Frustrated by banks evading their safety rules, regulators from 10 wealthy nations meet in Basel, Switzerland, to hammer out an accord intended to close loopholes and harmonize practices between countries.
After five years of negotiation, the regulators announce a new accord, Basel II. Instead of imposing crude rules on capital buffers that are easy to work around, the accord tells the biggest banks to use their own assessments of risk--on the logic that the bankers know better than anyone else the risk levels of their loans.
In the U.S., domestic bank regulators openly worry that Basel II will allow banks to reduce the amount of capital they have to hold as a buffer against loan losses. The FDIC manages to delay U.S. entry until 2009 and demands extra safeguards for U.S. banks.
The mood swiftly changes as housing prices fall and mortgage defaults spike. Some analysts warn that in a sharp downturn, Basel II might actually require many banks to hold more capital, not less. That would mean raising more money or shedding weak loans.
...AND ONE NASTY SCENARIO
Banks in Europe and the U.S. might need to bolster their finances. But raising money is hard in a crisis atmosphere because no one wants to invest in bank stocks. The only alternative would be to curtail new lending and refuse to roll over some existing loans, which could exacerbate the credit crunch.
Troubles could snowball as U.S. banks begin to implement BaselII alongside the old way of doing things. The problem: The worse the credit crunch gets, the more banks could be forced by BaselII to cut back further on lending, pushing more borrowers into default. Some banks could be forced to seek bailouts. The economy might just limp along.
If the slump drags on, regulators might ease up on enforcing the rules, allowing banks to keep making loans even if shareholders have lost the bulk of their stake. But that would give banks the incentive to gamble on risky loans because the owners have little to lose if the loans go bad.