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Rebalancing the Three Pillars of Basel II
Company: FRBNY Economic Policy Review
Year Of Publication: 2004
Month Of Publication: September
Pages: 7-21
Download Count: 704
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Comment Num: 0
Language: EN
Who Can Read: Free
Date: 2-26-2005
Publisher: Administrator
Even though the initial capital ratio (BIS 1988) has beenseverely criticized for being too crude and opening the door toregulatory arbitrage,2 it seems strange to insist so much on theimportance of supervisory review3 and market discipline asnecessary complements to capital requirements whileremaining silent on the precise ways4 this complementarity canwork in practice. One possible reason for this imbalance is agap in the theoretical literature. As far as I know, there is notractable model that allows a simultaneous analysis of theimpact of solvency regulations, supervisory action, and marketdiscipline on the behavior of commercial banks.This paper aims to fill that gap by providing a simpleframework for analyzing the interactions between the threepillars of Basel II. We start by offering a critical assessment ofthe academic literature on the three pillars,5 and argue thatnone of the existing models allows for a satisfactory integration of these pillars. We therefore develop in Section 3a new formal model that tries to incorporate the mostimportant criticisms of existing theoretical models of bankregulation. Section 4 shows that minimum capital ratios canbe justified by a classical agency problem, à la Holmstr?m(1979), between bankers and regulators, even in the absenceof mispriced deposit insurance. We demonstrate in Section 5that, under restrictive conditions, these capital requirementscan be reduced if banks are mandated to issue subordinateddebt on a regular basis (direct market discipline). Finally,Section 6 explores the interactions between market disciplineand supervisory action and shows that they are complementaryrather than substitutes
Rochet, Jean-Charles Sign in to follow this author
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