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WILMARTH 4/1/2011 1:11 PM 1010 OREGON LAW REVIEW [Vol. 89, 951 based regulation has repeatedly failed in the past. 244 As regulators learned during the banking and thrift crises of the 1980s and early 1990s, capital levels are “lagging indicators” of bank problems 245 because (1) “many assets held by banks... are not traded on any organized market and, therefore, are very difficult for regulators and outside investors to value,” and (2) bank managers “have strong incentives to postpone any recognition of asset depreciation and capital losses” until their banks have already suffered serious damage. 246 Second, LCFIs have repeatedly demonstrated their ability to engage in “regulatory capital arbitrage” in order to weaken the effectiveness of capital requirements. 247 For example, the Basel II international capital accord was designed to prevent the arbitrage techniques (including securitization) that banks used to undermine the effectiveness of the Basel I accord. 248 However, many analysts concluded that the Basel II accord (including its heavy reliance on internal risk-based models developed by LCFIs) was seriously flawed and allowed LCFIs to operate with capital levels that were “very, very low... unacceptably low” during the period leading up to the financial crisis. 249 In September 2010, the Basel Committee on Bank Supervision (BCBS) gave tentative approval to a new set of proposals known as “Basel III,” which seeks to strengthen the Basel II capital standards significantly. 250 BCBS’ adoption of Basel III was widely 244 See Reforming Banking: Base Camp Basel, ECONOMIST (Jan. 21, 2010), http://www .economist.com/node/15328883 (stating that “the record of bank-capital rules is crushingly bad”). 245 1 FED. DEPOSIT INS. CORP., HISTORY OF THE EIGHTIES: LESSONS FOR THE FUTURE 39–40, 55–56 (1997). 246 Wilmarth, supra note 120, at 459; see also DANIEL K. TARULLO, BANKING ON BASEL:THE FUTURE OF INTERNATIONAL FINANCIAL REGULATION 171–72 (2008). 247 JOHNSON & KWAK, supra note 137, at 137–41; Wilmarth, supra note 120, at 457– 61. 248 TARULLO, supra note 246, at 79–83. 249 Reforming Banking: Base Camp Basel, supra note 244 (quoting unnamed regulator); see also supra note 76 and accompanying text (noting that European banks and U.S. securities firms that followed Basel II rules operated with very high leverage during the pre-crisis period); TARULLO, supra note 246, at 139–214 (identifying numerous shortcomings in the Basel II accord). 250 Daniel Pruzin, Capital: Financial Sector Gives Cautious Welcome to Agreement on Bank Capital Standards, 95 Banking Rep. (BNA) 385 (Sept. 14, 2010); see infra note ___ and accompanying text (discussing adoption of the Basel III accord and criticisms of its apparent shortcomings).
WILMARTH 4/1/2011 1:11 PM 2011] The Dodd-Frank Act 1011 viewed as an implicit admission of Basel II’s inadequacy. 251 After reviewing a preliminary version of the Basel III proposals, a prominent U.K. financial commentator observed, “We can say with conviction now that Basel II failed.” 252 Third, the past shortcomings of capital-based rules are part of a broader phenomenon of supervisory failure. Regulators did not stop large banks from pursuing hazardous (and in many cases fatal) strategies during the 1980s, including rapid growth with heavy concentrations in high-risk assets and excessive reliance on volatile, short-term liabilities. During the 1980s, regulators proved to be unwilling or unable to stop risky behavior as long as banks continued to report profits. 253 Similarly, although the full story is yet to be told, there is wide agreement that federal banking and securities regulators repeatedly failed to restrain excessive risk taking by LCFIs during the decade leading up to the financial crisis. 254 Fourth, repeated regulatory failures during past financial crises reflect a “political economy of regulation” 255 in which regulators face significant political and practical challenges that undermine their efforts to discipline LCFIs. A full discussion of those challenges is beyond the scope of this Article. For present purposes, it is sufficient to note that analysts have pointed to strong evidence of “capture” of financial regulatory agencies by LCFIs during the two decades leading up to the financial crisis, due to factors such as (1) large political contributions made by LCFIs, (2) an intellectual and policy environment favoring deregulation, and (3) a continuous interchange of senior personnel between the largest financial institutions and the top echelons of the financial regulatory agencies. 256 Commentators 251 See, e.g., Reforming Banking: Base Camp Basel, supra note 244; Yalman Onaran et al., The Global Battle over New Rules for Banks, BLOOMBERG BUSINESSWEEK, May 31– June 6, 2010, at 41. 252 Onaran et al., supra note 251, at 42 (quoting Charles Goodhart). 253 FED.DEPOSIT INS.CORP., supra note 245, at 39–46, 245–47, 373–78. 254 See JOHNSON &KWAK, supra note 137, at 120–50; McCoy et al., supra note 14, at 1343–66; see also Coffee, supra note 239, at 17–18 (stating that “[a]greement is virtually universal that lax regulation by all the financial regulators played a significant role in the 2008 financial crisis”). 255 Gordon & Muller, supra note 200, at 26. 256 JOHNSON &KWAK, supra note 137, at 82–109, 118–21, 133–50; see also Deniz Igan et al., A Fistful of Dollars: Lobbying and the Financial Crisis (Int’l Monetary Fund, Working Paper 09/287, 2009), available at http://ssrn.com/abstract=1531520; ROBERT WEISSMAN &JAMES DONAHUE, ESSENTIAL INFO. &CONSUMER EDUC. FOUND., SOLD OUT: HOW WALL STREET AND WASHINGTON BETRAYED AMERICA (2009), available at http://www.wallstreetwatch.org/reports/sold _out.pdf.
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