Will Basel II Help Prevent Crises or Worsen Them?

29 2 Two points of view on whether Basel II—a set of guidelines on how much capital banks should hold to guard against current and future risks—adds to boom-bust cycles T he current financial market turmoil—which began in the U.S. subprime mortgage market in summer 2007 and quickly spread to europe—has exposed glaring weaknesses in how financial institutions are supervised and regulated. As a result, at the 2008 IMF–World Bank Spring Meetings, top financial leaders endorsed a series of measures to beef up the global supervisory and regulatory structure, including a proposal by the Financial Stability Forum that calls for more vigilant oversight of capital and liquidity at financial institutions. Currently, bank regulators across the globe are implementing what is known as Basel II—an international standard for the amount of capital that banks need to put aside to deal with current and potential financial and operational risks. As it stands, Basel II requires banks to set aside more capital for higher-risk exposures. An ongoing review by the Basel Committee could further increase the capital requirements for complex structured products and off-balance-sheet vehicles, which were the main sources of stress in recent months. A 2006 survey by the Financial Stability Institute suggests that about 100 countries plan to apply Basel II over the next few years, although implementation is not expected to be uniform across regions. Already, most of europe has implemented the new standard, and the United States is slated to do so in 2009. But now there are calls to make the rules even tougher. After all, why didn't the rules soften the fallout from the current market turmoil? (For more on that question, see " Banking on More Capital, " on page 24 in this issue.) And the several-year-old controversy over whether the rules would offer a panacea for financial crises, or instead exacerbate them, is once again front and center. The critical question turns out to be: Are the rules too procyclical: that is, are they too lax on capital requirements during the " good times " and too tough during the " hard times, " exacerbating boom-bust cycles in the process? In an effort to shed more light on this question, F&D turned to two experts for their insights.