Basel II Has Been a Costly Distraction on the Road to Minimizing the Societal Cost of Bank Failures and Financial Crises

Abstract

As is amply demonstrated in the ongoing financial turmoil, banking (depository and similar types of institutions) crises have proven costly throughout the world. As a result, the major objective of public policy with respect to banking now is to protect against the adverse externalities from large or multiple bank failures without at the same time reducing efficiency in the banking and financial systems. Inefficient or unlucky banks should be permitted to exit, but at little if any societal loss. As crossborder barriers to the flow of financial capital have been reduced in recent years, public policy to minimize the adverse externalities of, in particular, large bank failures has added an important international component. This was reflected in the wide-spread international adoption of the minimum regulatory risk-based capital ratio requirements developed by the Basel Committee of Banking Supervision, known first as “Basel I” and then in revised form as “Basel II.”

This chapter was initially prepared for presentation at a “Symposium on the U.S. Implementation of Basel II,” jointly sponsored by the FDIC and Journal of Financial Services Research in Washington, D.C., on September 13, 2006, and circulated as a working paper dated July 10, 2007. I am thankful to Edward Kane, participants at the symposium, and readers of the earlier working paper for helpful comments. The views presented are solely those of the author and do not necessarily represent those of the Federal Reserve Board or the Federal Reserve Bank of Chicago.