Basel II: A Post-Crisis Post-Mortem

The outbreak of the Global Financial Crisis (“Crisis”) coincided with the programmed phase-in of the second-generation Basel internationally harmonized capital adequacy regime (“Basel II”). Basel II transformed the 1988 Basel Accord’s primitive capital adequacy rules into a more general risk management regime. In so doing, it largely abandoned the one-size-fits-all rule for more elastic, institution-specific requirements. The failure of major banks and other financial institutions in the United States, Europe and elsewhere prompted a sober reevaluation of the possible limits of effective financial regulation, with Basel II losing its operational significance during the Crisis. The capital required by Basel II proved inadequate to save many important banks from destruction. This Article explores three weaknesses of Basel II. The first weakness is the illusion of safety that Basel II engendered. The second is the use of credit ratings to determine the regulatory capital needed to support the holding of particular financial assets. The third weakness is the negative spiral effect resulting from the interplay between asset value declines occasioned by mark-to-market accounting and Basel II’s rigid capital demands, generally described as pro-cyclicality. The Article examines the remains of Basel II with two general inquiries: to what extent did Basel II contribute to the creation of conditions that led to the Crisis and what effect does the failure of Basel II have on the prospects for a post-Crisis internationally harmonized capital adequacy regime.