Basel II: an example of 'smart' regulation

Abstract

In contrast to Basel I, Basel II features with three-pillar framework which has been acknowledged as superior both by academics and industry. Fundamentally, the three-pillar framework reflects a major shift from simple risk measurement under Basel I to comprehensive risk management under Basel II. However, this obvious aspect of superiority is not a sufficient explanation for the likely success of Basel II as a regulatory system designed for maintaining financial stability. Basel II embraces certain features of "third-way" regulatory strategies which are positioned mid-way between direct government command and self-regulation. This paper will draw on two of those "middle-path" concepts to evaluate Basel II; one of these is "reflexivity" as explicated by Aalders and Wilthagen (1997), another is "responsive regulation" as developed by John Braithwaite and his co-researchers (Ayres & Braithwaite, 1992). This paper will examine the congruence between Basel II and these two concepts of "third-way" regulation to evaluate the likely effectiveness of prudential controls under Basel II.