Lehman Brothers failed. In July 2009, the
Committee issued a further package of documents to strengthen the Basel II capital framework, notably
with regard to the treatment of certain complex securitisation positions, off-balance sheet vehicles and
trading book exposures. These enhancements were part of a broader effort to strengthen the regulation
and supervision of internationally active banks, in the light of weaknesses revealed by the financial
market crisis.
In September 2010, the Group of Governors and Heads of Supervision announced higher global
minimum capital standards for commercial banks. This followed an agreement reached in July
regarding the overall design of the capital and liquidity reform package, now referred to as “Basel III”.
In November 2010, the new capital and liquidity standards were endorsed at the G20 Leaders Summit
in Seoul and subsequently agreed at the December 2010 Basel Committee meeting.
The proposed standards were issued by the Committee in mid-December 2010 (and have been
subsequently revised). The December 2010 versions were set out in Basel III: International framework
for liquidity risk measurement, standards and monitoring and Basel III: A global regulatory framework
for more resilient banks and banking systems. The enhanced Basel framework revised and strengthen
the three pillars established by Basel II. It also extended the framework with several innovations,
namely:
• an additional layer of common equity – the capital conservation buffer – that, when breached,
restricts payouts of earnings to help protect the minimum common equity requirement;
• a countercyclical capital buffer, which places restrictions on participation by banks in system-
wide credit booms with the aim of reducing their losses in credit busts;
• a leverage ratio – a minimum amount of loss-absorbing capital relative to all of a bank’s assets
and off-balance sheet exposures regardless of risk weighting (defined as the “capital measure”
(the numerator) divided by the “exposure measure” (the denominator) expressed as a
percentage);
• liquidity requirements - a minimum liquidity ratio, the liquidity coverage ratio (LCR), intended
to provide enough cash to cover funding needs over a 30-day period of stress; and a longer-
term ratio, the net stable funding ratio (NSFR), intended to address maturity mismatches over
the entire balance sheet; and
• additional proposals for systemically important banks, including requirements for
supplementary capital, augmented contingent capital and strengthened arrangements for cross-
border supervision and resolution.

Box 5- C Basel III

Defining, regulating, and Managing Banking Risks

37
 We will focus on the risk management process, as it relates to capital requirements.

In line with the New Paradigm defined in previous sections, the Basel Committee has issued,

and subsequently updated, a very important document referred to as “The Core Principles”

(Basel Committee, Core Principles for Effective Banking Supervision). In this document, the

Basel Committee sets out the best practices for the regulation and supervision of financial

activity, and especially banks. These are 29 principles, that range in subject and reach. To

our subject, the most relevant are principles 15 through 25. Especially Principle 15, which

describes the Risk Management Process (Core Principles, 40):

“Principle 15:

The supervisor determines that banks have a comprehensive risk management process

(including effective Board and senior management oversight) to identify, measure,

evaluate, monitor, report and control or mitigate all material risks on a timely basis

and to assess the adequacy of their capital and liquidity in relation to their risk profile

and market and macroeconomic conditions. This extends to development and review of

contingency arrangements (including robust and credible recovery plans where

warranted) that take into account the specific circumstances of the bank. The risk

management process is commensurate with the risk profile and systemic importance of

the bank.”

In a specific publication regarding the described new paradigm, I had called the process

defined by this principle the IMMM Process, short for Identify, Measure, Monitor, and

Mitigate each relevant risk10. If we close-read principle 15, we notice that these are the main

elements of the risk Management Process proposed by the Basel Committee.

Following, principle 16 defines Capital adequacy:

10
The original presentation of the IMMM process, was published in ¨Hacia una Cultura de RISK
MANAGEMENT¨ Roisenzvit, A and Zarate, M . Published by ASBA, E Newsletter N8 (Originally in Spanish).
Web.

38
 “Principle 16:

The supervisor sets prudent and appropriate capital adequacy requirements for banks

that reflect the risks undertaken by, and presented by, a bank in the context of the

markets and macroeconomic conditions in which it operates. The supervisor defines the

components of capital, bearing in mind their ability to absorb losses. At least for

internationally active banks, capital requirements are not less than the applicable Basel

standards.”

The importance of the paradigm change, in the interrelation between risks and capital

requirements, resides in the fact that the whole IMMM process requires not only the

establishment of capital requirements based on a coefficient (as it was with the old paradigm

described in previous sections) but the appropriate capital adequacy in line with material

risks. As explained, we are moving form a table-like capital requirement that does not reflect

risk in a dynamic manner, to a risk sensitive measure for capital. Moreover, according to

principle 15, this measure also requires for a rather comprehensive risk management process,

where risks have to be identified and measured, in line with the risk profile of each bank.

We have claimed repeatedly that risk, as an intangible, is very difficult to ascertain,

and therefore to measure. In fact, many of the models used to measure risk have failed

dramatically during the crisis of 2008. So this focus is not alien to serious criticism. It is,

anyhow, a forward looking preventive structure, that intends to utilize the latest

developments, the state of the arts tools available, in order to make capital requirements as

sensitive to risk as possible. If regulators can come forward and actually enforce this logic,

they will give a definitive step forward in the regulation of the complexities of banks. The

question then of which are the material risks, becomes an important point in regulation. In

fact, the Basel Committee has defined three risks that are the most important in banks (Basel

39
II Capital Accord, Pillar I). These are: Credit Risk, Market Risk, and Operational Risk. For

these risks, defined in Pillar I of the Basel Accord, Banks need to assign regulatory capital

according to the models and directives established by each regulator, although virtually every

regulator of the world is in line with the Basel Committee standards, at least all of the G20

regulators, in line with the last report issued by the Basel Committee on standard

implementation, (Implementation of Basel Standards, BIS.org). There are, however, other

risks that the Core Principles identify, and suggest that Banks apply the IMMM process to,

such as: Concentration Risk (Principle 19); Country and Transfer Risks (Principle 21);

Interest Rate Risk (Principle 23); and Liquidity Risk (Principle 24). Furthermore, Banks and

regulators usually identify other relevant risks that would require to apply the IMMM process

and to establish an economic capital requirement in line with those risks, on top of the three

Pillar I risks that are always mandatory. Figure 4 below shows the results of a survey by Mc

Kinsey Co. that can be helpful to demonstrate how banks in fact treat those different risks.

On the figure, we can see the percentage of surveyed banks that actually utilize economic

capital models for each risk type. As expected, the commented Pillar I risks, which are

mandatory, have undergone full implementation so far. According to the survey then, some

of the other risks are still being identified, and their models are being implemented in order to

better measure the risks.

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Figure 3 - The scope of Risks for Economic Capital. Source: Mc Kinsey

In the jargon used by banks and regulators of these risk management and capital

adequacy standards issued by the Basel Committee have defined two kinds of capital:

Regulatory Capital, referring to that requirement that is directly mandated by regulators,

and Economic Capital, referring to that capital charge that is calculated internally by the

bank, completely on the basis of the underlying risks, and not utilizing any regulatory

mandates or generalizations. It is understood that this kind of bank capital is the best in

relation to make up for unexpected losses, which is one of the main known functions of bank

capital. However, many supervisors still remain skeptical of the ability and compromise of

banks to calculate economic capital the right way, again because as risk is intangible, it is

difficult to ascertain, and therefore, economic capital based on risk is too. Plus, as we have

seen, Banks have a particular incentive to determine as little capital as possible, in order to be

able to leverage as much as possible.

In light of this new regulatory paradigm, the supervisory process has also evolved

accordingly. The best way for supervisors now to check on a bank´s stability and solvency,

41
is to analyze a particular document that was also generated by the Basel Committee

Standards. It is called the ICAAP, short for Internal Capital Adequacy Assessment Process.

In essence, this important document describes the formal opinion of the bank regarding their

capital adequacy, which entails the whole process of risk management, including of course

Identification, Measurement, Monitoring and Mitigation of all the material risks, and the

consequent capital determination, usually both economic and regulatory. Thus, ICAAP will

probably become in the near future, the centerpiece of supervisory processes, as the best way

for a regulator to analyze the past, current and prospective likelihood of a bank. By

understanding the banks´ capital adequacy and their comprehensive risk management and

capital calculation processes, regulators can identify and classify banks accordingly. A good

indicator of the implementation of the new paradigm will be to see how many regulators rely

heavily on the ICAAP for their regulatory process.11

Perhaps the whole argument about how much regulation is appropriate could be better

approached under the logic of capital requirements at the center of regulation, as I propose in

this work. The whole discussion is now very present about overregulation and de-regulation.

In a very recent public speech (in April 2016), Dr Andreas Dombret, Member of the

Executive Board of the Deutsche Bundesbank, discussed this topic extensively. Dombret

finds a very balanced viewpoint as a regulator that was a former banker. His primary point

between overregulation and complexity is “Regulators repeatedly hear calls for the reform of

banking and financial market regulation now to be brought to completion” (Dombret). That

is, for parts of the reforms to be scaled back again. “On the other hand, there is a desire for

reforms to go much further. This is expressed by well-regarded experts such as Paul Volcker,

Martin Hellwig, as well as by Nobel Prize winners Joseph Stiglitz and Eugene Fama.”

11
See “Implementation of Basel Standards” in Bibliography for detailed implementation advancements in the
G20 countries.

42
Between these two positions there is also a third one. Its proponents firmly believe that the

current reform projects will eliminate the existing shortcomings of the regulatory framework

and that the reforms therefore have to be completed” (Dombret, 4)

In fact, as per Basel Capital Accords evolution, minimum capital requirements have been

growing in general, and are expected to keep growing in time. Figure 5 below shows how

this growth is estimated.

Figure 4 - PWC depiction of Capital requirements. Source: PwC

A key part of regulation is the supervisory process

In order to have good supervision, there has to be good regulation. The whole

argument discussed above about regulation being too burdensome, affects proper oversight

and supervision, as supervisors need to focus on thousands of details from the cumbersome

43
and excessive regulations in place, instead of focusing on the key elements of bank

functioning, which coincide with the already described intrinsic problems of banks. Albeit,

proper supervisory surveillance also depends on how much resources regulators have at their

disposal. Therefore, the core of the supervisory process should be aimed to asses three

particular elements. First, if capital requirements are properly met, in line with risk

assessments that relate to capital calculation. These are all usually together so far, in they

key instrument described above: ICCAP, undertaken by the banks in order to comply with

Basel III regulations. Second, and in line with the defined intrinsic problems of banks,

supervisors should check the real value of assets. In general, this is the bulkiest part of the

supervisory process, as models are to be assessed, and also compliance tests and sampling

elements must be ordained. Lastly, the whole risk management and measurement process has

to be evaluated, in line with the capital adequacy process, in order to determine if risks are

being Identified, measured, monitored, and controlled in a manner that is consistent with the

risk profile of the institution, and with the expected level of capital in relation to the

determined levels for each of the stylized risks by the Basel Committee

Good regulation yields to good oversight, as bad regulation is complex and casuistic,

hence very difficult to supervise. Conversely, good regulation, that stands on principles, is

rather easier to supervise, only if the regulation is understood correctly. There seems to be

evidence about the idea that is presented here, that banking and capital are not correctly

understood in the new paradigm, then the misconception emerges in terms of trying to

supervise the new paradigm with old paradigm rules. If the focus is not placed in the three

main elements described above, then the supervisory process can be extenuating, and in fact

very ineffective, as the focus may be placed in trivial but cumbersome elements of casuistic

regulations. If the key elements of regulation, based on risk based capital requirements

44
occupy the center of the regulatory framework, and therefore the center of the supervisory

process, both regulation and supervision should work together seamlessly and reinforce one

another.

As before, the whole focus cannot be isolated from possible criticism

Even if these points we propose sound clear and convincing, observers and critics

may think that there is no real difference in what has been the evolution of regulation thus far

and my proposal for its presentation. After all, it is true that banks transact information

costs, and are efficient intermediaries between demand and supply of financial resources.

Furthermore, risk based capital regulation is the current regulatory paradigm, and if we agree

with the intrinsic problems defined for banking activity, there will still be failures and most

probably crises. And it is all true indeed. My point, further to these realities, is that the

proper understanding and communication of these intrinsic problems of banking: incentives

towards excessive leverage, and presenting the real value of assets, together with the

dynamics of banking risks, will facilitate the further implementation of effective regulation.

By contrast, historically comparable pendular movements in our stance towards regulation,

has led to periods were regulation, and its oversight, has been deficient, either by being too

heavy, yet not concentrated in the important aspects of capital requirements, or by being too

light, allowing for the unstable equilibrium intrinsic to banks to tilt too much in favor of the

natural concentration of power within stakeholders.

Conclusion

Perhaps the stronger point that can be made towards any regulatory approach, regardless of

its communication and propagation stance, even if it is, as is the case of the Basel Committee

45
Standards, the latest effort of the whole banking community (including Regulators, the

Industry, Governments, and International Organizations) to formalize a modern and

comprehensive regulatory framework, is that there will probably be crises along the way. As

there have always been so far. The question is, then, how deep does an eventual banking

crisis affect economic activity, and how it impairs the growth of sound financial instruments

that in turn foster economic development. As the presented proposal intends to establish, my

strong point is that when regulations stay close to the core intrinsic problems of banks, crises

should be less grave, and easier to recover from. To this point, we have presented evidence

in this paper that suggests that when in fact regulations departed from the control of the

intrinsic problems of banking, crises have been more severe. The new regulatory structures

proposed by the Basel Committee are well aligned with the intrinsic problems of banks, and

are well prepared to attack the unstable equilibrium also intrinsic to banking, as I have

proposed. The challenge remains for proper implementation of this modern framework. And

such challenge, as is proposed in this paper, resides largely in the proper understanding by all

stakeholders not just of the normative and positive elements of the regulations, but more

importantly, on the principles that stand behind them. And those principles require an

appropriate “System 2” understanding of the complexities of banking activities. It is my

intent to contribute to that process with my continuing work on this stimulating subject.

46
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