Are international capital adequacy rules adequate? The basle accord and beyond

University of Pennsylvania Law Review

Volumn 148, Issue 5, 2000, Pages 1771-1849

  Tarbert, Heath Price ^a  

^a NONE

Author keywords

[No Author keywords available]

Indexed keywords

EID: 23044519597     PISSN: 00419907     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Article

References (408)

1. See PAUL A. SAMUELSON & WILLIAM D. NORDHAUS, ECONOMICS 488 (15th ed. 1995) (stating that "from a macroeconomic vantage point the most important instrument is bank money . . . primarily provided today by commercial banks").
2. THE AMERICAN HERITAGE DICTIONARY 67 (3d ed. 1994).
3. See ROBERT F. MEIGS & WALTER B. MEIGS, ACCOUNTING: THE BASIS FOR BUSINESS DECISIONS 20 (9th ed. 1993) (defining the central "accounting equation" as "Assets = Liabilities + Owner's Equity").
4. See Raj Bhala, Equilibrium Theory, the FICAS Model, and International Banking Law, 38 HARV. INT'L L.J. 1, 4 (1997) ("Even the international banking law scholar, who has time for quiet reflection, admits it is 'impossible to keep up.'").
5. Id. at 21.
6. David Zaring, International Law by Other Means: The Twilight Existence of International Financial Regulatory Organizations, 33 TEX. INT'L L.J. 281, 282 (1998).
7. See Bank for Int'l Settlements: Basle Comm. on Banking Supervision, International Convergence of Capital Measurement and Capital Standards (July 1988) 〈http://www.bis.org/publ/index.htm〉 [hereinafter Basle Accord] (setting out the guidelines known as the 1988 Basle Capital Accord).
8. The G-10 consists of the "ten industrial nations that agreed in 1962 to lend money to the International Monetary Fund (IMF). They are Belgium, Canada, France, Italy, Japan, Netherlands, Sweden, Germany," the United Kingdom, and the United States. HAL S. SCOTT & PHILIP A. WELLONS, INTERNATIONAL FINANCE: TRANSACTIONS, POLICY AND REGULATION 1239 (6th ed. 1999).
9. See infra Part III.D (discussing the countries that have adopted the Basle Accord).
10. See Basle Comm. on Banking Supervision, A New Capital Adequacy Framework (June 1999) 〈http://www.bis.org/publ/index.htm〉 [hereinafter New Framework] (outlining a major revision to the 1988 Accord).
11. See U.S. Shadow Fin. Regulatory Comm., International Bank Capital Regulation: A Flawed System in Need of Reform 29 (Sept. 15, 1999) (unpublished manuscript, on file with the University of Pennsylvania Law Review) [hereinafter Shadow Proposal];
12. see also U.S. Shadow Fin. Regulatory Comm., Statement No. 160: Reforming Bank Capital Regulation (Mar. 2, 2000) 〈http://www.aei.org/shdw/shdw160.htm〉 [hereinafter Statement No. 160] (discussing international bank standards).
13. See generally ADAM SMITH, AN INQUIRY INTO THE NATURE AND CAUSES OF THE WEALTH OF NATIONS (1776) (discussing how societal wealth is generated through the self-interested pursuits of individuals).
14. TAMAR FRANKEL & CLIFFORD E. KIRSCH, INVESTMENT MANAGEMENT REGULATION 18 (1998).
15. Id.; see also Walter I. Conroy, Note, Risk-Based Capital Adequacy Guidelines: A Sound Regulatory Policy or a Symptom of Regulatory Inadequacy?, 63 FORDHAM L. REV. 2395, 2412-13 (1995) ("[Banks] solicit funds in the form of demand deposits and time deposits from individuals with a surplus of savings and pass these funds on in the form of loans and investments to companies and individuals who have a deficit of funds.").
16. Conroy, supra note 14, at 2412.
17. See NATHAN ROSENBERG & L.E. BIRDZELL, JR., HOW THE WEST GREW RICH: THE ECONOMIC TRANSFORMATION OF THE INDUSTRIAL WORLD 166 (1986) (stating that in the Industrial Revolution, "[t]he funding of the factories was facilitated by the English system of country banks which, by the usual effects of deposit banking, created the money supply needed for their factory customers' working capital").
18. Shadow Proposal, supra note 11, at 1; see also SCOTT & WELLONS, supra note 8, at 216 (describing the "dramatic growth in banks' international and cross-border activities").
19. See SCOTT & WELLONS, supra note 8, at 89-90 (describing the "importance of foreign banks" to our national economy).
20. See IAN F.G. BAXTER, INTERNATIONAL BANKING AND FINANCE 55-62 (1989) (discussing the impact of the three major international financial centers, London, New York, and Tokyo, on banking).
21. See generally RAJ K. BHALA, FOREIGN BANK REGULATION AFTER BCCI 1-23 (1994) (discussing the virtual ineptness of individual countries' legal systems to regulate the activities of global banks, especially with regard to the Bank of Credit and Commerce International ("BCCI"), the world's seventh largest private bank with operations in over 72 countries, which had engaged in many illegal activities in the 1980s and early 1990s that led to its insolvency).
22. %quot;Credit risk is most simply defined as the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms." Basle Comm. on Banking Supervision, Principles for the Management of Credit Risk (July 1999) 〈http://www.bis.org/publ/index.htm〉;
23. see also Thomas W. Albrecht & Sarah J. Smith, Corporate Loan Securitization: Selected Legal and Regulatory Issues, 8 DUKE J. COMP. & INT'L L. 411, 414 (1998) ("By far the greatest type of risk incurred in carrying on a banking business is the credit risk inherent in the holding of long-dated assets, particularly since the principal funding source of most banks traditionally has been short-dated deposits.");
24. Basle Papers Set Tone for Sweeping Accord Overhaul, FIN. NEWS, Aug. 2, 1999, available in 1999 WL 5992124 ("Regulators maintain that credit risk, or the risk of loss which banks face if a borrower or counterparty to a deal defaults, accounts for anything up to 90% of a bank's overall risk profile. It still represents the greatest threat to the health of the global banking system.");
25. BIS Reviews Basle Committee Guidelines, EUR. BANKER, Feb. 24, 1994, at 4 ("Credit risk - that a borrower cannot repay a loan - is still the main risk facing banks."). The definition of credit risk can be made even more expansive. See id. ("Credit risk today, however, now includes such things as exposure to counterparty risk from margin lending, over-the-counter derivatives, foreign exchange settlement or credit derivatives."). Loan defaults, however, are still the primary component of credit risk. Besides credit risk, banks are also susceptible to market risk, interest rate risk, liquidity risk, and others. Market risk is the "risk of losses in on and off-balance-sheet positions arising from movements in market prices, including interest rates, exchange rates and equity values."
26. The Wharton Sch. of Bus., International Banking Glossary 20 (July 21, 1994) (unpublished manuscript, on file with the University of Pennsylvania Law Review). Interest Rate Risk is the "risk that changes in the market interest rates might adversely affect an institution's financial condition." Id. at 17. Liquidity Risk is the "risk that the firm will be unable to fund assets or meet obligations at reasonable cost or at all; for financial assets, the risk that an instrument cannot be sold or otherwise exchanged for its full market value." Id. at 19.
27. This refers to "capital" in the academic sense of the term. By contrast, "Regulatory Capital" often encompasses long-term liabilities. See infra text accompanying notes 97-104 (noting that regulatory capital can include such diverse instruments as non-equity capital, bonds that do not mature for some time, as well as common equity). Regulators often treat debt with a distant maturity date (e.g., 20-30 years) as "quasicapital" since there is no obligation to pay savers in the current period.
28. Shadow Proposal, supra note 11, at 1; see also FRIEDRICH A. HAYEK, THE PURE THEORY OF CAPITAL 54 (1941) (defining capital as "the aggregate of those non-permanent resources which can be used only in this indirect manner to contribute to the permanent maintenance of the income at a particular level");
29. CHRIS MATTEN, MANAGING BANK CAPITAL: CAPITAL ALLOCATION AND PERFORMANCE MEASUREMENT 7 (1996) ("An essential element of capital is therefore its availability to absorb future, unidentified losses.").
30. Shadow Proposal, supra note 11, at 6.
31. See John W. Head, Lessons from the Asian Financial Crisis: The Role of the IMF and the United States, 7 KAN. J.L. & PUB. POL'Y 70, 81-82 ("Capital adequacy refers to the ability of a bank to face risks by relying on amounts that have been paid in by the shareholders, together with certain other reserves.").
32. Duncan E. Alford, Basle Committee International Capital Adequacy Standards: Analysis and Implications for the Banking Industry, 10 DICK. J. INT'L L. 189, 191 (1992)
33. (citing G. HEMPEL ET AL., BANK MANAGEMENT: TEXT & CASES 272 (3d ed. 1990)).
34. The Great Banking Capital Conundrum, RETAIL BANKER INT'L, Apr. 30, 1999, at 17, available in 1999 WL 13033209 [hereinafter Capital Conundrum].
35. [L]osses indicate that the firm has taken important resources and diminished their value. Losses also help separate people with poor judgment from the control of resources. One of the market's greatest strengths is its ability to match greater control over society's resources with those who have the best ability to make decisions. WAYNE GABLE & JERRY ELLIG, INTRODUCTION TO MARKET-BASED MANAGEMENT 26 (1993).
36. Shadow Proposal, supra note 11, at 6.
37. LUDWIG VON MISES, HUMAN ACTION: A TREATISE ON ECONOMICS 447 (3d ed. 1966). "If the governments had never interfered, the use of banknotes and of deposit currency would be limited to those strata of the population who know very well how to distinguish between solvent and insolvent banks." Id. at 448;
38. see also DAVID REISMAN, THE POLITICAL ECONOMY OF JAMES BUCHANAN 93-94 (1990) (discussing why the interference of central banks in regulating other banks causes more harm than good).
39. This moral hazard is especially prevalent in bank capital regulation. "Banking is a highly leveraged activity. The size of the capital base is a key parameter in determining potential profitability." Capital Conundrum, supra note 27. If a bank can justify lowering its capital, it can make more loans and, at the same time, increase the amount of deposits for which it is liable.
40. See MATTEN, supra note 23, at 7 ("[T]he level of capital affects the return required by shareholders and a bank with a lower capital requirement would be able to price its products more keenly, as its threshold return would be lower.").
41. See The Regulation of International Banking, in 11 FINANCIAL CENTRES 5 (1989) [hereinafter 11 FINANCIAL CENTRES] ("[I]f the requirements shield banks and their customers from the dangers of an over-aggressive management they cannot shield them from the possibility of stagnation or the perils of cut-throat competition."); Conroy, supra note 14, at 2442 ("When regulators interfere with the market by creating adequacy guidelines, they do not necessarily ensure the stability of individual banks.").
42. See John J. Mingo, Toward an "Internal Models" Capital Standard for Large Multinational Banking Companies, 80 J. LENDING & CREDIT RISK MGMT. 49, 53 (1998) (phrasing the question as, "should major banks operate with such a high default probability (i.e., should they operate as if they were well below investment-grade corporations)?").
43. There has been some regulation by the SEC and the securities regulation agencies of other nations mandating capital standards for financial services companies such as investment banks and brokerage houses. See SCOTT & WELLONS, supra note 8, at 251 (discussing such regulatory efforts). "The International Organization of Securities Commissions (IOSCO) tried to issue common standards for its members but the effort collapsed in late 1992." Id. at 252. In Europe, entities providing financial services other than banking are also required to maintain a certain amount of capital as a cushion against losses. "For members of the European Union, the European Commission issued the Capital Adequacy Directive (CAD) for investment firms and credit institutions in March 1993." Id. at 251.
44. See Shadow Proposal, supra note 11, at 6-7 (discussing the potential adverse effects of runs).
45. See Lawrence L.C. Lee, The Basle Accords As Soft Law: Strengthening International Banking Supervision, 39 VA. J. INT'L L. 1, 2 (1998) ("[O]ne attendant risk arising from the growth of financial globalization is the potential for international financial crises which disrupt macroeconomic performance.").
46. But see Michael Taylor, The Search for a New Regulatory Paradigm, 49 MERCER L. REV. 793, 804 (1998) ("The loss of confidence argument has probably been overstated in a modern economy: there is little evidence that the failure of one bank leads to a widespread systemic crisis as the result of panic withdrawals by depositors.").
47. See Shadow Report, supra note 11, at 8 (noting that "deposit insurance also increases the banking system's tolerance for incompetent bankers who unwittingly increase risk" and who "lower their capital consciously to take advantage of the weaker depositor discipline produced by government insurance").
48. See Capital Conundrum, supra note 27 (discussing the incentives for banks to fully leverage their assets absent market discipline guiding them to be more prudent).
49. Susan M. Phillips & Alan N. Rechtschaffen, International Banking Activities: The Role of the Federal Reserve Bank in Domestic Capital Markets, 21 FORDHAM INT'L L.J. 1754, 1757 (1998).
50. See infra Part III (discussing the implementation of the 1988 Accord around the world).
51. Basle Accord, supra note 7.
52. Pub. L. No. 98-181, tit. IX, § 908, 97 Stat. 1278, 1280 (1983) (codified at 12 U.S.C. §§ 3901-3912 (1994 & Supp. II 1996)).
53. See id. (discussing the powers of the Federal Reserve).
54. Bhala, supra note 4, at 23-24.
55. See MICHAEL GRUSON & RALPH REISNER, 1 REGULATION OF FOREIGN BANKS: UNITED STATES AND INTERNATIONAL 4-4 (1995) (explaining that when the first "risk-based capital proposal [by the Federal Reserve pursuant to ILSA] was issued for public comment in early 1986," the consensus "emphasized the importance of achieving uniformity of capital standards with other countries").
56. SCOTT & WELLONS, supra note 8, at 216; see also Lee, supra note 37, at 10 ("Modern banks conduct diversified operations across borders to diversify their earning sources and enhance their profits. Advances in data processing and telecommunications have enabled banks to offer global services easily, even without establishing a physical presence in some markets.").
57. Pierre Fleuriot, Financial Regulation As the Safeguard of Balances in a Global Context, in FINANCIAL MARKETS REGULATION 33, 33 (Alain Jeunemaitre ed., 1997).
58. See Shadow Proposal, supra note 11, at 1-2 ("[B]ecause international banks were active in multiple countries and were linked together through common clearing and settlement systems . . . the failure of one or more of these institutions in one country could adversely affect the financial welfare of other institutions in other countries.").
59. See 11 FINANCIAL CENTRES, supra note 33, at 5 ("[T]he banking system is international; the failure of a bank in Frankfurt could affect the banking system around the world."); see also F.R. RYDER, LEGAL PROBLEMS OF INTERNATIONAL BANKING 49-52 (1987) (discussing problems international bankers faced in the years preceding the Basle Accord).
60. See Thomas F. McInerney III, Note, Towards the Next Phase in International Banking Regulation, 7 DEPAUL BUS. L.J. 143, 170 (1994) ("Naturally, the tighter the regulatory structure, the less attractive a country becomes for foreign banks.").
61. Taylor, supra note 37, at 793.
62. Lee, supra note 37, at 32.
63. See Kanishka Jayasuriya, Globalization, Law, and the Transformation of Sovereignty: The Emergence of Global Regulatory Governance, 6 IND. J. GLOBAL LEGAL STUD. 425, 428 (1999) ("The extensive international effort to regulate environmental, health, weapons, and even human rights standards bears witness to this trend toward international regulation. But nowhere is this demand for regulation more apparent than in the international financial sphere.").
64. See DANIEL G. PARTAN, THE INTERNATIONAL LAW PROCESS 86 (1992) (defining "general international law" as "rules of law that bind all members of the international community even though such rules have not been established by state practice");
65. BURNS H. WESTON ET AL., INTERNATIONAL LAW AND WORLD ORDER 11 (2d ed. 1990) ("'International law governs relations between independent States.'" (quoting S.S. Lotus (Fr. v. Turk.) 1927 P.C.I.J. (ser. A) No. 10, at 18 (Sept. 7))).
66. See Lee, supra note 37, at 7 (discussing the distinction between "hard" international law, which "places obligations on members," and "soft" international law).
67. See PARTAN, supra note 55, at 85 (noting that rules of international law are "'rarely easily established'" (quoting Daniel G. Partan, The "Duty To Inform" in International Environmental Law, 6 B.U.INT'L L.J. 43, 64 (1988))).
68. See McInerney, supra note 51, at 170 ("The political difficulties involved in creating an agreement among various states on supervisory standards are heightened by intertwined issues of competitiveness.").
69. Lee, supra note 37, at 2.
70. The Bank of England is the central bank of the United Kingdom. It performs functions similar to those of the U.S. Federal Reserve.
71. Alford, supra note 26, at 195-96.
72. SCOTT & WELLONS, supra note 8, at 217. The BIS was originally established in 1930 as a financial entity to oversee the payment of reparations resulting from the First World War. See id. at 1233 (describing the BIS as "[a]n international bank originally established in 1930 as a financial institution to coordinate the payment of war reparations between European central banks"); Bank for International Settlements - Information About the BIS (last modified Jan. 2000) 〈http://www.bis.org/about/index.htm〉 (explaining the history of the BIS). Today, the BIS sponsors the Basle Committee in the limited capacity of secretariat. See id. (providing a profile and general information on the BIS). As secretariat, the BIS provides both a neutral forum for debate and support staff to maintain the Committee's communications with the world. The BIS initiated its sponsorship of the Committee in 1976, endeavoring to "coordinate banking supervision in member countries." SCOTT & WELLONS, supra note 8, at 217.
73. See SCOTT & WELLONS, supra note 8, at 217 (discussing the relationship between the Committee and G-10 central bankers).
74. See Bank for International Settlements (visited Mar. 4, 2000) 〈http://www.bis.org/ publ/index.htm〉 (listing the Basle Committee's publications during the past decade).
75. SCOTT & WELLONS, supra note 8, at 217.
76. See id.
77. Membership in the committee is limited. The institutions represented on the Basle Supervisors Committee are: Belgium: National Bank of Belgium, Banking Commission Canada: Bank of Canada, Office of the Inspector General of Banks France: Bank of France, Banking Commission Germany: Deutsche Bundesbank, Federal Banking Supervisory Office Italy: Bank of Italy Japan: Bank of Japan, Ministry of Finance Luxembourg: Luxembourg Monetary Institute Netherlands: The Netherlands Bank Sweden: Sveriges Riksbank, Royal Swedish Banking Inspectorate Switzerland: Swiss National Bank, Swiss Federal Banking Commission United Kingdom: Bank of England United States: Federal Reserve Board, Federal Reserve Bank of New York, Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation Secretariat: Bank for International Settlements JOSEPH JUDE NORTON, DEVISING INTERNATIONAL BANK SUPERVISORY STANDARDS 176 n.18 (1995).
78. The immense delegation of regulatory responsibility to central banks is especially true in the United States. "While the Federal Reserve is subject to familiar administrative law constraints, as a practical matter, neither Congress nor the judiciary is likely to overrule its exercise of discretion in the international banking arena. In practice, legal power lies with the domestic regulators." Bhala, supra note 4, at 25.
79. Basle Accord, supra note 7.
80. See infra Part III (describing current regulations adopted by the Committee).
81. See Zaring, supra note 6, at 288.
82. "The Basle Committee operates in secret and has sought throughout its existence to maintain an unpublicized existence and a low profile." Zaring, supra note 6, at 288.
83. Id. at 285.
84. Id.
85. NORTON, supra note 67, at 229.
86. See infra Part III.D (discussing the implementation of capital adequacy standards and noting that the standards were adopted by statute in the United States, Europe, and eventually much of Asia).
87. See Bank for International Settlements (last modified Jan. 2000) 〈http://www.bis.org/contact.htm〉 (giving instructions to interested parties on how to file comments concerning the Basle Committee's Consultative Papers).
88. See Bank for International Settlements (last modified Apr. 19, 2000) 〈http://www.bis.org/publ/index.htm〉.
89. Before the growth of the Internet, the general public was often excluded from viewing the Committee's proposals. This was especially true during the drafting and promulgation process of the 1988 Accord: [T]he Basle Committee issue [d] Consultative Papers to national central banks and banking supervisors, not to the international financial sector. Each central bank then determine [d] how comments [would] be collected domestically and transmit[ted] summaries of responses to the Basle Committee. This filtering of responses through national central banks was consistent with the Basle Committee's original mandate of providing a forum for discussion by bank regulators of domestic supervisory standards, because the focus was on regulations at the national level. Barbara C. Matthews, Capital Adequacy, Netting, and Derivatives, 2 STAN. J.L. BUS. & FIN. 167, 189-90 (1995).
90. This process is similar to the process of administrative rulemaking in the United States. See Administrative Procedure Act § 676, 5 U.S.C. § 553 (1994) (outlining the process of notice and comment for federal regulatory agencies).
91. Zaring, supra note 6, at 289 (quoting Charles Freeland, The Work of the Basle Committee, in 2 CURRENT LEGAL ISSUES AFFECTING CENTRAL BANKS 231, 233 (Robert C. Effros ed., 1994)).
92. Christos D. Hadjiemmanuil, Central Bankers' "Club" Law and Transitional Economies: Banking Reform and the Reception of the Basle Standards of Prudential Supervision in Eastern Europe and the Former Soviet Union, in EMERGING FINANCIAL MARKETS AND THE ROLE OF INTERNATIONAL FINANCIAL ORGANIZATIONS 179, 184 (Joseph J. Norton & Mads Andenas eds., 1996).
93. See generally supra note 68 (describing the degree of latitude afforded the Federal Reserve by the U.S. Congress in promulgating capital adequacy standards).
94. Zaring, supra note 6, at 290.
95. Lee, supra note 37, at 7.
96. Id. at 3-4.
97. Id. at 7 ("Unlike a hard law which places obligations on members, a soft law places no legally binding duties on the signatories.").
98. Matthews, supra note 79, at 184 ("These terms recognize that the documents are not treaties carrying the force of law.").
99. Lee, supra note 37, at 4.
100. Matthews, supra note 79, at 187.
101. Lee, supra note 37, at 6.
102. See 12 C.F.R. § 208.4 (1999) (stating the U.S. regulations regarding bank capital adequacy).
103. See id. § 208 app. A (noting that "[t]he risk-based capital ratio focuses principally on broad categories of credit risk, although the framework for assigning assets and off-balance-sheet items to risk categories does incorporate elements of transfer risk, as well as limited instances of interest rate and market risk").
104. See Basle Accord, supra note 7, ¶ 3 (stating that the first goal of the Accord is to "strengthen the soundness and stability of the international banking system").
105. See id. ¶¶ 28-43 (outlining the weighted risk approach).
106. See SCOTT & WELLONS, supra note 8, at 218 (noting "the practice of using a fixed percentage of the value of the asset regardless of its risk").
107. See Basle Accord, supra note 7, ¶¶ 12-27 (discussing what constitutes the regulatory definition of capital).
108. See id. ¶ 14 (defining regulatory capital as consisting of at least 50% "of equity capital and published reserves from post-tax retained earnings ([T]ier 1)" with the remaining elements consisting of supplementary capital (Tier 2)).
109. See generally, R. FRANKEL & C. LEE, ACCOUNTING DIVERSITY AND INTERNATIONAL VALUATION (NYSE Working Paper No. 96-01, 1996) (discussing differences among national accounting methods);
110. M. ZAFAR IQBAL ET AL., INTERNATIONAL ACCOUNTING: A GLOBAL PERSPECTIVE (1997) (same);
111. Sir Bryan Carberg, Global Issues and Implementing Core International Accounting Standards: Where Lies IASC's Final Goal?, Address to the Japanese Institute of CPA's (Oct. 23, 1998) (same).
112. See SCOTT & WELLONS, supra note 8, at 225 (noting that "[c]ountries differed so much in their definitions that it was essential to define capital").
113. Capital (owner's equity) is described as "[t]he amount of an owner's net investment in a business plus profits from successful operations which have been retained in the business." MEIGS & MEIGS, supra note 3, at 39.
114. Id.
115. Shadow Proposal, supra note 11, at 1.
116. See 12 C.F.R. § 208 app. A (1999) (discussing the specifics of Tier 1 and Tier 2 capital); Basle Accord, supra note 7, ¶ 14 (same).
117. For a definition of credit risk, see supra note 21.
118. SCOTT & WELLONS, supra note 8, at 230.
119. Off-balance-sheet items are "[b]anks' business, often fee-based, that does not generally involve booking assets and taking deposits. Examples are trading of swaps, options, foreign exchange forwards, standby commitments and letters of credit." The Wharton Sch. of Bus., supra note 21, at 23; see also SCOTT & WELLONS, supra note 8, at 232 ("Off-balance sheet [sic] items are obligations of banks that may or may not be called, such as bank guarantees. These contingent liabilities depend on some action or event for the bank to pay.").
120. See infra notes 120-21 and accompanying text (discussing the specifics of credit-conversion factors).
121. See Basle Accord, supra note 7, ¶ 44 (explaining the general rule and the target standard ratio).
122. 12 C.F.R. § 208 app. A, attachment II (1999).
123. Id.
124. Id.
125. See id. (showing that "[g]oodwill and other intangible assets" must be deducted from the total of Tier 1).
126. There is no stated limit on noncumulative, perpetual preferred stock, but the Committee offered this caveat: "[B]anks should avoid undue reliance on preferred stock in Tier 1." Id.
127. See id. Revaluation reserves were excluded from Tier 2 capital until October 1998, when less than 50% on specific gains were allowed. See SCOTT & WELLONS, supra note 8, at 224 (discussing the 1998 amendment allowing the inclusion of "up to 45% of pretax net unrealized holding gains").
128. See 12 C.F.R. § 208 app. A, attachment III (1999) (laying out the "Summary of Risk Weights and Risk Categories for State Member Banks").
129. See id. (delineating the various categories of risk for on-balance sheet assets).
130. The OECD is the: Organization for Economic Co-operation and Development Its members are Austria, Belgium, Canada, Denmark, Finland, France, West Germany, Greece, Iceland, Ireland, Italy, Japan, Luxembourg, the Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States. The Wharton Sch. of Bus., supra note 21, at 22.
131. PETER COOKE, BANK CAPITAL ADEQUACY AND CAPITAL CONVERGENCE 6 (1991).
132. See 12 C.F.R. § 208 app. A, attachment IV (1999) (laying out the "Credit Conversion Factors for Off Balance-Sheet Items for State Member Banks").
133. COOKE, supra note 119, at 6.
134. 12 C.F.R. § 208 app. A (1999).
135. Id.
136. Id.
137. See supra Part II.C (discussing the process by which the Basle standards become law).
138. See 12 C.F.R. § 208 (1988) (outlining the first regulations promulgated in accordance with the new Basle standard).
139. Bhala, supra note 4, at 23.
140. See Convergence of Capital Adequacy in the UK and US, 27 BANK ENG. Q. BULL. 85 (1987) (highlighting the Bank of England's preemptive adoption of the Basle Accord before its final issuance in 1988).
141. The European Community is "[n]ow known as [the] EU or European Union." SCOTT & WELLONS, supra note 8, at 1236.
142. "An EC directive creates a general binding obligation upon member states, but it leaves to each state the means by which to fulfill the obligation." Alford, supra note 26, at 205.
143. See Council Directive 89/299 of 17 April 1989 on the Own Funds of Credit Institutions, 1989 O.J. (L 124) 16.
144. See Council Directive 89/647 of 18 December 1989 on a Solvency Ratio for Credit Institutions, 1989 O.J. (L 386) 14; see also Michael Gruson & Wolfgang Feuring, The New Banking Law of the European Economic Community, 25 INT'L LAW. 1, 28 (1991) ("The Solvency Ratio Directive represents the EEC's version of the capital adequacy rules of the Basle Committee on Banking Regulations and Supervisory Practices . . . .").
145. Alford, supra note 26, at 205.
146. PHILIP MOLYNEUX ET AL., EFFICIENCY IN EUROPEAN BANKING 24 (1996) (citations omitted). "The capital adequacy requirements established by the Directive are in line with the Bank for International Settlements (BIS) proposals." Id.
147. See supra note 130 (describing the binding effect of European Community Directives on member nations).
148. Lee, supra note 37, at 32-33. "The Basle Accords have become the standard for international financial services regulations throughout the industrialized world. Banking institutions in non-Basle member countries that wish to do business with Basle member countries are likely to comply with the Basle Accords." Id. at 5.
149. For example, "India adopted them as part of the financial reforms package in 1992." S. Venkitaramanan, Basle Revisits Risks, BUS. LINE (Hindu), July 5, 1999, available in 1999 WL 21232504.
150. See Berry Fong-Chung Hsu, Legislative Control of Hong Kong Financial Markets: Some Aspects of Banking and Securities Regulations, 28 LAW & POL'Y INT'L BUS. 649, 676 (1997) (noting that the Basle Accord is the new capital adequacy regime in Hong Kong and reporting that "[a]ll authorized institutions incorporated in Hong Kong must maintain a capital adequacy ratio of eight percent, as calculated in accordance with the provisions of the Third Schedule of the Banking Ordinance");
151. see also Lawrence L.C. Lee, Adoption and Application of a "Soft Law" Banking Supervisory Framework Based on the Current Basle Accords to the Chinese Economic Area, 16 WIS. INT'L L.J. 687, 711 (1998) ("In supervising banks, the HKMA follows international practices as recommended by the Basle Accords - for example, the capital adequacy framework and the minimum standards for supervision of international banking groups.").
152. The International Monetary Fund ("IMF") is an "[o]rganization founded at Bretton Woods in July 1944, and located in Washington, D.C., with the goal of overseeing exchange arrangements and lending foreign currency reserves to members." The Wharton Sch. of Bus., supra note 21, at 16.
153. John W. Head, Lessons from the Asian Financial Crisis: The Role of the IMF and the United States, 7 KAN. J.L. & PUB. POL'Y 70, 80 (1998).
154. Ashish Lall & Ming-Hua Liu, Liberalization of Financial and Capital Markets - Singapore Is Almost There!, 28 LAW & POL'Y INT'L BUS. 619, 645 (1997).
155. See Decree of the President of the Republic of Kazakhstan, "Law on Banks and Banking Activity in the Republic of Kazakhstan," art. 42 (adopting the Basle Accord into the national banking regulation of Kazakhstan). "The [National Bank of the Republic of Kazakhstan's] implementation of prudential normative regulations sets forth, among other things, a minimum capital level substantially in accordance with the Basle Committee's Accord on Capital Adequacy." Gary A. Gegenheimer, Bank Regulatory Reform in the Republic of Kazakstan, 17 ANN. REV. BANKING L. 153, 184-85 (1998).
156. The following chart is replicated from Lee, supra note 37, at 29.
157. Id. at 6.
158. See supra Part III.C (detailing the current risk-weighted asset categories promulgated through the Basle Accord).
159. See 12 C.F.R. § 208 app. A, attachment III (1999) (detailing the types of assets classified in the 100% risk category).
160. Jules Stewart, Another Reason for Banks To Make Friends of Credit-Worthy, FIN. DIRECTOR, Sept. 17, 1999, available in 1999 WL 2027705.
161. See supra note 118 (listing the member nations of the OECD).
162. See 12 C.F.R. § 208 app. A, attachment III (detailing the types of assets classified in the 0% risk category).
163. Basle Reforms Overdue, FIN. NEWS, Oct. 7, 1999, available in 1999 WL 24779976.
164. An unsecured loan to a business would be rated as having a 100% risk. A mortgage securing a single-family home is rated at having only a 50% risk of default. See 12 C.F.R. § 208 app. A, attachment III (detailing the types of assets classified in the 100% and 50% risk categories).
165. The Wharton Sch. of Bus., supra note 21, at 1.
166. Mingo, supra note 34, at 51.
167. Alford, supra note 26, at 216.
168. See RICHARD DALE, INTERNATIONAL BANKING DEREGULATION: THE GREAT BANKING EXPERIMENT 170 (1992) ("[B]ecause the riskiness of a bank's assets is no longer reflected in the cost or availability of its funding, the propensity for risk-taking by banks has greatly increased.");
169. David Jones & John Mingo, Industry Practices in Credit Risk Modeling and Internal Capital Allocations: Implications for a Models-Based Regulatory Capital Standard, ECON. POL'Y REV. FED. RESERVE BANK N.Y., Oct. 1998, at 53, 54 ("[C]apital arbitrage stems from the disparities between true economic risks and the 'one-size-fits-all' notion of risk embodied in the Accord."); Mingo, supra note 34, at 51 ("[I]f a bank acts to maintain a chosen insolvency probability, requiring it to hold more capital may lead the bank to hold riskier assets sufficient to exactly offset the additional capital and leave insolvency probability unchanged."); Basle Reforms Overdue, supra note 150 ("The crude weighting system applied to different types of lending is often incentivising banks to assume risk. For instance, the rules make it attractive to lend short-term to other banks.").
170. "As the Basle Accord became final in 1992, a slowdown in bank lending seemed to be creating or intensifying a recession in the U.S. and other industrial countries." SCOTT & WELLONS, supra note 8, at 233.
171. See infra text accompanying notes 162-66.
172. See 12 C.F.R. § 208 app. A, attachment III (1999) (detailing the types of assets classified in the 0% and 100% risk categories); Albrecht & Smith, supra note 21, at 417 ("Corporate loans are relatively expensive items, in terms of capital, to hold on a bank's balance sheet, because they are risk-weighted at one hundred percent, irrespective of the actual credit quality of the counterparty.").
173. "[T]he Accord encouraged banks to invest in government bonds, with zero risk weight and therefore no capital cost, rather than lend to commercial and consumer borrowers subject to as much as 8% capital." SCOTT & WELLONS, supra note 8, at 233; see also R. Litan, Nightmare in Basle, INT'L ECON., Nov.-Dec. 1992, at 7 (discussing how much more expensive it is for a bank to loan to a company in contrast to purchasing a government bond under the Basle rules).
174. Conroy, supra note 14, at 2431-32 (footnotes omitted).
175. Zaring, supra note 6, at 284 (quoting Richard C. Breeden & William N. Isaac, Thank Basle for the Credit Crunch, WALL ST. J., Nov. 4, 1992, at A14).
176. New Framework, supra note 10, annex 2, ¶ 3.
177. See Hsu, supra note 138, at 676 ("While the risk weight for residential mortgages is fifty percent, this level is not suitable in the Hong Kong environment where the real estate price is unrealistically high and quite speculative.").
178. Id.
179. Id.
180. Timothy A. Canova, Banking and Financial Reform at the Crossroads of the Neoliberal Contagion, 7 U.S.-MEX. L.J. 85, 106 (1999).
181. Even nations represented on the Basle Committee failed to reach a true consensus on the definition of "regulatory capital": The Germans regarded the broadening by the [Basle] Committee of any definition beyond shareholders' equity as undermining the rigor of German capital requirements. France, which had a number of state-owned banks that would have found it difficult to increase shareholders' equity, argued for including a substantial amount of subordinated debt in the definition. The United States, which had counted loan loss reserves as part of regulatory capital, argued that such a practice should be continued. The Japanese, whose banks had substantial unrealized capital gains in securities holdings, argued that such gains should be counted as assets and, hence, as higher equity. Statement No. 160, supra note 11.
182. Alford, supra note 26, at 203.
183. 12 C.F.R. § 208 app. A, attachment II (1999) (emphasis added); see also supra Part III.B (outlining the components of Tier 1 capital).
184. Deutsche Reopens Tier 1 Capital Issue, INT'L BANKING REG., Feb. 9, 1998, at 1;
185. see also Arturo Estrella, Formulas or Supervision? Remarks on the Future of Regulatory Capital, ECON. POL'Y REV. FED. RESERVE BANK N.Y., Oct. 1998, at 191, 191 (describing the "risk of an increasing disconnect between regulatory capital and what banks and other financial institutions do").
186. See Deutsche Reopens Tier 1 Capital Issue, supra note 170, at 1 (describing the new equity offering Deutsche Bank hoped to qualify as Tier 1).
187. Id.
188. See 12 C.F.R. § 208 app. A (stating that the Federal Reserve has the ability to increase the capital ratio when it considers such action necessary); Lall & Liu, supra note 141, at 645 (discussing how Singapore adopted the basic standards of Basle, but increased the capital ratio to provide even more of a capital cushion against credit risk).
189. Jones & Mingo, supra note 155, at 53.
190. Shadow Proposal, supra note 11, at 21.
191. See Mingo, supra note 34, at 51 ("From a regulatory perspective the [hypothetical] bank is 'well-capitalized;' but from an economic perspective the bank is undercapitalized by nearly 3 percentage points.").
192. See Jones & Mingo, supra note 155, at 53 ("The basic problem is that securitization and other forms of capital arbitrage allow banks to achieve effective capital requirements well below the nominal 8 percent Basle standard.").
193. See supra Part I.C (discussing the reasons for capital adequacy regulation by the government). Regulators have decided that they do not fancy "major banks operat[ing] with such a high default probability." Mingo, supra note 34, at 53.
194. "The temptation shareholders sometimes face to profit at the expense of debtholders by increasing asset risk is known as the 'asset substitution' problem . . . ." Shadow Proposal, supra note 11, at 30 n. 18.
195. See infra Part V.A (discussing the impact of debtholders on capital adequacy regulation and the basics of the subordinated debt requirement of the Shadow Committee Proposal).
196. Professor Hal Scott of Harvard Law School has even remarked that "it would be an accident if the Accord evened the playing field." Hal S. Scott, The Competitive Implications of the Basle Capital Accord, 39 ST. LOUIS U. L.J. 885, 891 (1995).
197. Id. at 886; see also MAXIMILIAN J.B. HALL, BANKING REGULATION AND SUPERVISION: A COMPARATIVE STUDY OF THE UK, USA AND JAPAN 183 (1993) ("Despite common objectives and the pressures created for convergence in regulatory and supervisory practice, the regulatory and supervisory regimes currently in place in the UK, USA and Japan are likely to retain a significant degree of distinctiveness for a considerable time to come.").
198. See supra note 38 (mentioning the moral hazard created by deposit insurance regimes).
199. Scott, supra note 181, at 887.
200. Id. at 892.
201. See 12 C.F.R. § 208 app. A, attachment II (1999) (ascribing "no limit" on the amount of non-cumulative perpetual preferred stock included in Tier 1).
202. See Scott, supra note 181, at 892 ("Insofar as this results in foreign banks using more expensive forms of capital, they are at a competitive disadvantage with U.S. banks which make significant use of such instruments."). The Japanese also lack the ability to incorporate certain types of equity into their required regulatory capital. See id. ("Japanese banks have not been able, due to legal impediments, to take advantage of the Basle rules permitting the use of preferred stock.").
203. See id. at 893 (explaining, for instance, that "there is less financing of residential real estate in Japan due to different housing conditions").
204. HALL, supra note 182, at 183-84.
205. ROBERT C. HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT 375 (4th ed. 1995).
206. Phillips & Rechtschaffen, supra note 40, at 1765. "An asset's risk in isolation is greater than its portfolio risk whenever the asset's cash flows and the portfolio's cash flows are less than perfectly correlated." HIGGINS, supra note 190, at 317. When this usual event occurs, "some of the asset's cash flow variability is offset by variability in the portfolio's cash flows, and the effective risk the investor bears is reduced." Id. at 317-18; see also A. James Meigs, The Financial System, in HANDBOOK OF MODERN FINANCE 1-1, 1-5 (Dennis E. Logue ed., 1984) ("Diversification through financial institutions and markets permits investors to hold a variety of assets whose prices are not tied to one another. Therefore, as a matter of random chance, losses on some assets should be offset to some degree by gains on others.").
207. Bruce S. Darringer, Swaps, Banks, and Capital: An Analysis of Swap Risks and a Critical Assessment of the Basle Accord's Treatment of Swaps, 16 U. PA. J. INT'L BUS. L. 259, 260 (1995); see also Lee, supra note 37, at 15 ("Banks are also increasingly using new financial instruments to diversify their earnings, enhance their profits, and hedge potential risk.").
208. Darringer, supra note 192, at 265; see also SCOTT & WELLONS, supra note 8, at 1236 (defining derivatives in the glossary as "[f]inancial instruments whose value is based on that of another security or its underlying asset"). Derivatives are very important instruments because they allow parties with different risk rates and preferences to hedge against changes brought about by the market. See Darringer, supra note 192, at 265 ("Derivatives are extremely important because they facilitate the ability to transfer and accept risks, enabling entities to hedge against fluctuations in profits which may be caused by changes in exchange rates, interest rates, commodity prices, or equity prices.").
209. See Darringer, supra note 192, at 265.
210. S. Henderson, Swap Credit Risk: A Multi-Perspective Analysis, in INTERNATIONAL BANKING AND CORPORATE FINANCIAL OPERATIONS 41 (K. Lian et al. eds., 1989); see also Darringer, supra note 192, at 266 ("A swap is a contract whereby two counterparties agree to exchange future cash flows at periodic intervals during the life of the swap according to a prearranged formula.").
211. See Basle Accord, supra note 7, annex 3, at 24 (discussing the treatment of "foreign exchange and interest rate related items," including swaps, as off-balance-sheet assets).
212. See Amendment to the Capital Accord to Incorporate Market Risks, Jan., 1996, at 1-8 (amending the 1988 Accord to include capital cushions for market risk, brought mainly by derivatives activities); see also Matthews, supra note 79, at 167-70 (discussing the treatment of derivative holdings by banks under the current Basle Accord). The fifth flaw of the Accord, its ignorance to diversification, has combined with this last flaw to increase the inaccuracy of derivative risk calculations. "Basle fails to take account of whether a bank's swap portfolio is diversified across various counterparties and industries." Darringer, supra note 192, at 311-12.
213. See Darringer, supra note 192, at 301-11 (discussing the Committee's approval of banks determining credit risk through models).
214. Jones & Mingo, supra note 155, at 59.
215. HENRY HAZLITT, ECONOMICS IN ONE LESSON 17 (3d ed. 1979) (emphasis omitted).
216. See New Framework, supra note 10, ¶ 44 ("Over 100 countries have adopted the Accord . . . .").
217. See id. ¶¶ 4-8 (describing some of the weaknesses of the Accord).
218. Id. ¶¶ 6-7.
219. Id.
220. Id. ¶ 2 (emphasis added).
221. Id. ¶ 20; see also id. annex 2, ¶ 1 ("The Committee does not propose at this stage to make further amendments to the definition of capital.").
222. See supra text accompanying note 109 (discussing the required capital ratio banks must maintain under the terms of the Basle Accord).
223. 12 C.F.R. § 208 app. A (1999).
224. See id. attachment II (discussing the limitations on Tiers 1 and 2 of qualifying regulatory capital).
225. See New Framework, supra note 10, ¶ 23 (discussing how "the Committee is proposing revisions to the existing approach to credit risk" in the new proposal).
226. See id. annex 2, ¶ 6 (explaining what the various risk-weights signify).
227. See id. ("Claims on countries rated below B- would be weighted at 150%."); see also id. annex 2, ¶ 23 (describing why the Committee is proposing to add higher risk categories for specific assets with a "relatively adverse default history and high price volatility").
228. See id. ¶¶ 23, 25 (providing summaries of the standardised approach and the internal ratings-based approach).
229. Id. ¶ 23.
230. See infra text accompanying notes 245-47 (describing the alternative internal ratings-based approach, which allows certain banks to be exempted from relying on external credit agencies if they maintain an internal system for assessing the financial risks of borrowers).
231. New Framework, supra note 10, ¶ 23.
232. See id. annex 2, ¶ 18 (explaining the new, proposed weighting methodology).
233. See 12 C.F.R. § 208 app. A, attachment III (1999) (requiring that "[a]ll other claims by private obligors" including commercial loans, be assessed at 100%); Stewart, supra note 147 ("At present, if an AA-rated corporate and another rated BBB have ten-year facilities with a given bank, they both require the same capital usage.").
234. The $80 million capital requirement derives from multiplying the value of the Microsoft loan by its corresponding risk weight and the required capital ratio of the Accord. Thus, $80,000,000 = $1,000,000,000 × 100% × 8%.
235. See New Framework, supra note 10, annex 2, ¶ 5 (discussing the various risk weights that correspond to the external credit ratings of private rating agencies).
236. $16,000,000 = $1,000,000,000 × 20% × 8%.
237. See New Framework, supra note 10, annex 2, ¶ 4 (discussing the application of different risk weights corresponding to the "assessment results of eligible external credit assessment institutions").
238. Although rating agencies differ somewhat in their designations of good and bad ratings, the ratings used by the most popular agencies are similar: Credit Assessment Very High Quality Very Low Quality Institution Assessment Assessment Fitch IBCA AA- and above Below B-Moody's Aa3 and above Below B3 Standard & Poor's AA- and above Below B-Export insurance 1 7 agencies Id. annex 2, ¶ 32, Table 2 (footnotes omitted).
239. If the risk rate is 100%, a full 8% of qualified regulatory capital must serve as a cushion. This requirement means that the bank must set aside eight cents of capital for every dollar loaned. If the risk rate is 150%, the bank must hold 1.5 times the capital ratio. In effect, this changes the required capital ratio for the full dollar amount of the asset to 12%. Thus, for every dollar of the claim assessed at 150%, the bank must set aside a corresponding 12 cents of regulatory capital. 225 See supra text accompanying note 166 (discussing the financial conundrum of allocating zero risk to Mexico, which had recently joined the OECD).
240. See New Framework, supra note 10, annex 2, ¶ 3.
241. See id. annex 2, ¶¶ 11-12 (discussing the current proposal's treatment of "[c]laims on banks").
242. Id. annex 2, ¶ 11.
243. See id. ("The weight applied to the bank would be one category less favourable than that applied to the country.").
244. See id. annex 2, ¶ 12 ("The second option would be to use ratings assigned directly to banks by an external credit assessment institution.").
245. See id.
246. Id. annex 2, ¶ 16.
247. See id. annex 2, ¶ 18 (proposing to allow only "claims on corporates of a very high quality" to be afforded a lower risk weight).
248. See id. (noting "that a weighting of 150% [should] be given to claims on corporates which are of very low quality").
249. Id.
250. See id. annex 2, ¶ 20, tbl. 1.
251. See id. annex 2, ¶ 21 (stating that "lending fully secured by mortgages on residential property . . . should continue to be weighted at 50%").
252. See 12 C.F.R. pt. 208 app. A, attachment IV (1999) (delineating the credit conversion factors currendy in force in the United States).
253. See New Framework, supra note 10, annex 2,1 25 ("The Committee is not proposing to change the existing conversion factors for off-balance-sheet items . . . ."). Commitments, which will not remain the same if the new proposal is adopted, comprise the one small exception. "Given that even short-term commitments entail some risk, the Committee is proposing a credit conversion factor of 20%, which would principally apply to business commitments." Id. annex 2, ¶ 26.
254. See id. annex 2, ¶ 28 (acknowledging that when "the credit quality of two borrowers is equivalent, the exposure to the borrower with the longer-term claim would generally be riskier than that to the borrower with the shorter-term claim").
255. Id.
256. See id. annex 2, ¶ 29 (listing the minimum criteria suggested by the Committee).
257. Id. annex 2, ¶ 32.
258. External credit assessments can result in credit-rating arbitrage as well. For example, if Standard and Poor's were to rate a corporate claim as the very highest quality, the corresponding risk weight under the proposal would be 20%. If other external agencies, such as Moody's and Fitch IBCA, were to rate the corporate claim at anything lower than the very highest appraisal, the corresponding risk weight under the proposal would be 100%. Therefore, the bank would clearly have an incentive to choose the S & P rating since it requires 80% less regulatory capital per dollar of the claim. The Committee wants to prevent this form of regulatory arbitrage. "Banks must adopt a consistent approach in using a particular assessment mechanism and should not 'cherry pick' among assessments." Id. annex 2, ¶ 2.
259. Id. annex 2, ¶ 42.
260. See id. annex 2, ¶ 46 (stating that "prior supervisory approval would be necessary before banks could be allowed to use their internal ratings systems for setting minimum capital requirements").
261. Id. annex 2, ¶ 45.
262. Id. ¶ 12.
263. Id. annex 2, ¶ 42.
264. Id. annex 2, ¶ 43.
265. See SUMMARY OF THE STANDARISED APPROACH, supra text accompanying notes 236-44 (discussing risk weighting in the standardised approach).
266. New Framework, supra note 10, annex 2, ¶ 43.
267. Id. annex 2, ¶ 39.
268. See id. annex 2, ¶ 45 ("[I]nternal ratings . . . would represent a major step forward for supervisors from the proposed standardised approach.").
269. SCOTT & WELLONS, supra note 8, at 245.
270. Jones & Mingo, supra note 155, at 54.
271. Id. "When estimating the PDF for credit losses, banks generally employ what we term either 'top-down' or 'bottom-up' methods." Id. The "top-down" method relies on "the volatility of charge-offs historically for the type of loan rather than for individual loans." SCOTT & WELLONS, supra note 8, at 246. Thus, for small loans to individuals and entities, the top-down approach is likely to be the most efficient. The "bottom-up" method involves the assessment of each asset credit risk "based on an explicit credit evaluation of the underlying customer." Jones & Mingo, supra note 155, at 55.
272. Mingo, supra note 34, at 50.
273. See Jones & Mingo, supra note 155, at 54 (explaining that "required economic capital is the amount of equity over and above expected losses necessary to achieve the target insolvency rate").
274. See New Framework, supra note 10, ¶ 20; see also id. annex 2, ¶ 1 ("The Committee does not propose at this stage to make further amendments to the definition of capital.").
275. Id. annex 2, ¶ 52.
276. Id. ¶ 12.
277. Id. annex 2, ¶ 53.
278. Id. ¶ 32.
279. See id. ¶ 36 (encouraging regulatory agencies to examine closely "the number and skill level of supervisory staff required to carry out this work").
280. Id. ¶ 34.
281. See id. ¶ 36 (requiring "bank supervisors to work in close co-operation to evaluate the risk profile of internationally active banks and to ensure consistency of standards across national borders").
282. Id. ¶ 39.
283. Id. ¶ 41. "This information should, at a minimum, be provided in annual financial reports and should include quantitative and qualitative details on the bank's financial condition and performance, business activities, risk profile, and risk management activities." Id.; see also Basle Comm. on Banking Supervision, Enhancing Bank Transparency (Sept. 1998) 〈http://www.bis.org/publ/index.htm〉 (discussing ways to optimize disclosure to ensure banking supervision and market discipline).
284. See New Framework, supra note 10, ¶ 40 (admitting that "a bank may not be subject to market discipline from a fully insured depositor who has nothing at risk, and therefore no motive to impose discipline").
285. See Statement No. 160, supra note 11 (discussing the universal "sense of urgency for [the Basle Committee to reform its] international capital standards").
286. See supra text accompanying notes 145-66 (discussing the first "sin" of the Accord).
287. See supra table accompanying note 236 (discussing the various risk weights and their retention as whole percentages); supra text accompanying notes 211-12 (same).
288. This is certainly true for the majority of regulated banks, which mil follow the standardised approach. For the internal ratings-based approach, the Basle Committee has not yet made a definitive determination of the risk weights it will institute corresponding to internal ratings. It has suggested, however, that "banks could map their internal rating categories to the standardised risk weights." New Framework, supra note 10, annex 2, ¶ 39.
289. See New Framework, supra note 10, annex 1, ¶¶ 2-20 (same); supra Part IV.A.1 (discussing the new risk-weighting procedures for sovereigns, banks, and corporates under the standardised approach).
290. Since Mexico and the United States are OECD countries, the Accord currently assigns a 0% risk weight to all claims on them. See Basle Accord, supra note 7, ¶ 36 (noting that "claims on central governments within the OECD will attract a zero weight"); 12 C.F.R. § 208 app. A, attachment III (1999) (summarizing risk weights). This effectively means that no regulatory capital must be held against these assets. If Mexico is assigned a risk weight higher than zero, claims on the Mexican central government will require a cushion of regulatory capital.
291. Conroy, supra note 14, at 2443; see also Jones & Mingo, supra note 155, at 59 (stating that "in contrast to the one-size-fits-all Basle standard, a bank's internal capital allocation against a fully funded, unsecured commercial loan will generally vary with the loan's internal credit rating").
292. See supra table accompanying note 236 (summarizing the standardised approach).
293. See New Framework, supra note 10, annex 2, ¶¶ 12, 18 (discussing the lowest risk weights that banks and corporations are eligible to receive). The Shadow Committee surmises that "[t]he disparity presumably reflects an attempt to enlist support for the proposed system from countries where most firms are not rated but is unlikely to represent the true credit quality of many unrated borrowers." Statement No. 160, supra note 11.
294. See New Framework, supra note 10, annex 2, ¶ 12 ("[N]o claim on a bank could receive a risk weight less than that applied to claims on its sovereign."); id. annex 2, ¶ 13 ("No claim on a corporate could be given a risk weight preferential to the risk weighting assigned to a claim on the sovereign of the corporate's country of incorporation.").
295. Basle Capital Accord: The First Revision Is Out, INT'L BANKER, June 7, 1999, available in 1999 WL 5992124.
296. See New Framework, supra note 10, annex 2, ¶ 18 ("The Committee now proposes that the standard weighting of claims on corporates remains at 100%, but that a weighting of 20% be given to claims on corporates of a very high quality . . . .").
297. See id. (stating that all loans to corporations below "a minimum rating of AA-" would be adjudged at least a 100% risk weighting).
298. This topic will be discussed in the evaluation of the proposal's efforts to level the playing field among member nations. See infra text accompanying notes 296-98.
299. See New Framework, supra note 10, annex 2, ¶ 20, tbl. 1 (showing that claims of unrated "corporates" would be assigned a 100% risk weight).
300. See New Capital Proposal Hits Short-Term ABS, FINANCIAL MODERNIZATION REP., June 21, 1999, at 1 (discussing how the proposal will not help short-term asset-backed securities since they are not usually assessed by external credit rating agencies).
301. See New Framework, supra note 10, annex 2, ¶ 21 (stating that "lending fully secured by mortgages on residential property . . . should continue to be weighted at 50%").
302. See id. annex 2, ¶ 25 ("The Committee is not proposing to change the existing conversion factors for off-balance-sheet items . . . ."). There is one small exception, commitments, which will not remain the same if the new proposal is adopted. "Given that even short-term commitments entail some risk, the Committee is proposing a credit conversion factor of 20%, which would principally apply to business commitments." Id. ¶ 26.
303. See supra text accompanying notes 168-72 (discussing the second "sin" of the Accord).
304. New Framework, supra note 10, annex 2, ¶ 1.
305. See supra text accompanying notes 173-77 (discussing the third "sin" of the Accord).
306. Improving the Basle Committee's New Capital Adequacy Framework: Joint Statement by a Sub-Group of the Shadow Financial Regulatory Committees of Europe, Japan, and the U.S. (visited Feb. 8, 2000) 〈http://www.aei.org/shdw/shdwbasle.htm〉 [hereinafter Improving the New Framework].
307. See supra text accompanying notes 178-80 (discussing the fourth "sin" of the Accord).
308. See infra Part V.A (discussing the reasons why subordinated debt holdings may be a better form of regulatory capital than common equity).
309. See supra text accompanying notes 181-89 (discussing the fifth "sin" of the Accord).
310. Alford, supra note 26, at 218.
311. See supra text accompanying notes 181-89 (discussing the failure of the Basle Accord to level the playing field among member nations).
312. The Committee forthrightly admits that "differences in national accounting, tax, legal and banking structures will inevitably create differences between national markets and that the use of banking supervisory rules cannot address all these differences." New Framework, supra note 10, ¶ 14.
313. New Framework, supra note 10, Executive Summary, ¶ 7.
314. Venkitaramanan, supra note 137.
315. See Capital Adequacy: Striving Towards an Optimal Ratio, BUS. LINE, June 9, 1999, available in 1999 WL 17712223 (stating that in terms of the new proposal, "Indian banks will not score well on any of these counts");
316. Framework to Provide for Capital Flexibility, EUR. BANKER, June 1, 1999, available in 1999 WL 11536387 ("Banks with low credit ratings will also have to face the possibility that the cost of international bank borrowing will increase.");
317. New Basle Norms To Raise Bank's Capital Needs, BUS. STANDARD, Aug. 12, 1999, at 3 (stating that the "new Basle Committee norms on capital adequacy would increase the capital requirement of commercial banks in India").
318. German Banks Say Basle Capital Adequacy Proposals Favour U.S., U.K. Rivals, AFX, Sept. 29, 1999, available in 1999 WL 25405947.
319. Id. (quoting Deutsche Bank AG chairman Rolf Breuer).
320. See supra text accompanying notes 190-91 (discussing the sixth "sin" of the Accord).
321. Statement No. 156 of the Shadow Financial Regulatory Committee on September 27, 1999, The Basle Committee's New Capital Adequacy Framework (visited Nov. 22, 1999) 〈http://www.aei.org/shdw/shdw156.htm〉 [hereinafter The Basle Committee's New Capital Adequacy Framework].
322. See supra text accompanying notes 192-99 (discussing the seventh "sin" of the Accord).
323. See supra note 197 and accompanying text (discussing subsequent amendments to the 1988 Accord that included capital cushions for market risk).
324. James B. Ransom, Note, "Capital Adequacy" in Crisis: Towards an Optional Bank Deposit Insurance Regime, 7 S. CAL. INTERDISC. L.J. 445, 453 (1998).
325. See New Framework, supra note 10, annex 2, ¶ 25 ("The Committee is not proposing to change the existing conversion factors for off-balance-sheet items . . . ."); Richard M. Schetman, Legal Aspects of "Netting" in Respect of Insolvent Derivative Products Counterparties, in BROKER-DEALER REGULATION 87, 137-40 (1999) (explaining how the netting of derviatives would basically remain unchanged under the new Basle proposal).
326. See Alain Hirsch, Supervision of Bank Groups, TRENDS AND FORCES IN INTERNATIONAL BANKING LAW 62, 72 (1990) ("Faced with the reality of bank groups, national supervisory agencies have been led to realize that separate supervision of different banks in a group is insufficient.");
327. BIS Reviews Basle Committee Guidelines, EUR. BANKER, Feb. 24, 1999, available in 1999 WL 11536292 (reporting that "banks are growing to global proportions and more income is being generated from trading and other nontraditional fee-generating areas, risk is becoming much harder to keep track of").
328. Basle Accord Revision Looking to Ratings, CFO ALERT, Nov. 23, 1998, available in 1999 WL 5283722.
329. See Phillips & Rechtschaffen, supra note 40, at 1762-63 ("[C]redit rating agencies enhance the capital markets infrastructure by distilling a great deal of information into a single credit rating for a security. That rating reflects the informed judgment of the agency regarding the issuer's ability to meet the terms of the obligation."). Some also believe that entities change their risk behavior to avoid getting poor ratings by external agencies. See supra text accompanying note 256 (discussing that banks conform their internal credit risk models to a preferred rating by an external agency). Thus, one conclusion is that once banks become fully subject to external credit ratings, they will adjust their capital ratio to receive a better rating. Others suggest that credit rating agencies do not have such a dynamic effect on the entities they assess: The evidence in support of the hypothesis that banks raise their capital ratios as a response to pressure from rating agencies is inconclusive. All bankers who have been involved with their organisation's contacts with rating agencies know that this is indeed a major topic of discussion, but the empirical evidence suggests that the link between capital ratios and credit ratings is not as strong as one might think. MATTEN, supra note 23, at 11.
330. Interview with Richard J. Herring, Professor of International Banking and Finance, The Wharton School of Business at the University of Pennsylvania, in Philadelphia, Pa. (Nov. 22, 1999) [hereinafter Herring Interview].
331. Venkitaramanan, supra note 137; see also Statement No. 160, supra note 11 ("[R]atings agencies move slowly, and changes in ratings lag changes in actual credit quality, so that the ratings have a questionable ability to predict default. Indeed, the record of the ratings agencies before the recent Asian financial crisis was particularly poor.").
332. See supra Part III.E (discussing the lack of rating agencies in countries outside the United States and United Kingdom as making the playing field among nations even more uneven).
333. See Venkitaramanan, supra note 137 ("Most rating agencies are still not equipped adequately to handle large extra load cast on them.").
334. See Herring Interview, supra note 313 (discussing the circumstances to which rating agencies currently owe their success).
335. Improving the New Framework, supra note 292; see also Statement No. 160, supra note 11 ("Ratings agencies would have incentives to engage in the financial equivalent of 'grade inflation' by supplying favorable ratings to banks seeking to lower their capital requirements.").
336. Bhala, supra note 4, at 11.
337. Id. at 13.
338. Id. at 17.
339. See FEDERAL RESERVE SYS. TASK FORCE ON INTERNAL CREDIT RISK MODELS, CREDIT RISK MODELS AT MAJOR U.S. BANKING INSTITUTIONS: CURRENT STATE OF THE ART AND IMPLICATIONS FOR ASSESSMENTS OF CAPITAL ADEQUACY 33-34 (May 1998) (discussing the Federal Reserve's finding that credit risk models failed various tests performed by regulators and are not likely to be depended upon to set capital standards);
340. David Shirreff, Models Get a Thrashing, EUROMONEY, Oct. 1998, at 31 ("European regulators concluded that the models were 'half-baked' and could not be used to set regulatory capital.").
341. Basle Accord Revision Looking to Ratings, supra note 311.
342. See Shirreff, supra note 322, at 32.
343. Id.
344. See Mingo, supra note 34, at 54 (noting that "'models-based' approaches to capital adequacy could become as ineffective as the traditional ratio-based approaches may now be, and may impose similar unnecessary costs on banks, unless regulators approach the problems of prudential regulation in systematic fashion").
345. See Darringer, supra note 192, at 334 (asserting that while there is a risk that this models-based approach could lead to capture of the bank regulators, the Basle guidelines and audit procedures should prevent industry capture). With regard to the assessment of market risk of various derivative instruments, recent amendments have permitted banks to use internal risk models. See BASLE COMM. ON BANKING SUPERVISION, AN INTERNAL MODEL-BASED APPROACH TO MARKET RISK CAPITAL REQUIREMENTS (Apr. 1995) (discussing the use of internal models in determining market risk). These models must be regulated by audit and other procedures. Credit risk, however, is one of the major problems facing banks today. The use of credit risk models would provide far more power to banks in determining adequate capital than using models to measure only market risk.
346. See Taylor, supra note 37, at 802 (noting that "the supervisory community generally lacks the human resources to be able to monitor the more sophisticated risk management systems").
347. See MATTEN, supra note 23, at 51 ("[I]mbalance[s] between internal and external models makes it very difficult for the internal model to be simply a more accurate version of the regulatory model, with higher levels of granularity.").
348. Improving the New Framework, supra note 292; see also The Basle Committee's New Capital Adequacy Framework, supra note 305 (noting that "it is likely to be politically and economically difficult for government agencies to penalize banks when they suffer losses and become undercapitalized, particularly when information about bank compliance remains solely in the hands of the regulators").
349. See Arturo Estrella, Formulas or Supervision? Remarks on the Future of Regulatory Capital, ECON. POL'Y REV., Oct. 1998, at 192 (arguing that "scarce public resources are better employed to enhance supervision than to develop new formulas whose payoff may be largely illusory"); Mingo, supra note 34, at 54 (asserting that "'models-based' approaches to capital adequacy could become as ineffective as the traditional ratio-based approaches may now be, and may impose similar unnecessary costs on banks, unless regulators approach the problems of prudential regulation in systematic fashion"); Shirreff, supra note 322, at 32 (remarking that "modellers [are metaphorically] in search of the holy grail").
350. See Herring Interview, supra note 313 (discussing the number of years the U.S. Shadow Committee has existed).
351. Shadow Fin. Regulatory Comm., About the Shadow Financial Regulatory Committee (visited Dec. 1, 1999) 〈http://www.aei.org/shdw/shdw.htm〉 [hereinafter About the Shadow Committee].
352. Shadow Fin. Regulatory Comm., Shadow Financial Regulatory Committee: Statement of Purpose (visited Dec. 1, 1999) 〈http://www.aei.org/shdw/shdwpur.htm〉.
353. See id. (laying out the Shadow Committee's goals).
354. See Shadow Fin. Regulatory Comm., European Shadow Financial Regulatory Committee - A New Initiative (visited Dec. 1, 1999) 〈http://www.aei.org/shdw/shdweuro.htm〉 (describing the European Shadow Financial Regulatory Committee ("ESFRC") as a "group of European professors and experts in the field of banking, finance, and regulation of financial services").
355. The Shadow Committee is composed of such notable scholars as George J. Benston of Emory University, Charles W. Calomiris of Columbia University, Franklin R. Edwards of Columbia University, Scott E. Harrington of the University of South Carolina, Richard J. Herring of the University of Pennsylvania, Paul M. Horvitz of the University of Houston, George G. Kaufman of Loyola University Chicago, Robert E. Litan of Brookings Institution, Roberta Romano of Yale Law School, Hal S. Scott of Harvard Law School, Kenneth E. Scott of Stanford University, and Peter J. Wallison of the American Enterprise Institute. See About the Shadow Committee, supra note 333 (listing the committee members).
356. Subordinated debt is a "debt that can only be claimed by an unsecured creditor, in the event of a liquidation, after the claims of secured creditors have been met." SCOTT & WELLONS, supra note 8, at 1249; see also Alford, supra note 26, at 190 ("Subordinated debt includes interest-bearing obligations that pay a fixed amount at a future date."). The term "uninsured" simply means that the subordinated debtholders will not be reimbursed for losses by a deposit insurance regime in the event of the borrowing bank's insolvency. See Shadow Proposal, supra note 11, at 40 (stating that truly un-insured debt demands that the instrument not be subject to one of the "mechanisms for bailing out" its holders (i.e., debt insurance)).
357. See supra text accompanying notes 178-80 (explaining that debtholders may have more incentives to insist that bankers do not issue risky loans).
358. See supra text accompanying notes 178-80 (noting that debtholders have a limited upside for their investments and cannot expect higher returns on their investments when the bank takes risks like shareholders can).
359. Shadow Proposal, supra note 11, at 29. The Shadow Committee also summarizes the principal reason why debt may serve as a better cushion than common equity: The incentives of debtholders are different because they hold a fixed income claim. A fixed income claim does not entitle debtholders to share in upside gains beyond their coupon payments, as shareholders do. Increased asset risk benefits shareholders of insured banks when capital is low or negative and deposit insurance is underpriced, but always hurts uninsured debtholders because higher risk increases the probability of their not being fully repaid. Id. at 30.
360. Id.
361. See id. at 30-31 ("[I]f a bank suffered losses of asset value and increases in asset risk, vigilant subordinated debtholders . . . would discipline the bank by raising the cost of finance, curtailing the amount of finance, or requiring the bank to act in credible ways to reduce asset risk or raise equity.").
362. Alford, supra note 26, at 191.
363. See Shadow Proposal, supra note 11, at 30 ("The incentives of uninsured debtholders in measuring and penalizing risk are aligned with the deposit insurer, not the bank shareholders."); see also Statement No. 160, supra note 11 ("[T]he presence of subordinated debt reduces banks' incentives to take on inappropriate risks because, for solvent banks, the incentives of the subordinated debt holders and the deposit insurance agency are aligned.").
364. Shadow Proposal, supra note 11, at 50; see also Statement No. 160, supra note 11 ("[I]ncreases in the interest yield on existing traded debt provide a warning from investors of the risks banks are taking.").
365. Shadow Proposal, supra note 11, at 32.
366. According to the Shadow Committee, "The decisions of subordinated debtholders would provide powerful information about bank risk to supervisors and regulators, and to the public at large, thus facilitating the management of risk and capital standards by regulators." Id. at 31.
367. Statement No. 160, supra note 11. The Shadow Committee conducted a study comparing the costs of issuing equity to issuing subordinated debt for large U.S. banks during the period of 1995-1999. The results support the contention that equity is a more expensive form of capital for banks. The present value of issuing costs for bank subordinated-debt offerings sold to the public averaged 1.53 percent of offerings. The average issuing cost for common stock offerings sold to the public for the same sample of banks was 3.46 percent. Thus, the transaction costs of subordinated-debt offerings are less than half those of common stock offerings for large U.S. banks. Id.
368. See Shadow Proposal, supra note 11, at 34 (stating that "because of the deductibility of interest payments . . . [there is a] tax advantage favoring subordinated debt"). But see Alford, supra note 26, at 211 ("The disadvantage of subordinated debt over equity is that bank operating income is decreased by the interest charges on the debt.").
369. See Shadow Proposal, supra note 11, at 33 (noting that a "deep market in uninsured bank debt would produce a new demand for clear accounting").
370. Id. at 47. The Shadow Committee proposes that uninsured subordinated debt have a minimum maturity with maturity dates evenly spaced. See id. at 48 ("A minimum maturity is necessary to limit the ability of subordinated debtholders to flee without bearing losses when banks suffer losses on assets."); see also Statement No. 160, supra note 11 (proposing that "large banks be required to back at least 2 percent of their outstanding assets and off-balance-sheet commitments with subordinated debt").
371. See Shadow Proposal, supra note 11, at 40 (contending that "for subordinated debt (or any uninsured debt) issued by a bank to be a source of market discipline, and for its yield to reflect market perceptions of default risk, that debt must be credibly uninsured"). Deposit insurance often impairs market discipline by providing participants with an ultimate safety net See Ransom, supra note 308, at 447 ("Deposit insurance 'gets in the way of the depositors signaling a bank when it takes excessive risks.'" (quoting Laurence H. Meyer, The Transformation of the U.S. Banking Industry and Resulting Challenges to Regulators: Speech Before the Ohio Bankers Day Conference (Nov. 21, 1996), available in Federal Reserve Bd., FRB: Federal Reserve Board Speech from 11/21/96 (visited May 22, 1998) 〈http://www.bog.frb.fed.us/BOARDDOCS/ SPEECHES/19961121.htm〉)).
372. See 12 U.S.C. § 1823(c) (4) (1994) (specifying the limits on the FDIC's ability to reimburse subordinated debtholders). The current rule is rather complicated: The FDIC may only do so if the cost to it of the assisted acquisition does not exceed the cost of a bank liquidation, which is defined as the sum of insured deposits minus the present value of the total net amount to be reasonably expected from a straight liquidation. Shadow Proposal, supra note 11, at 41.
373. Shadow Proposal, supra note 11, at 41.
374. See id. at 43 ("By purchasing their bank's debt at a price above its true value the owners would both lose and gain equal amounts on the transaction, so overpaying for its debt would entail no net cost. . . . [and would] permit a weak or insolvent bank to appear strong . . . .").
375. To avoid this problem, the Shadow Committee proposes: [Regulators should] require that purchasers of subordinated debt be entities that have no direct or indirect connection to the issuer. . . . [B]orrowers from the bank, affiliates within the issuing bank's holding company, firms managed or owned by major shareholders of the issuing bank, or firms with other significant dealings with the bank . . . should be prohibited from purchasing its subordinated debt. Id.
376. See id. at 44 ("Disclosure requirements that require that holders disclose their identity to regulators would facilitate enforcement of the arms-length holding requirement.").
377. See id. at 36 (asserting that "10% is a conservative estimate of what the market would require"); see also Statement No. 160, supra note 11 ("Accordingly, we recommend that regulators raise the requirement - at least for large banks - to something on the order of 10 percent of (unweighted) on-balance-sheet assets and off-balance-sheet commitments.").
378. See, e.g., MYRON L. KWAST & WAYNE PASSMORE, FEDERAL RESERVE BD., THE SUBSIDY PROVIDED BY THE FEDERAL SAFETY NET: THEORY, MEASUREMENT AND CONTAINMENT 27-29 (1997) (discussing that financial institutions in the United States that are similar to banks maintain, on average, a capital ratio greater than 10%).
379. See Shadow Proposal, supra note 11, at 3 (stating the Shadow Committee's commitment to "eliminating the distinction between Tier 1 and Tier 2 capital").
380. Id. at 34; see also Statement No. 160, supra note 11 ("Accordingly, we favor the elimination of regulatory risk weights on assets, on and off the balance sheet.").
381. Shadow Proposal, supra note 11, at 35. In its most recent public statement, the Shadow Committee remained fervent in its stance to eliminate the current risk-weight categories of the Basle Accord: [A] limit on leverage, without the complication of risk weighting, has the advantage of greater simplicity and is less misleading, since it does not purport to weigh the relative risks associated with broad categories of assets. Moreover, a straightforward leverage requirement reduces banks' incentives to manipulate required capital by shifting assets among risk-weight categories, when those shifts do not represent real changes in portfolio risk. Statement No. 160, supra note 11.
382. "A maximum yield spread would force adjustment to take place in quantities, not just prices, and thus would have an automatic stabilizing effect on the permissible level of risky assets in the bank." Shadow Proposal, supra note 11, at 50. In its most recent public statement, the Shadow Committee has proposed the following brightline rule for tracking yield spreads. "Whenever, for three consecutive months, the yield on the qualifying subordinated debt of a bank rises above the yield of moderately risky corporate bonds (say, those rated BBB or Baa) with similar maturity, the bank is considered to be in violation of its subordinated-debt requirement" Statement No. 160, supra note 11.
383. See Shadow Proposal, supra note 11, at 39 ("Supervisors would ascertain the existence of bona fide outstanding subordinated debt contracts that satisfy the law's requirements.").
384. The Shadow Committee recognizes that the insured subordinated debt requirement will lead to quicker intervention among regulatory authorities. "Structured early intervention and resolution, as codified in the United States under FDICIA, provides a powerful tool for holding banks accountable to regulations, and is particularly valuable for enforcing quantitative rules . . . . The Shadow Committee recommends the adoption of similar provisions in other countries." Id. at 52.
385. Id. at 37 (emphasis added).
386. Id. at 60.
387. Id.
388. Darringer, supra note 192, at 335.
389. See supra text accompanying note 362 (discussing the uniform 100% risk weight).
390. Basle Reforms Overdue, supra note 150; see also Joseph J. Norton & Christopher D. Olive, The Ongoing Process of International Bank Regulatory and Supervisory Convergence: A New Regulatory-Market "Partnership," 16 ANN. REV. BANKING L. 227, 229 (1997) (arguing that, in the optimal capital adequacy regime, "regulatory and market participants must interact compatibly, on an interdisciplinary basis, to provide an appropriate environment for the necessary formation of a new regulatory-market 'partnership'").
391. See Taylor, supra note 37, at 805 ("The movement towards relying on greater use of market forces and self-regulation can only be carried so far if there remains an explicit (or even implicit) taxpayer guarantee against the consequences of firm failure.").
392. For example, there is generally more risk associated with uncollaterized loans than those that are fully collaterized, and generally it is riskier to loan to private business than to a central government.
393. Shadow Proposal, supra note 11, at 35.
394. Id. In its most recent public statement, the Shadow Committee has argued that the subordinated-debt requirement will reduce regulatory arbitrage regardless of the risk-weighting system in place. Banks would not benefit from moving assets off balance sheet or by creating off-balance-sheet derivatives risks, because the private market (which is often in a superior position to identify the risks of those off-balance-sheet transactions) should incorporate those risks into the pricing of the bank's subordinated debt. Thus, off-balance-sheet transactions that increase risk will be penalized by the market and, if the regulators rely on market signals to measure risk, by the regulators as well. Statement No. 160, supra note 11.
395. See Shadow Proposal, supra note 11, at 7 (discussing capital ratios of U.S. banks for the past hundred years).
396. See id. at 36 (stating that "U.S. finance companies today - which share functional and structural features of banks, but do not enjoy safety net protection - maintain capital ratios that typically exceed 10% of assets").
397. See SAMUELSON & NORDHAUS, supra note 1, at 489 (noting that originally bankers were goldsmiths who kept the entire stock of gold on hand until repayment).
398. Because federal deposit insurance has skewed the true optimal market level of capital, we cannot prove this assertion. The Shadow Committee concedes that after the full implementation of the "federal safety net," the optimal capital ratio has "settled in the 6% to 8% range." Shadow Proposal, supranote 11, at 11.
399. With the recent constructive repeal of the Glass-Steagall Act, see Gramm-Leach-Bliley Act, Pub. L. No. 106-102, § 101, 113 Stat. 1338 (1999), however, banks may become indistinguishable from other financial institutions, thus strengthening the Shadow Committee's position.
400. Shadow Proposal, supra note 11, at 46.
401. See id. at 41-42 (discussing the FDIC's power under 12 U.S.C. 1823(c)(4) to bail out subordinated debtholders and what means should be taken to eliminate this possibility).
402. Id. at 44.
403. See generally supra Part III.D (discussing the reasons for the prompt incorporation of the 1988 Accord into national regulatory regimes). The U.S. Congress has explicitly delegated rulemaking authority to the Federal Reserve in the realm of capital adequacy. See International Lending Supervision Act of 1983 ("ILSA"), Pub. L. No. 98-181, tit. IX, § 908(a)(2), 97 Stat. 1278. 1280 (codified at 12 U.S.C. § 3907 (1994)) ("Each appropriate Federal banking agency shall have the authority to establish such minimum level of capital for a banking institution . . . .").
404. See Joseph J. Norton, Structuring the Banking Regulators and Supervisors: Developed Country Experiences and Their Possible Implications for Latin America and Other Developing Countries, NAFTA: L. & BUS. REV. AM., Summer 1998, at 5, 9-12 (highlighting that in many countries promulgation and supervision of aspects of capital adequacy rules are split among the central bank and other agencies).
405. Mingo, supra note 34, at 52.
406. Darringer, supra note 192, at 259.
407. Shadow Proposal, supra note 11, at 31.
408. Darringer, supra note 192, at 330.