Rebalancing the 3 Pillars of Basel 2 ∗

This paper develops a formal model of banking regulation where the interactions between the 3 pillars of Basel 2 can be analyzed. It also provides a formal analysis of the mandatory subdebt proposal and shows that, under certain conditions, Pillar 1 (solvency ratio) and Pillar 3 (market discipline) are partially substitutable. The same is true for Pillar 2 (supervisory action) and Pillar 3. Moreover, I find a strong complementarity between market discipline and supervisory action: one cannot work efficiently without the other. The main policy implication is that, instead of spending so much time on refining Pillar 1, the Basel Committee should seriously think about the practical ways to implement Pillars 2 and 3. ∗Paper prepared for the Columbia-N.Y. Fed conference “Beyond Pillar Three in International Banking Regulation”, New-York City, October 2-3, 2003. I thank Jean-Paul Décamps and Benôıt Roger for allowing me to use in this paper some material drawn from our joint paper Décamps et al. (2003). All errors are mine. †Toulouse University and L.S.E., Email: [email protected].