Managing risk: a skeptic's view of Basel II.

• Author: Whalen, Christopher

Since the failure of Penn Square Bank in 1974, successive chairmen of the Federal Reserve Board have attempted to protect the U.S. financial system from a "systemic" shock that might bring the whole game to a crashing halt. As my father, Richard Whalen, once told me after attending a meeting on Capitol Hill in the early 1980s: "It is the duty of the current generation to pass the bubble on to future generations."

The means of maintaining market stability have evolved since the 1970s even as the scope of the risks to the system have likewise multiplied. Since the October 1987 market break in particular, the Fed has provided any amount of funding demanded by the marketplace, using only the cost of credit as a policy tool, a tacit admission that any link between the dollar and tangible valuation measures is gone forever.

It may seem intellectually inconsistent for the U.S. central bank to at once encourage greater risk management by financial institutions while at the same time following regulatory and monetary policies that increase the probability of a systemic event, but that is a concise description of the Fed's role in America's political economy. No Fed Chairman can ignore the ultimate power of politicians to create fiscal chaos and Greenspan is a good enough politician to know it. But the Fed's own tendency toward statist rather than free market solutions has allowed the Fed to actually exacerbate America's financial problems.

Compromised politically, the "independent" Fed accommodates Washington's fiscal excesses even as it preaches the gospel of price stability. It encourages the growth of derivatives trading and other types of risktaking not traditionally associated with banking even as it pushes for higher bank capital levels and better internal controls through the Basel process. The economist priesthood at the Fed attacks Fannie Mae and other bloated government-sponsored entities as a potential "systemic threat" to the U.S. economy, while allowing the creation of goliath universal banks that pose similar risks.

The schizophrenic quality of the Fed's approach to its dual responsibilities for monetary policy and bank soundness is a good argument for getting the central bank out of the business of regulating banks, but we'll leave that juicy morsel for another day. At issue here is the latest set of bank capital rules being championed by the Fed, known as Basel II, and how these new rules square with the mandate from Congress to all regulators to measure and anticipate risk to the U.S. financial markets.

When the first Basel agreement was announced by the Group of Seven regulators in 1988, it set broad, relatively simple minimum levels of capital for banks based on a percentage of assets. This approach was focused on addressing market and interest rate risk. The Basel Accord followed the near-failure of several large U.S. banks and investment houses after the Third World loan crises of the 1980s and was the first consistent effort among the industrial nations to set uniform financial standards for banks.

Also at that time was born the informal policy of "too big to fail," under which the Fed and other...