Simon Johnson is the Ronald A. Kurtz Professor of Entrepreneurship at the M.I.T. Sloan School of Management and co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.”

The fundamental assumption of modern bank regulation is that nations need to coordinate, and they negotiate the relevant international standards in the Swiss city of Basel, home to the Bank for International Settlements, under whose auspices such negotiations are held. The United States has an important seat at the table, but so do the Europeans and others. These negotiations are shaped by three main forces: the United States, Britain and the euro zone, with Japan often siding with the euro zone. (It’s one country, one vote, so this can easily go against the United States.)

Today’s Economist

Perspectives from expert contributors.

This week the Basel Committee on Banking Supervision, as it is known, let us down – once again. Faced with renewed pressure from the international banking lobby, these officials caved in, as they did so many times in the period leading to the crisis of 2007-8. As a result, our financial system took a major step toward becoming more dangerous. (A visual representation of the Basel Committee’s centrality to all key regulatory matters is clear on this organizational chart, as well as in its charter.)

Why did this happen? Must Basel always let us down? And is there any alternative?

You will no doubt have noticed that very large banks with a global span have an unusual degree of political influence. In particular, they have the ability to threaten the economic recovery. Their line is: if you don’t give us what we want, credit will not flow and jobs will not come back.

Policy makers in Washington are often impressed by this line, although less frequently than they used to be. More and more, managers have begun to understand that the people who run large banks have distorted incentives. Because they receive downside protection from the public sector – the too-big-to-fail phenomenon – bank executives want to take a great deal of risk. When things go well, they get the upside; when things go badly, that is largely someone else’s problem.

How does that desire for risk manifest itself? The banks lobby for the ability to fund themselves with more debt and less equity, and they also want to be less safe on other dimensions, including holding fewer liquid assets.

The Basel Committee this week agreed to water down its liquidity requirements. Felix Salmon of Reuters has a good explanation of why this is a bad idea. Writing in The Atlantic, Jesse Eisinger and Frank Partnoy have a very nice article about continued fragility of banking, because investors think the banks are hiding trouble in the published balance sheets. Confidence in the system is not restored by relaxing regulation.

The deeper problem with the Basel Committee is it overrepresents the euro-zone Europeans. Not only is the euro zone in great difficulty because of economic mismanagement, but its leaders are hoping to get out of their current predicament in part by relaxing bank regulation.

The idea that the Basel process is all about expertise – or smart people working out the right answers – is exploded by Sheila Bair’s book, “Bull by the Horns.” Read Chapter 3, in which she describes in convincing detail the fight over the Basel II agreement during the mid-2000s (and Chapter 4, which is more about how some United States agencies play against in each and on behalf their clients, the big banks).

What we saw before 2007 and what we see now is not officials applying some sort of optimization procedure or sensible independent thinking. Rather, this is about an industry that wants to take more risk because that is how it gets larger subsidies. And this industry is expert at playing the regulators off against each other, including across borders. The Europeans are again the patsy.

Unfortunately, some United States officials are so captured or captivated by the ideology of modern banking that they want to play along. For example, as Ms. Bair mentions, the most dangerous “advanced approaches” of Basel II were developed by the Federal Reserve Bank of New York – not surprising, given how close many people at that institution are to Wall Street. Those advanced approaches let the banks set their own risk-weights on assets, essentially using complex math to determine what was risky and what was relatively safe. Of course, they were almost completely wrong, and Basel II was a dismal failure.

Thank goodness Ms. Bair and her colleagues at the Federal Deposit Insurance Corporation resisted the full implementation of Basel II. Their insistence on simpler safeguards, including a tough cap on debt relative to bank size, helped make our financial crisis less severe than it would otherwise have been. The Europeans drank the Basel II Kool-Aid, and their banks loaded up on poorly understood risks. They will lose a decade of growth partly for this reason.

Now we have moved on to what is known as Basel III, and again the Europeans want to double down by letting the banks do want they want. The stock price of European banks jumped on the news of the latest Basel Committee relaxation of the rules – you should interpret that as a larger expected transfer from taxpayers to bank insiders and (perhaps) stockholders.

The United States must go it alone. Basel agreements should be a floor on our bank regulation (including bank capital, leverage and liquidity), not a ceiling. If our tighter rules induce dangerous banking activities to leave the United States, that is fine. In fact, we should offer to help them pack.

We need a financial sector that works for the real economy – not a continuation of the dangerous, nontransparent government subsidy schemes that have brought the Europeans to their knees.

Article source: http://economix.blogs.nytimes.com/2013/01/10/betrayed-by-basel/?partner=rss&emc=rss