By Omar Ahmad & Michael Koehler
Created in 1929 as a bank for facilitating German post-war reparations, the role of the Bank for International Settlements (BIS) has changed since its founding. Today, it is the central bank for central banks. Central bankers meet regularly at the BIS headquarters, located in Basel, Switzerland, to coordinate national financial regulation policies and stabilize the international financial system. The BIS functions through a variety of committees to provide background analysis and policy recommendations. The most influential committee is the Basel Committee on Banking Supervision (BCBS). The BCBS provides banking information and suggests ways to improve global banking supervision. We argue that the problem of the BCBS is that its policy recommendations are only suggestive. For the BCBS to be more effective at managing international financial stability, it must create legally mandatory recommendations for banks. However, obligating central bankers to follow the BCBS policy recommendations requires an amendment to Article 1, Section 3 of the BCBS Charter.
The BCBS controls international financial stability by setting recommended capital adequacy ratios (CAR). That is, member central bankers of the BCBS set the recommended ratio of on-hand capital to risk-weighted assets for private banks. This ensures that banks can absorb short-term losses, while restricting the amount of risky loans the bank can issue. The Basel III Accords were the latest adjustment to the CAR in response to the financial crisis of 2007-2008.
However, the BCBS recommended CAR is merely a suggestion. Therefore, international financial stability depends on the commitment of central bankers to the BCBS CAR recommendations, because the BCBS lacks legal obligation. Central banks ultimately decide whether to honor the recommendations. Thus, there is no guarantee of financial stability from the BCBS, causing it to be ineffective at preventing international financial crises.
To best address the frequency and severity of international crises of capital adequacy, we recommend that the Basel III Accords be made mandatory by increasing the obligation and the delegation of the BCBS charter. This would change the strategy from a more flexible soft law, into a more rigid hard law.
The idea of a hard strategy originates in the “Concept of Legalization”, where increasing the obligation, precision, or delegation can shift a law from being soft to hard. Specifically, we argue that the obligation and delegation should become harder.
Legal obligation would ensure that a state who agrees to the Basel Accords would follow that agreement at the risk of losing its reputation for making credible commitments. Since a state does not enter into agreements it believes it cannot follow, other states will perceive commitment as the willingness to follow through on its obligation and to accept punishments for infraction. Central banks who choose not to ratify the Accords face the risk of not being competitive since their perceived risk will be higher, making obligation the more attractive option. Also, higher legal obligation allows the BCBS to introduce the principle of pacta sunt servanda for its laws, which implicitly means that central banks will follow the rules and commitments because they have legal status, per se.
Additionally, increased delegation to the BCBS would reduce infractions dramatically. Since national legislatures delegate power to central bankers, additional legislative oversight from an outside actor, like the BCBS, would deter central banks from not adhering to the capital adequacy ratios. Additionally, this will open up channels for communication between central banks and the BCBS, allowing for increased information sharing and cooperation.
For the BCBS to implement obligation of the CAR requirements for central banks, it must amend the BCBS Charter. Specifically, the BCBS should reverse the language of Article 1, Section 3, which explicitly states that the BCBS has no supranational legal authority. This would effectively shift the legal status of the BCBS from low legalization toward higher legalization and would increase the degree of pacta sunt servunda.
Second, the BCBS should add an oversight mechanism for legislative bodies. As experts of international finance, the BCBS generally has more knowledge and information about the dynamics of international finance. Therefore, the BCBS should create a mechanism that works closely with member national legislatures to inform them when their central banks are engaging in risky behavior and failing to comply with BCBS CAR requirements.
The BCBS currently is not as effective as it could be. The non-legal nature of its capital adequacy ratios harms the ability of the organization to effectively prevent financial crises of capital adequacy. Our recommendation of making the Basel Accords from suggestive to obligatory and enforceable will motivate states to adhere to the recommended CARs or otherwise face reputation losses and lose the ability to be competitive. By amending Article 1, Section 3 of the Charter to make the CARs mandatory, the BCBS could better prevent financial crises.
Reforming International Organizations 