Peterson Institute for International Economics
Washington, DC
August 2008
Banking on
Basel
e Future of International
Financial Regulation
Daniel K. Tarullo
Daniel K. Tarullo is a professor of law at
Georgetown University Law Center. He has
taught at Harvard Law School (2005) and
Princeton University (2004). He held several
senior positions in the Clinton administra-
tion, ultimately as assistant to the president
for international economic policy, responsi-
ble for coordinating the international eco-
nomic policy of the administration. From
1993 until early 1996, he was assistant sec-
retary of state for economic and business
affairs. In March 1995, President Clinton ap-
pointed Tarullo as his personal representa-
tive to the G-7/G-8 group of industrialized
nations, with responsibility for coordinating
US positions for the annual leaders’ sum-
mits. He continued this assignment after he
moved to the White House, participating in
four summits. He serves on the editorial ad-
visory board of the International Economy and
the Advisory Committee of Transparency
International.

Tarullo, Daniel K.
Banking on Basel : the future of interna-
tional financial regulation /
Daniel K. Tarullo.
p. cm.
Includes bibliographical references and
index.
1. Banks and banking, International—
State supervision. 2. Banks and banking,
International—Standards. 3. Bank capital.
4. Banking law. I. Title.
HG1725.T37 2008
332’.042—dc22
2008037233
The views expressed in this publication are those of the author. This publication is part
of the overall program of the Institute, as endorsed by its Board of Directors, but does
not necessarily reflect the views of individual members of the Board or the Advisory
Committee.
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To VT
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v
Contents
Preface ix
Acknowledgments xiii
1 Introduction 1
Summary of Argument 5
Outline of the Book 7
A Note on Timing 13

Indirect Benefits 222
Conclusion 223
7 Alternatives to Basel II 225
Retaining a Standardized Approach 226
Market Discipline: Mandatory Subordinated Debt 231
Precommitment Approach 246
Establishing an International Supervisory Role 251
Eliminating International Cooperation on Safety
and Soundness 255
Conclusion 256
8 Conclusions and Recommendations 259
Recommendations 262
Implications Beyond Capital Regulation 279
References 285
Index 299
Tables
Table 2.1 US bank capital ratios, 1970–81 32
Table 3.1 The world’s 10 largest banks, 1974, 1981, and 1988 47
Table 3.2 Capital ratios of selected large banks, 1981 and 1988 48
Table 3.3 Credit conversion factors for off-balance-sheet
items in Basel I 60
Table 3.4 Capital charges for debt instrument market risks
in the Basel Committee 1993 proposal 62
vi
ch00_FM_15092_Peterson_Basel 9/4/08 8:26 PM Page vi
Table 4.1 External agency ratings and risk weights in
the first consultative paper 95
Table 4.2 Results of second quantitative impact study
change in capital requirements under second
consultative paper proposals 112

vii
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ix
Preface
The financial distress that followed the implosion of markets for securi-
tized mortgages in 2007 has raised profound doubts about the adequacy
of supervision of financial markets—in the United States and in other
countries. One question in the ensuing public policy debate has been
whether financial institutions would have been in sounder condition had
the capital regulations agreed upon internationally in the Basel II accord,
negotiated between 1999 and 2004, already been in place. Basel II marks a
dramatic change in capital regulation of large banks in the countries rep-
resented on the Basel Committee on Banking Supervision, composed of
13 of the most important financial centers, by using banks’ own credit risk
models in setting minimum capital requirements.
In this book Daniel Tarullo considers the Basel II approach both as a
paradigm for domestic banking regulation and as the basis for an interna-
tional cooperative arrangement. While highly skeptical of Basel II as a do-
mestic regulatory system, he does not definitively reject some use of
banks’ own risk models in setting minimum capital requirements. Al-
though he is troubled by the theoretical and practical problems in relying
on the value-at-risk credit models used by large banks, he finds no clearly
superior alternative approach to capital regulation.
As to the Basel II agreement that each participating country imple-
ment the same “internal ratings” method of minimum capital regulation
for its large banks, however, Tarullo is unequivocal in his criticism. He
concludes that the shortcomings of this method as the foundation for do-
mestic regulation will only be magnified at the international level. The de-
tails of this very complicated set of regulations are unlikely to be appro-

advance or hinder the cause of effective and efficient regulation. This last
point has relevance well beyond the area of financial regulation.
The Peter G. Peterson Institute for International Economics is a pri-
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economic policy. Its purpose is to analyze important issues in that area
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Acknowledgments
My first note of thanks goes to Fred Bergsten, who was willing to commit
to a book proposal that was somewhat atypical for the Peterson Institute.
In researching this book, I spoke with dozens of past and present officials
from national bank supervisory agencies, central banks, and international
institutions, all of whom had been involved in the Basel II process. I am
grateful to each of them for taking the time to discuss, analyze, and some-
times argue the history and merits of Basel II with me. I also profited
enormously from two peer review sessions organized at the Peterson In-
stitute and from comments received from participants at a session of the
FDIC’s Annual Bank Research Conference. Finally, I extend special
thanks to Mark Carey of the Federal Reserve Board and Ted Truman of
the Peterson Institute. Each carefully read and critiqued successive drafts
of this book and spent considerable time helping me work through both
my major themes and important details. It goes without saying that nei-
ther is responsible for—and should not be associated with—the content,
conclusions, or ultimate quality of the book. But their generosity and in-
sight made the book a much better informed policy analysis than it other-

2. Up until 1999, the committee called itself the Basle Committee, using the French spelling.
In 1999, apparently in response to the expressed preferences of the predominatly German-
speaking residents of the city, the committee began calling itself the Basel Committee. The
committee’s website now uses standard indexing for “Basel,” but specific documents from
the 1980s and most of the 1990s have the old spelling, “Basle.” For the sake of consistency,
the name is spelled “Basel” throughout the book.
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2 BANKING ON BASEL
Box 1.1 Basel Committee on Banking Supervision
The Basel Committee on Banking Supervision states its objective as “im-
prov[ing] supervisory understanding and the quality of banking supervision
worldwide” (Basel Committee 2007a). Originally the Committee on Regulations
and Supervisory Practices, it was created by the Group of Ten Countries (G-10)
at the end of 1974, after the failure of Herstatt Bank caused significant distur-
bances in currency markets throughout the world.
1
National representation on
the committee comes from central banks and other agencies with responsibility
for supervision of banks.
The committee has no formal legal existence or permanent staff, and the
results of its activities do not have the force of international law. It provides a
forum for exchanges of views several times a year in Basel, Switzerland, where
it is housed at the headquarters of the Bank for International Settlements
(box 1.2). Its proceedings are neither open to the public nor—as with some
entities like the Executive Board of the International Monetary Fund—memo-
rialized in publicly available summaries. However, it releases and maintains on
its website a steady stream of documents on standards, recommendations,
guidelines, and best practices for supervision of internationally active banks.
The committee describes its activities as “encourag[ing] convergence towards
common approaches and common standards without attempting detailed

tional financial regulation, a future that is likely to arrive sooner than the
INTRODUCTION 3
Box 1.1 Basel Committee on Banking Supervision (continued)
Lyon summit in 1996. The “Core Principles for Effective Banking Supervision”
were published in 1997 and revised in 2006. These principles are addressed to
banking supervisors throughout the world, not just those represented on the
Basel Committee. The committee has established structured interchanges with
supervisors and organizations outside the G-10 in order to encourage compli-
ance with the core principles.
The third ongoing activity of the Basel Committee is the formulation of capi-
tal adequacy standards. As explained in chapter 3, the first set of capital stan-
dards (Basel I) was issued in 1988. Basel II, the completely overhauled set of capi-
tal standards issued in 2004, is the subject of this book. While concern with the
capital adequacy of internationally active banks has been at least one of the two
most important activities of the Basel Committee since negotiations on Basel I
began in 1987, this activity has become dominant during the negotiation and
implementation of Basel II.
Following completion of the Basel II negotiations, the Basel Committee reor-
ganized its work in October 2006 into four principal subcommittees: the Accord
Implementation Group (dealing specifically with Basel II), the Policy Develop-
ment Group (dealing with new and emerging issues), the Accounting Task Force,
and the International Liaison Group (which structures interactions between the
Basel Committee and non-Basel Committee supervisors).
1. Despite the committee’s origins in the G-10, 13 nations are represented in the Basel
Committee. Twelve were original members: Belgium, Canada, France, Germany, Italy,
Japan, Luxembourg, the Netherlands, Sweden, Switzerland, the United Kingdom, and the
United States. Spain joined in 2001.
ch01_15092_Peterson_Basel 9/4/08 8:29 PM Page 3
Basel Committee might have thought when it released the revised frame-
work. The search for additional or alternative regulatory mechanisms as-

banks, acting as an agent or trustee in connection with international financial
operations and a prime counterparty for central banks in their financial transac-
tions and providing or organizing emergency financing to support the interna-
tional monetary system (including as part of stabilization programs such as
those for Mexico in 1982 and Brazil in 1998 led by the International Monetary
Fund). The BIS assists central banks in their management of foreign currency re-
serves and itself holds about 6 percent of global foreign exchange reserves
invested by central banks.
ch01_15092_Peterson_Basel 9/4/08 8:29 PM Page 4
ening. However, that crisis has highlighted two more basic questions
about Basel II. First, is the method of capital regulation incorporated in
the revised framework fundamentally misguided? Second, even if the ba-
sic Basel II approach has promise as a paradigm for domestic regulation,
is the effort at extensive international harmonization of capital rules and
supervisory practices useful and appropriate? This book provides ex-
tended and, on balance, reasonably negative answers to both questions.
Summary of Argument
The core policy issue is whether an international effort at regulatory con-
vergence around Basel II’s bank capital rules will produce net benefits for
the United States greater than those that could be gained through viable
policy alternatives, including the status quo.
3
Narrowly framed, the con-
clusion of this book is that Basel II’s detailed rules for capital regulation
are not an appropriate basis for an international arrangement among
banking supervisors. As suggested by its wording, this conclusion is sup-
ported by three interrelated analyses, which themselves have broader im-
plications both for US banking regulation and for international coopera-
tion among banking supervisors.
First, and most important, is an evaluation of the rules for domestic

regulatory methods and rules resulting from most exercises in interna-
tional convergence, the IRB approaches were developed entirely during
the international negotiation itself, rather than adapted from regulatory
systems already in use in one or more countries. Insofar as capital require-
ments are central to contemporary banking regulation and the IRB ap-
proaches are essentially untested, the regulators adopting them are taking
at least a leap of faith and, critics fear, possibly a leap off a cliff. The mani-
fold conceptual and practical problems associated with the IRB approach
make it a questionable basis for domestic banking regulation, though
many regulators continue to believe it can be fine-tuned adequately after
some period of adaptation to be a sound regulatory paradigm.
Second is an assessment of the contribution of the specifically interna-
tional character of Basel II in achieving various national policy goals.
Even if an underlying bank regulatory design is flawed, perhaps signifi-
cantly so, adherence to those rules by other countries may produce im-
portant benefits for each participating country. On the other hand, even
if detailed harmonized regulatory rules produced in an international
arrangement rest on a conceptually sound foundation, they will necessar-
ily differ from rules tailored to the economic circumstances, legal environ-
ment, and policy preferences in each participating country. From the
standpoint of any one country, then, the key question is whether the gains
from having other countries subscribe to the Basel II rules will offset the
losses from following rules different from those that would have been
generated in a purely domestic process.
4
Specifying the gains from cooperation is considerably less straight-
forward than it might first appear. One familiar difficulty is that the po-
tential gains are of different types, and the more complete realization of
one goal may come at the expense of others. Moreover, the relative im-
portance of these various gains will be evaluated differently by groups

redeem the deficiencies of the IRB approach. On the contrary, the infirmi-
ties of the IRB approach as a basis for domestic regulation are multiplied
as more countries adopt it, while the difficulties in effective monitoring of
its implementation will limit any benefits arising from common adoption
of the regulatory model.
The third analysis is explicitly comparative. Since virtually any ini-
tiative will have drawbacks as well as merits, reasonable policy analysis
looks not for the perfect arrangement but for the best among practical
alternatives. Even significant shortcomings of a proposal do not necessar-
ily make it a bad policy choice. Other proposals might have even greater
unintended negative consequences or have fewer negative effects only at
the cost of poorly realizing the original policy aims. Comparing the bene-
fits and faults of Basel II with those of other options, including the status
quo ante, indicates that there is no single alternative that would be supe-
rior to the IRB approaches as the basis for an international arrangement.
However, a combination of uncertainty as to the optimal substantive ap-
proach for capital regulation and the institutional limitations of the Basel
Committee suggests that a simpler and more eclectic international
arrangement would be preferable to Basel II. The final chapter of the book
provides recommendations for such an alternative.
Outline of the Book
The evaluation of Basel II and its implications begins with some back-
ground on the role of bank capital regulation and then recounts the history
INTRODUCTION 7
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of Basel I and Basel II. It turns next to the core analysis of Basel II as a bank
regulatory paradigm and as an international arrangement, followed by
consideration of some possible alternatives, before ending with recom-
mendations for significant changes in the arrangement.
Chapter 2 reviews the rationale for, and history of, minimum bank

and that the opportunities it created for regulatory arbitrage became pro-
gressively more serious as the mix of bank activities shifted toward secu-
ritization, writing derivatives, and other financial products that had com-
prised much smaller segments of major bank activity during the period in
which Basel I was drafted. These criticisms formed much of the motiva-
tion for the launch of Basel II.
Chapter 4 recounts the tortured negotiation of Basel II and describes
the 2004 revised framework, including its implementation and modifica-
tion in the subsequent four years. Although the committee decided in 1998
to undertake a thorough revision of the accord, it seems to have had little
8 BANKING ON BASEL
ch01_15092_Peterson_Basel 9/4/08 8:29 PM Page 8
sense of direction. Particularly in light of the regulatory shortcomings re-
vealed by problems associated with subprime mortgage lending and secu-
ritization, there is a case to be made that the opportunity costs of this effort
were substantial. For example, the supervisory resources and energy de-
voted to the Basel II process necessarily delayed efforts to address liquidity
risks, which were realized with a vengeance during the subprime crisis.
The Basel Committee’s first effort, in 1999, introduced the “three-pillar”
approach to capital regulation that remains in the revised framework. Pillar
1 includes the minimum capital rules themselves, pillar 2 consists of guid-
ance for supervision of banks beyond the minimum capital rules, and pillar
3 addresses market discipline. Pillar 1 of the 1999 draft did not depart from
the basic risk-bucket approach of Basel I. It proposed using external credit
ratings, such as those developed by Moody’s or Standard & Poor’s, as the
basis for defining risk categories. Widespread dissatisfaction among large
banks with the failure to incorporate up-to-date risk management ideas in
the proposal sent the committee back to the drawing board. Attention was
redirected toward an approach that relied on banks’ own, internally gener-
ated credit ratings as the basis for regulatory capital calculations. However,