Slide 1

Professor Michael Mainelli, Executive Chairman, The Z/Yen Group

[An edited version of this article appeared as “Money In A Time Of Choleric: Basel Blows The Bubbles", Journal of Risk Finance, Volume 12, Number 4, Emerald Group Publishing (August 2011), pages 348 – 350.]

The Basel Committee on Banking Supervision, formed in 1974 by the Bank for International Settlements, issues the international standards (“accords”) for banking laws and regulations. In order to understand, evaluate and implement regulation properly, one must know the purpose of the regulation. Basel's primary purpose has changed over the years, a point upon which we shall expand in a moment. Unusually for this column, rather than a lengthy critique, we provide a short observation. In a time of anger over banking and finance, time and again observers return to the fact that money supply growth exceeded economic growth over the past two decades, thus leading to asset bubbles, albeit compounded by market structure and regulatory failures. This column wants to point out that those risks may now be worse. Bubble regulation may have migrated to Basel, and yet the Basel Committee may not realise they now set the limits for the global money supply. How can this be?

Basel I published a set of minimum capital requirements in 1988. In 25 pages Basel I was the outcome of a “consultative process on proposals for international convergence of capital measurement and capital standards” with seven risk categories. [July 1988] Basel II in 1994 proposed regulations about the capital banks need to put aside to guard against financial and operational risk. In 347 pages Basel II intended – “to secure international convergence on revisions to supervisory regulations governing the capital adequacy of internationally active banks” with over 200,000 risk categories. [June 2004] Basel III is meant to set a global regulatory standard on capital adequacy and liquidity, and has been in wide circulation since early 2011. Basel III is an ongoing, and paper-sprawling [3,000 pages?] process with ever-multiplying risk categories, but its purpose is clear – “This consultative document presents the Basel Committee's proposals to strengthen global capital and liquidity regulations with the goal of promoting a more resilient banking sector. The objective of the Basel Committee's reform package is to improve the banking sector's ability to absorb shocks arising from financial and economic stress, whatever the source, thus reducing the risk of spillover from the financial sector to the real economy.” [December 2009] All excellent stuff of course.

Clearly Basels I to III are concerned with a sound and stable international system, responding to East Asian and Russian crises to amend Basel I, and to the global financial crises of 2007 and 2008 to amend Basel II. But back in 1988's words - “two fundamental considerations, which lie at the heart of the Committee's work on regulatory convergence, are, firstly, that the framework should serve to strengthen the soundness and stability of the international banking system; and, secondly, that the framework should be fair and consistent in its application to international banks in different countries so as to diminish one important source of competitive inequality.” [July 1988: yes, emphasis added by author]

Whatever happened to competition? Basel I was about a level playing field. Basel I was going to open up markets by ensuring that local regulators found it more difficult to deviate from international norms and favour local bankers with pettifogging rules or onerous capital requirements. Competition was going to improve banking both by increasing choice and by encouraging international standards of capital adequacy leading to greater stability and security. Sleepy backwaters beware! Basel II attempted to get to grips with the games banks play. But Basel II failed to prevent financial crises so we needed Basel III. Now? Go to sleep as committees ensconce the status quo while banks that are too-big-to-fail write rules that certainly don't challenge their size, i.e. rules that would encourage competition from smaller players who might grow to usurp them.

So, a summary of Basels I to III? A move from competition to regulatory capture in three acts:

  • I – flatten regulators to open up foreign competition;
  • II – banks game the rules, so rework the rules;
  • III – financial system crashes using these rules, so rewrite them with the limited number of incumbents increasing the minimum size requirements;

However, our key observation is not that Basel has moved from opening competition to intricate attempts to prevent individual and systemic bank failure. Bank executives focus on maximising shareholders' return on capital. Return on capital with implicit government support, i.e. fractional reserve banking, creates the most profit using leverage. Our key observation is that Basel has become the standard for the global money supply because it is the global standard for leverage. This is a bold observation, but one made with a lot of informal agreement from central bankers and regulators.

So what if Basel is the standard for global money supply? Well, this may be an inevitable political outcome, but there are plenty of pitfalls. First, banks will, as ever, leverage themselves up to the limits. These limits vary a bit from 10:1 to 20:1 (23:1 among major investment banks before the 2008 fall). Remember, leverage creates money. Second, national regulators who object to international leverage ratios are clearly restraining competition, or are they? Third, fiat currencies face more challenges as the primary inflators of money supply, banks, are not answerable to central banks.  The banks answer to Basel, not the market, not a national regulator. In a speech exploring market-based reform mechanisms, Andrew Haldane, Executive Director, Financial Stability, at the Bank of England summarised:

      “The role of regulation is instead to set the overarching rules of the game. In tackling banking stress, that means the framework for banks' capital structure. As far as possible, that framework should aim to leave the pricing of risk ex-ante, and the consequences of risk ex-post, to the market. The framework outlined here could be one simple, robust and timely way to help achieve that. It is different. But it is far from radical. Nothing could be less radical than returning banks, and banking risk, to the market.” [Haldane 2011, page 13]

It would be nice if we were back where we started, trying to get vigorous, yet systemically safe, competition among bankers for the benefit of customers. Sadly, we're not back where we started. The Basel Committee has unwittingly become the organisation of leverage. Basel is the organisation determining how far we can inflate the bubbles, not market discipline. Basel IV is overdue, but there must be some surplus Soviet regulation we can use to start composing it.


HALDANE, Andrew G, “Capital Discipline”, based on a speech given at the American Economic Association, Denver, USA (9 January 2011) -


Professor Michael Mainelli, PhD FCCA FSI, originally undertook aerospace and computing research, followed by seven years as a partner in a large international accountancy practice before a spell as Corporate Development Director of Europe’s largest R&D organisation, the UK’s Defence Evaluation and Research Agency, and becoming a director of Z/Yen ( Michael is Emeritus Professor of Commerce at Gresham College ( and a Visiting Professor at the London School of Economics & Political Science.

Z/Yen operates as a commercial think-tank that asks, solves and acts on strategy, finance, systems, marketing and intelligence projects in a wide variety of fields (, such as developing an award-winning risk/reward prediction engine, helping a global charity win a good governance award or benchmarking transaction costs across global investment banks. Z/Yen’s humorous risk/reward management novel, Clean Business Cuisine: Now and Z/Yen, was published in 2000; it was a Sunday Times Book of the Week; Accountancy Age described it as “surprisingly funny considering it is written by a couple of accountants”.