Complete Contracting as a Source of Bad Institutional Performance: Explaining the Basel Accords’ Failure During the Financial Crisis

What explains the bad institutional performance of the Basel Committee during the financial crisis? Labelling financial market institutions and especially the Basel Accord as soft law, the literature would have expected it to have no (positive) effect on providing financial market stability. While the Basel Accord was indeed not able to prevent the crisis, it in fact even had a negative effect on stability as it reinforced the crisis. This regulatory outcome of the Basel Accord is an important puzzle that cannot be explained by common approaches. Based on our theoretical model on international institution’s regulatory performance, we argue that the negative performance of the Basel Committee can be explained by two factors: first, its complete contract that defined precise rules and standards for the behavior of private banks, and second, its regulatory conflict with the International Accounting Standards Board (IASB). The International Financial Reporting Standards defined by the IASB caused a change in the behavior of private banks, as they were required to record their financial assets to the fair value (or mark-to-market) method, meaning to the current market values. Although this method has some benefits like increasing transparency for investors, it produced, in combination with the public capital ratio requirements of the Basel Committee, systemic risks that further undermined the financial system. Owing to the complete contract of the Basel Accord which did not include flexibility mechanisms, private banks had to react to falling asset prices by reducing lending to the real economy in order to keep complying with capital ratio requirements which again had negative effects on market rates. Thus, the intersection of the Basel Accords policy instruments with the IASB caused a pro-cyclical effect that deepened the financial crisis. The paper contributes to the empirical literature on the financial crisis by tracing the sources of a specific crisis mechanism. It also provides a framework to evaluate post-crisis institutional reforms. While considerable attention was given on whether the Basel Committee raised the capital ratio requirements for private banks, less attention was put to questions of whether the Basel standards were adapted towards reducing regulatory conflicts with the IASB or whether reforms included institutional flexibilities for banks to react to crises. The paper furthermore contributes to the theoretical literature on international institutions’ performance. Thus, it shows that performance not only depends on an institution’s design but also on its relationship with other institutions that define functionally overlapping rules and standards. Under the condition of regulatory conflicts, incomplete contracts exhibit institutional advantages towards complete contracts as it allows regulatory targets to react to regulatory crises.