The Basel Capital Adequacy Framework should be Reconsidered

The Basel capital adequacy framework that has guided bank regulation and supervision for nearly 20 years deserves serious attention when the world turns to reform of financial market regulation in response to the current crisis which originated with US sub-prime mortgages and structured products. It has been unhelpful and should be reconsidered in favour of a framework which leads financial groups to hold higher levels of capital and gives greater weight to the benefits of portfolio diversification as a means of managing risk. A well –designed capital adequacy framework should provide both more restraint against excess and more of a buffer to absorb losses when they emerge. The Basel framework has not only performed poorly in these regards but it creates too many incentives that work in the opposite direction, favouring high leverage and heavy concentrations on favoured asset classes, notably residential real estate lending. The experience of four major financial groups that have been prominent in the recent turmoil, reviewed in an Annex, illustrates the general softness of the Basel framework.