Preface to the Third Edition
It is just possible that the perpetual revolution in bank capital regulation which has now been going on since 1999 may be coming to an end. Consequently, although in the preface to the first edition of this book I noted that it would be out of date shortly after (if not before) publication, it is possible that this edition may last slightly longer. This is not because bank regulators have lost their zest for new regulation (although after the titanic struggles of the last years there may be an element of that), but because the future of bank regulation is increasingly seen through the prism of stress tests rather than capital calculation rules. Stress tests, although they are based on the Basel calculations, open up whole new areas of regulatory discretion, and permit supervisors to abandon the formalistic constraints placed around the pillar 2 element of the Basel framework. Consequently they are perceived as the way forward for supervisors tired of Basel battles.
It is likely that the idea of stress testing as the route back to unconstrained regulatory discretion will prove a chimera. The more stress testing is carried on, the more there develop orthodoxies as to how such tests should be carried out, what parameters should be set in what contexts, and how the results should be translated into requirements. It is highly likely that in 10 years from now there will be a Basel document on stress testing which will be every bit as rigorous as the current capital requirements. More importantly, this development is actually both valuable and necessary.
The reason that it is a bad idea for bank regulators to be able to pluck a capital requirement number out of thin air goes back to the original purpose of the Basel Accord. This was that in order to create an international capital market, the participants in that capital market—loosely, banks which are active across borders—should be subject to similar regulation to each other. This is sometimes misstated as an idea that there should be similar minimum levels of regulation, with an unstated assumption that regulators should be able to exceed that level as they see fit. However, if banks in a particular jurisdiction are required by their national regulator to operate at capital levels which are radically higher than those of banks in other jurisdictions, and are also permitted to operate across borders, the result of this is likely to be destabilizing—in particular, those banks are likely to attract deposits in those other jurisdictions. Unless regulators and resolution authorities are absolutely confident that the funds transferred out of their regulatory control will be immediately returned in full in the event of a crisis, it is a proper use of their authority for them to restrict or prevent such deposits. Thus differential (p. viii) regulatory capital requirements will, if left unchecked, restrict or eliminate cross-border banking of the kind that Basel exists to underpin.
In order to preserve the international capital market, it is therefore as important that national regulators do not overcapitalize their banks as it is that they do not undercapitalize their banks. Consequently, if stress tests appear to be becoming a tool of international regulatory competition, it will be as important that they be standardized internationally as it was that the original Basel capital rules were standardized internationally.
This book was written in time stolen from my wife and children, to whom it is dedicated. It is a poor recompense. I would also like to thank the Warden and fellows of All Souls College, Oxford, where it was written. All Souls is even more impressive from within than it is from without, and I am grateful for the extraordinary privilege of having been a visiting fellow there.
All Souls, Oxford
Extracts from the Basel Accords and from other publications of the Basel Committees are reproduced with the permission of the Bank for International Settlements. All of these documents are available free of charge on their website: http://www.bis.org/bcbs/index.htm.