Basel II and Bankers’ Propensity to Take or Avoid Excessive Risk

Abstract

Both Basel I and Basel II are concerned (indeed, obsessed) with risk taking by bankers. But risk is an essential part of banking. The essential issues are “when are such risks excessive and does Basel II effectively constrain bankers from taking excessive risks?” I answer these questions by outlining alternative definitions of excessive risk and analyzing the extent to which Basel II deals effectively with this risk. I find the Basel II measures both costly and inadequate, and likely increase excessive risk taking. I conclude with a preferable alternative procedure – including subordinated debt fully in required capital and prompt corrective action based on prestructured capital/asset ratios.

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Notes

  1. 1.

    See Benston (1995) for a review of this experience.

  2. 2.

    See Shadow Financial Regulatory Committee (2006).

  3. 3.

    The results of the Fifth Quantitative Impact Study (QIS5) are summarized in Basel Committee on Banking Supervision (2006). Only averages are presented; the range of outcomes is not disclosed.

  4. 4.

    Evidence supporting the conclusion that banks would voluntarily increase their capital when the tax cost of equity is removed by allowing banks to hold debt as regulatory capital is found in the US experience with trust preferred securities (TPS). TPS allow any corporation to issue preferred stock through a trust. The, stock is exchanged for debt, the tax-deductible interest payments on which pay the dividends on the stock. When the trust is consolidated with the corporation, its financial statements report preferred stock rather than debt. When the Federal Reserve allowed bank holding companies (BHCs) to count this preferred stock as tier 1 capital, BHCs issued more TPS than all other corporations, the proceeds of which were used to increase their downstream bank’s tier 1 capital. See Benston et al. (2003) for a description and analysis of which banks did and did not take advantage of this regulatory change.

  5. 5.

    See Benink and Benston (2005) and Shadow Financial Regulatory Committee (2005) for more extensive descriptions.

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Correspondence to George J. Benston.

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Benston, G.J. Basel II and Bankers’ Propensity to Take or Avoid Excessive Risk. Atl Econ J 35, 373–382 (2007). https://doi.org/10.1007/s11293-007-9093-7

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Keywords

  • Basel II
  • Risk
  • Excessive risk
  • Bank failure
  • Subordinated debt
  • Prompt corrective action

JEL

  • G28