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Transnational regulatory capture? An empirical examination of the transnational lobbying of the Basel Committee on Banking Supervision Kevin L. Young

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Niehaus Center for Globalization and Governance , Princeton University Published online: 06 Feb 2012.

To cite this article: Kevin L. Young (2012) Transnational regulatory capture? An empirical examination of the transnational lobbying of the Basel Committee on Banking Supervision, Review of International Political Economy, 19:4, 663-688, DOI: 10.1080/09692290.2011.624976 To link to this article: http://dx.doi.org/10.1080/09692290.2011.624976

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Review of International Political Economy 19:4 October 2012: 663–688

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Transnational regulatory capture? An empirical examination of the transnational lobbying of the Basel Committee on Banking Supervision Kevin L. Young Niehaus Center for Globalization and Governance, Princeton University

ABSTRACT Since the global financial crisis, scholars of international political economy (IPE) have increasingly relied on the concept of ‘regulatory capture’ to explain the weakness of regulatory oversight and, hence, regulatory failures. Yet despite the widespread use of the concept of regulatory capture, its precise mechanisms are not well understood. This paper empirically investigates this hypothesis by examining one important institution of global financial governance that has been subjected to intense private sector lobbying at the transnational level: the Basel Committee on Banking Supervision. Using extensive archival material as well as interviews with participants in the generation of the Basel II Capital Accord, I argue that while private sector lobbyists had unprecedented access to the regulatory policymaking process, this access did not always translate into influence. Furthermore, when influence was present, it sometimes had the effect of increasing regulatory stringency, rather than weakening regulation. As such, I argue that our understanding of the process of transnational policy formation would benefit from a more nuanced understanding of the contingency of private sector ‘influence’ over the regulatory process, rather than the extensive, all-or-nothing depiction of regulatory ‘capture’ that currently prevails within the IPE literature.

KEYWORDS Financial regulation; transnational lobbying; interest groups; regulatory capture; Basel Committee.

1. INTRODUCTION Since the onset of the recent global financial crisis, conjecture regarding the influence of financial sector groups over regulatory policy has reached Review of International Political Economy C 2012 Taylor & Francis ISSN 0969-2290 print/ISSN 1466-4526 online  http://www.tandfonline.com http://dx.doi.org/10.1080/09692290.2011.624976

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a new high watermark. A central conceptual device within this literature is the notion of ‘regulatory capture’, the idea that the content of regulation is actively designed by, and in the interests of, the regulated industry itself (Bo, 2006; Stigler, 1971). Many have treated the notion of regulatory capture as not merely plausible, but as empirically robust in light of the profound failure of regulatory policy to prevent one of the worst economic calamities of our time. And yet, the precise mechanisms that financial sector groups employ to exert influence on regulatory policymaking are still not well understood. This lacuna in our understanding is particularly true of instances when private sector groups organize on a transnational basis through associations which advocate for banks’ interests. International Political Economy (IPE) scholarship has focused in particular upon one specific organ of global financial governance that has been subjected to intense private sector lobbying: the Basel Committee on Banking Supervision (BCBS). Born from the ashes of the Bretton Woods system, the BCBS has been working to develop international regulatory standards in banking since 1974. Its work in generating the 1988 Basel Accord is very familiar to scholars of IPE, as this original Accord constituted one of the boldest attempts to generate new international regulatory standards in the face of the deregulatory pressures of globalization (e.g. Kapstein, 1992; Singer, 2004). More recently, the BCBS has been extensively cited as the site of transnational ‘regulatory capture’ by the special interests of the banking community organized on a transnational basis. Specifically, IPE scholars have argued that financial sector associations actively contributed to the highly permissive regulatory character of the most recently completed international regulatory standard prior to the crisis of 2007–2009, the Basel II Capital Accord of 2004. As such, some have traced the weakness of the banking regulatory framework prior to the crisis to the active lobbying efforts of banks themselves (see Mattli and Woods, 2009: ix; Walter, 2010: 134, 156). This article subjects the claim of transnational regulatory capture to empirical scrutiny. Through several case studies, I focus on the actions of various transnationally organized private sector groups as well as the responses of the BCBS itself as it constructed Basel II. This research draws on empirical material gathered through 97 semi-structured interviews conducted between May 2006 and November 2009, and utilizes the extensive archival material produced in the wake of Basel II’s creation.1 Because lobbying influence can operate through many different channels, I restrict my analysis to a study of organized private sector influence conducted at the transnational level. I argue that existing accounts of transnational regulatory capture of the BCBS, which assert that private sector groups systematically weakened regulatory capital requirements during this period, are overstated and misleading. In contrast to existing accounts, I argue that the private sector did execute influence over the Accord’s content, but this 664

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influence was more circumscribed than the regulatory capture narrative would suggest. While the character of the financial policy network at the time meant that transnational banking associations had access to the regulatory policymaking process, this access did not translate into influence in the manner posited by the existing literature. This article is organized as follows. Section 2 reviews the existing IPE literature on private sector influence over the formation of the Basel II Accord. I argue that while existing accounts have shown strong confidence in the transnational regulatory capture narrative, the empirical standards employed to support this confidence have been weak. I draw from the existing IPE literature to differentiate the various causal mechanisms for private sector influence occurring at the transnational level. I differentiate between remote causal factors, such as the shared norms and interdependent relationships between regulators and bankers and their shared ‘intellectual bubble’ on the one hand, and proximate causal factors such as the strategic provision of information aimed at regulators, on the other. In Section 3, I describe the contextual conditions under which banker– regulator relationships operated during this period at the transnational level. In Section 4, I conduct three detailed case studies of different transnational lobbying campaigns waged by private sector groups during this period. I demonstrate that, despite extensive mobilization and lobbying efforts, within a socio-institutional environment thought to be conducive to private sector influence, private sector influence did not always manage to weaken regulatory standards. In the first case study, I demonstrate that a major transnational private sector lobbying effort to allow banks to use their own internal risk models failed to achieve its aims. In a second case study, I argue that while private sector groups were successful in encouraging the BCBS to adopt the use of particular internal risk rating systems, this achievement was highly circumscribed. In the third case study on the regulation of operational risk, I demonstrate that private sector efforts by one transnationally organized private sector group to veto an expensive regulatory policy failed, but efforts by another group succeeded in helping instantiate a more stringent regulatory policy. I briefly discuss the main findings of these case studies before concluding. 2. EXISTING LITERATURE ON THE FORMATION OF BASEL II The Basel II Accord was an international regulatory standard developed by the BCBS, an informal group of central bankers and banking regulators drawn during this period from the ‘G10’ states: the United States, the United Kingdom, Switzerland, Sweden, Spain, the Netherlands, Luxembourg, Italy, Japan, Germany, France, Canada and Belgium.2 The process of 665

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drafting Basel II involved years of detailed technical analysis and consultation. The Accord evolved from a set of preliminary ideas about how best to approach banking regulation in 1998, into an extremely detailed 239page document of regulatory policies in 2004. The Accord itself included everything from the regulation of detailed risk models and internal bank operations, to the definition of capital itself. Within IPE, the formation of Basel II has become a touchstone for critiques of global financial governance. IPE scholars regularly argue that the Basel Committee was systematically influenced by transnationally organized private interests during the drafting of the Accord, with numerous studies invoking Stigler’s (1971) claim that the content of regulation is actively designed by and in the interests of the regulated parties themselves. Helleiner and Porter (2009: 20), for example, cite Basel II as the prime example of ‘capture of the regulatory process by the industry it is supposed to regulate’. For Baker (2010: 650 – citing Tsingou, 2008), Basel II is the prime example of regulatory capture at the international level; and for Underhill and Zhang (2008: 553), Basel II is a prime example of ‘the domination of global financial supervision and regulation by private actors’.3 While some literature expresses some mild reservations about regulatory capture (Claessens et al., 2008: 321; Wood, 2005: 157), the concept is relatively ubiquitous and relatively unquestioned in the existing IPE literature ¨ (however, see Mugge, 2010). Because my aim is to address the transnational regulatory capture narrative in the existing IPE literature, it is important that I clarify my understanding of this narrative. On the one hand, regulatory capture is something much more unequivocal than private sector influence, which can be circumscribed. Influence could take place in some instances, but not others, and can vary under different conditions. Regulatory capture conveys a situation wherein private sector influence is consistent and systematic. Such an interpretation is evinced by the fact that all existing studies use only empirical evidence in which private sector groups get what they demanded, and depicts such influence as systematic.4 The IPE literature also adds a twist which did not exist in the original political literature on capture – private sector influence is not only consistent and unequivocal, but it leads to the weakening of regulatory standards. It is for this latter reason that regulatory capture has been invoked so widely since the recent financial crisis. Indeed, since the crisis, regulatory capture of the BCBS is often discussed self-evidently, given the size of the global financial crisis and the policy calamity that is understood to underlie it (Goldin and Vogel, 2010: 13; Ocampo, 2009: 10; Tsingou, 2010: 24; cf. Underhill et al., 2010: 307). To be sure, Basel II’s liberalizing orientation may well have contributed to the financial crisis and its negative effects;5 however, such an empirical assertion differs significantly from the claim that private sector groups engendered the weakening of such regulatory 666

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standards through a systematic manipulation of the policymaking process. To begin to assess the transnational regulatory capture claim, we must ask: what standards are employed to support the transnational regulatory capture claim, and what mechanisms are envisaged to affect capture?

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Empirical standards Central to many of the existing analyses of the transnational regulatory capture of the BCBS is an ascription of influence through a simple assess¨ 2008: 567). These ment of the degree of preference attainment (see Dur, analyses point out that Basel II is highly (neo-)liberal in character, actually weakens regulatory restrictions on banks, and matches the preferences of transnational associations such as the Institute of International Finance (IIF) (see Griffith-Jones and Persaud, 2008: 264; Tsingou, 2008: 60–61). Yet a central problem with ascertaining influence by means of preference attainment is that the causal process is merely presumed, rather than documented, not only ‘black-boxing’ the process through which influence is ¨ exercised, but excluding alternative explanations for policy choices (Dur, ¨ 2008: 568). As Buthe (2010: 6) has recently articulated in the context of global private politics, it is spurious to simply assume that policy changes which benefit a group are made at the behest of that group. Existing analyses also point out that international banking associations interacted with the BCBS (see Tarullo, 2008: 100, 104; Tsingou, 2008: 61–62). Yet evidence that a private sector group interacted with the BCBS does not mean that it managed to have its preferences met because of that interaction. Such a precautionary stance to interest group research is well established within the broader theoretical conceptualizations of business power in global governance (see Fuchs, 2007: 89–90). Access does not necessarily ¨ and De Bi`evre, 2007). equal influence (see Dur While some studies of regulatory capture and Basel II’s formation are more empirically systematic than others (e.g. Lall, 2011; Wood, 2005), most empirical standards within IPE literature are very relaxed, and the case for regulatory capture is asserted more than it is actually subject to empirical scrutiny. Compounding this problem is the fact that no existing IPE scholarship examines the variation in private sector lobbying success, choosing instead to exclusively highlight instances where private sector lobbyists’ demands or presumed preferences are reflected in regulatory outcomes. Such case-selection bias stands in contrast to some studies conducted at the national level of regulatory policymaking, which feature detailed examination of empirical variation in regulatory outcomes (Heinemann and ¨ Schuler, 2004; Kroszner and Stratmann, 1998). Many national-level studies also employ more detailed empirical research than is typically the case in their IPE equivalents (e.g. see Johnson and Kwak, 2010; Kroszner, 2001; Moran, 1986; Tett, 2009). However, there is also a more general way in 667

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which both national-level studies and the IPE literature mirror each other, namely that the emphasis is on critiquing private sector influence normatively, more than actually analyzing these processes in a systematic fashion. Given the context of the financial crisis, many scholars are, perhaps for good reasons, more concerned with highlighting a worrying set of public–private relationships than analyzing these social relations in analytical detail. Yet while this has put important issues and hypotheses on the agenda and has highlighted nefarious practices, it does not necessarily get us any closer to understanding the processes we are actually interested in – in particular, the causal mechanisms of influence.

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Causal mechanisms of influence A wide variety of causal mechanisms have been envisaged within the existing literature to explain private sector influence over financial regulatory policymaking. Among these are campaign contributions to elected officials, the presence of ‘revolving doors’, and structural power in its various avatars (Kroszner, 2001; Seabrooke and Tsingou, 2009; Strange, 1988). Within the existing work on Basel II, however, the scope is more limited – especially when the focus is at the transnational level where the Committee as a whole cannot be held to account (in contrast to national regulatory policymaking, which can be directly affected through legislative oversight, for example).6 On the one hand, scholars have detailed the qualitative character of the social relationships which underlie regulatory policymaking processes and, in so doing, have articulated the common ideational perspective of bankers and the members of the BCBS. Tsingou (2008: 62) has, for example, described the ‘formal and informal practices of public–private interaction and agreement among an increasingly coherent . . . transnational policy community’ that characterized Basel II’s formation (see also King and Sinclair, 2003; Porter, 2009; Wood, 2005). Such thinking draws implicitly from the literature on ‘policy networks’ (see Busch, 2008; Thatcher, 1998), and from earlier sociological perspectives on the finance community as a coherent interdependent whole (cf. Cerny, 1994; Moran, 1986), and one can think of regulators and bankers both working in the same ‘intellectual bubble’ during the period in question. On the other hand, existing scholarship has also emphasized the importance of the strategic provision of detailed technical information. In this vein, Griffith-Jones and Persaud (2008: 266) posit that regulatory capture occurs because ‘private bankers possess better technical expertise than regulators, as well as superior resources to pay for studies that better inform their positions’. Similarly, Helleiner and Porter (2009: 20) argue that the highly technical character of regulatory networks, such as the BCBS, ‘provide[s] privileged access points for business’, making the BCBS ‘especially susceptible to “capture” by the financial firms they are supposed 668

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to be regulating’. In a similar vein, Lall (2009) has emphasized that it is not just contact per se with regulators that engenders regulatory capture, but the fact that large, internationally active banks and their information reach regulators at the earliest stage in the policymaking process, long before other actors have a chance to convey their concerns and information. The mechanism of influence by information has been theorized by a great deal of scholarship which has emphasized the informational asymmetry between financial regulators and evolving private sector knowledge (Cerny, 1994: 331; Porter, 2009; Underhill et al., 2010: 6). Indeed, the private provision of information to policymakers is well established as the ‘coin of the realm’ within broader interest group research (Kerch, 2007), and a particularly appropriate mechanism for the influence of policymaking organized in a committee setting (Bennedson and Feldman, 2002). Information is conceived here not as the simple ‘signaling’ of private sector protest, but rather the provision of detailed technical information and/or technical arguments concerning the consequences of regulators’ actions. These two different causal mechanisms do not have to be considered as in competition with one another, but rather as (potentially) complementary, working together in a conjuctural manner to explain private sector influence (see Ragin, 2006: 639–640). However, it is important from an analytical perspective to underscore the fact that they represent two different kinds of causal explanations. Specifically, the emphasis on the character of the public–private (inter)relationships that underlie financial regulatory policymaking points to what can be understood as a remote causal factor, while the emphasis on the strategic provision of information points to a proximate causal factor. As analytical concepts, remote causes refer to time-invariant factors for the period in question, sometimes referred to as ‘structural’ factors or simply ‘the context’ in which actors operate. They are ‘remote’ in that they are outside the immediate reach of actors and are treated as exogenously given (Schneider and Wagemann, 2006: 760). Proximate causal factors, in contrast, refer to factors which are more temporally variant, as they are the product of agency within the context in which actors operate. In a hypothetical narrative of regulatory policy change, the remote causal factors are the socio-institutional context, and the particular historical conjuncture in which actors find themselves. Conversely, proximate causal factors are subject to changes introduced by actors – they are the specific decision-making processes and actions of groups engaged in interaction within a given historical conjuncture (see Schneider and Wagemann, 2006). As such, in the next section I describe the remote causal factors, that is, the socio-institutional contexts in which private sector lobbying took place during the formation of Basel II, before turning to the more specific case study analysis of different private sector lobbying efforts, which focuses attention on proximate causal factors of advocacy and information exchange. 669

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3. THE CONTEXTUAL CONDITIONS UNDERLYING BASEL II’S DEVELOPMENT The institutional context in which Basel II was developed was one in which regulators had increasing interest in inducting private sector practices, and were relatively uncritical of doing so. As many works within IPE have illuminated, the period between the East Asian financial crisis and the recent global crisis was characterized by an increasingly cozy relationship between regulators and bankers (see Baker 2010; Tsingou, 2008; Wade, 2007: 126–127). Such contextual conditions impacted the way that many regulators viewed the risk-modeling practices being generated by the private banking community in the mid- and late 1990s in important ways. These quantifiable risk measurement systems were regarded as innovative new instruments that regulators could potentially use to regulate an increasingly concentrated and sophisticated financial technostructure. Throughout the 1990s, the use of standardized risk analysis packages, such as that produced by the credit rating agency Moody’s (in particular, Moody’s KMV Expected Default Frequency package), became widely used in the financial sector. In 1997 JPMorgan had published their advanced credit risk methodology, called CreditMetrics, Credit Suisse’s Financial Products Division had released CreditRisk+ in the same year, and similar such models were being used within the US banking community especially. As these particular risk measurement technologies grew, the BCBS made efforts to learn from these new practices. Within some BCBS countries – such as the US and the UK – such regulatory ‘induction’ was stronger than others (e.g. Germany and Japan), as there was a sentiment that the increased complexity of financial innovation made ‘intrusive supervision less meaningful, if not virtually impossible’ (interview with regulator 74R; Courtis, 2000: 50). To be sure, these views were likely motivated in no small part by the widespread dominance of neo-liberal economic thinking at the time; nevertheless, they were initiatives developed internally within these regulatory agencies, rather than something simply pressed on to them instrumentally by private sector initiatives. Efforts actually began within the Fed Board in the mid-1990s to investigate the use of banks’ own credit risk models as a way of improving regulatory practices, and were followed up on by the UK FSA thereafter.7 However, by the late 1990s it was widely believed within the BCBS that a new and revised Basel Accord would need to draw on ‘best practices’ within the financial industry itself in some way (interviews with regulators 18R, 95R). Such a decision to draw from ‘industry best practices’ and to ensure close contact with the very institutions to be regulated is difficult to conceive of except in the broader discursive environment of the time whereby there was strong confidence in efficient financial markets (see Baker, 2010; Tsingou, 2008). As one former BCBS member recalls, at the 670

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time the BCBS believed ‘that consultations with market parties was of paramount importance to get [the] Accord “right”’ (interviews with regulators 22R, 18R). Regulators’ desire for private sector engagement was also motivated by strategic concerns associated with the international nature of the regulatory policymaking process. Specifically, because competitive equity across national jurisdictions was a major concern across the G10, consulting with private sector actors was seen as a way of enabling differences across BCBS member countries to be taken into account. The contextual setting in which Basel II construction proceeded can thus be seen as a relatively ideal one for regulatory capture taking place (see Mattli and Woods, 2008). Not only did regulators and bankers both work within the same ‘intellectual bubble’, but the BCBS conducted closed meetings with transnationally organized private sector groups, away from the press or non-governmental organization (NGO) participants, in an exclusive and non-transparent setting. How did transnationally organized private sector groups actually fare in such a setting? 4. CASE STUDIES OF TRANSNATIONAL LOBBYING While a variety of methods are available to investigate private sector influence empirically, because this article deals with a small number of exhibitive cases, I employ process tracing analysis, the method most often ¨ 2008; Woll, formally employed in small-n interest group research (Dur, 2007: 74). Process tracing analysis identifies the key events, individuals, relationships and decisions that link causal conditions to outcomes (George and Bennett, 2005; Bennett, 2008). It thus allows for the exploration of causal linkages between events in a chronological fashion as events unfold in a narrative and, in what follows, I provide a succinct summary of events and actor behavior to account for how regulatory policy decisions were made (George and Bennett, 2005: 206). Below I describe three different transnationally organized efforts by private sector groups to influence various aspects of Basel II’s content. My selection of these specific cases is motivated by my effort to engage with accounts in the existing literature, which principally have addressed the broad features of the Accord, namely the architecture of its risk models developed at the early stages of the Accord’s development. Private sector influence is conceived of as the independent causal effect of lobbying efforts. By successful lobbying efforts, I mean the actions of firms and their associations successfully engendering changes in regulatory policy content that cannot be attributed to other factors. Evidence of influence can be one of the following: either a specific proposal articulated as part of a lobbying effort can be shown to have made its way into actual regulatory policy, or, a regulatory proposal that was already on the agenda of policymakers is later removed as the result of private sector 671

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efforts. Agenda-setting is an important aspect of this analysis; however, to qualify as an instance of influence the item on the agenda has to survive the policymaking process and cannot be dropped. In addition, if private sector groups lobbied for a policy which did not transpire, I consider this sufficient evidence for lobbying failure.

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Case study 1: The transnational private sector push for full internal credit risk models In 1998, just as the BCBS began to seriously contemplate a revision of the Basel Accord, a transnational private sector lobbying campaign emerged to press its own vision. This campaign was spearheaded by the Institute of International Finance (IIF), the transnational association of large banks that had acted since 1982, following the Latin American debt crisis, as the industry’s globally representative body. As soon as word of a new Accord moved through the financial policy network, the IIF began lobbying for a particular approach. Specifically, it wanted the BCBS to allow banks with sophisticated internal risk management and measurement systems to calculate their own levels of capital adequacy by using their own internal credit risk models.8 This transnational effort featured the IIF and its members trying to persuade the BCBS that the banking industry’s own internal credit risk models, such as those based on CreditRisk+ and CreditMetrics (described above) were advanced enough to be used in an international regulatory framework. To spearhead their efforts, the IIF organized a Working Group on Capital Adequacy, which was composed of senior credit risk managers in IIF member banks – most of the largest international banks in the world at the time – and produced a report urging the BCBS to ‘move quickly to recognize bank’s internal credit risk modeling systems to generate regulatory capital cushions that would be more closely attuned to real risks’ (IIF, 1998; 2000b: 2; 2001b: 3; 2007: 69). The association made a technical argument to the BCBS that if the Basel framework was not revised in this way, it would lead to behavioral distortions and undermine the credibility of the existing Accord (IIF, 1998: 37, in IIF, 2007: 69). The move to a full internal models approach to capital adequacy regulation, the IIF argued, would be in the best interests of both regulators and banks. Soon the International Swaps and Derivatives Association (ISDA), another prominent transnational financial sector association, argued a similar position, further bolstering the legitimacy of the IIF’s claims (ISDA 1999; ISDA, 1998, in ISDA, 2000a: 8). In the words of one IIF participant in this process, ‘We had hope. We had hope that they were actually going to go all the way toward recognizing portfolio credit risk modeling . . . full internal modeling’ (interview with lobbyist 61P). 672

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The character of the financial policy network at the time described above arguably allowed this private sector initiative to reach the BCBS agenda. Yet while there was consensus within the BCBS that the Accord should be reformed, views on the potential usefulness and viability of using full internal credit risk models for regulatory purposes were very mixed. While the Fed was the BCBS participant closest to the IIF position at the time, the other US members of the BCBS, such as the US Office of the Comptroller of the Currency (OCC) and especially the Federal Deposit Insurance Corporation (FDIC) were strongly against the idea from the outset.9 Outside the US there was also skepticism, such as the German and French BCBS members.10 However, because the Fed had the greatest interest in credit risk models in the first place, it established a special Task Force on Internal Credit Risk Models to assess the potential use of banks’ internal credit risk models within the context of banking supervision (interview with regulator 80R). After empirical study of the issue, involving an intense period of interviewing individual US banks and investigating their internal practices, the Fed drew its own conclusion that a full internal models approach would be highly problematic – a position soon confirmed by internal research at the Bank of England (interview with regulator 74R; English and Nelson, 1998; Federal Reserve Board, 1998: 2; Jackson, 1999; Jones and Mingo, 1999). The BCBS as a whole then decided to conduct a G10-wide study on the issue, wherein 31 senior regulatory officials from the G10 surveyed and analyzed the credit risk modeling practices of the 20 largest banks in the world in 10 different countries. This research led the BCBS to find even further evidence of deficiency within private sector risk modeling practices. As one BCBS participant recalls, ‘ . . . [I remember] talking to banks, and saying “OK, you want to talk about your models?” And then firing, you know, 20 bullet-holes right through. Because if you looked at the details of the models . . . you just blow them apart’ (interview with regulator 79R, corroborated with regulator 19R). Contrary to the views held within the IIF and the ISDA at the time, the BCBS’ Models Task Force concluded that banks’ internal credit risk models were problematic for two reasons. First, the Task Force had found that there were significant data limitations within the banks that they surveyed, which could have consequential repercussions for bank solvency if they were inaccurate.11 Second, the Task Force was not convinced that internal credit risk models could be validated based on a common standard (BCBS, 1999a: 1–2.). In the words of one BCBS participant, comparing internal models was ‘like comparing apples and oranges and cauliflower’, and after careful study had concluded that ‘[n]o one in the Committee thought it made the slightest bit of sense’ (interview with regulator 67R). After such research took place, there was consensus within the BCBS that a full internal models approach should not be employed in Basel II. In the words of one BCBS participant referring to the private sector effort 673

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Figure 1 Calculated differences between the Basel II risk model and bank’s own internal credit risk models (calculated from data in Crouchy et al., 2005: 223).

at the time, ‘[t]hey pushed. And we said no’ (interview with Regulator 67R). While private sector groups did make further pushes later on, full internal credit risk models never transpired, however, and the fact that the BCBS never accepted private sector arguments for them had important consequences. Put simply, it meant that even in the most sophisticated approaches to credit risk, the regulatory capital requirements in Basel II would be systematically higher than banks’ own internal practices using their own models. Figure 1 below illustrates the percentage differences in regulatory capital requirements for different levels of risk from the highest quality (AAA) to less high quality (BBB-) exposures. As this figure shows, the ‘Internal Ratings-Based’ approach of Basel II that was eventually adopted was systematically higher in its capital requirements for medium- and high-quality risk exposures.12 Case study 2: Transnational lobbying over internal ratings While the BCBS rejected the industry view that full internal models should be used in the Accord to set levels of regulatory capital, it was still enthusiastic about drawing upon the banking industry’s best practices (interviews with regulators 18R, 67R). Initially the BCBS had thought to utilize the external ratings of bank’s exposures as a way to assess regulatory capital – i.e. using credit rating agencies as arbiters of riskiness. This idea was soon abandoned as the most comprehensive methodology for advanced banks in the Accord (it would remain, however, for small banks), partly because of how crude the approach was, and partly because of internal 674

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dissent within the BCBS over the coverage and reliability of external rating agencies from countries such as Germany (interview with regulators 90R, 95R, 76R). As a more advanced alternative, the BCBS agreed that it would utilize banks’ own internal risk ratings, i.e. the parameter inputs to a risk model given by regulators. Internal work conducted by staff economists at the Fed Board enabled this decision, as this work utilized the basic logic and mathematics of credit risk models to produce a regulatory model that the BCBS could use as a (more conservative) proxy for drawing on internal bank practices directly (interview with regulator 76R; see also Gordy, 1998; 2003). This gave the BCBS the ability to draw from industry best practice while at the same time maintaining their discretion as regulators. A vociferous transnational informational lobbying campaign followed, as groups like the IIF and the ISDA sought to ensure that their members could utilize as many internally assessed risk parameters as possible. The IIF began these efforts with an internal reorganization, and one month after the release of the first draft of the Accord it organized a new Steering Committee on Regulatory Capital specifically to focus the IIF’s Basel II lobbying efforts (IIF, 2001b: 14; interview with lobbyist 22P). The IIF now also had considerable insider-knowledge on their side, as the Vice-Chair of the Steering Committee was Tom de Swaan, the former Chair of the BCBS, now on the Managing Board of Directors from ABN-AMRO. The IIF was able to use its position as the well-connected, peak transnational association of large international banks to interact with the BCBS participants on a regular basis during this period. Such efforts were not resisted: indeed, the BCBS and its ‘Models Task Force’ (the sub-group within the BCBS working on the basic structure of risk modeling) used these discussions and data from the IIF as part of their overall research at the time. While the IIF was used as a sounding board, the BCBS also consulted bilaterally with individual banks: including 30 large banks across the G10, in order to gather information about banks’ internal rating systems, and to assess practices in this area (BCBS, 2000b: 3). The Models Task Force even published their preliminary findings in the explicit effort to receive further industry input (ibid.: 3). The IIF sought to influence these efforts by producing a report of internal rating practices for the BCBS Models Task Force in February 2000, outlining the banking industry’s common practices. In so doing, they outlined how the risk weightings could be modeled as a continuous function, based on the measurement of expected losses of bank’s credit risk exposures, rather than a ‘slotting’ approach whereby different risk grades were assigned into different risk categories as had been done traditionally (IIF, 2000a: 21–28; 2000b: 36–39). The ISDA and the IIF also worked together, compiling detailed data and conducting joint studies with the intention of giving the BCBS confidence that internal risk modeling systems were comparable across different banks (ISDA, 2000a; 2000b: 25–26; IIF, 2007: 69–70). 675

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The BCBS reacted to these efforts in a complex way – but a way that is distinct from what a straightforward ‘regulatory capture’ narrative would suggest. Without a doubt, the BCBS regarded the information it received from the private sector groups as highly valuable, and such engagement helped the Models Task Force to develop some of the technical elements of the Internal Ratings-Based approach within the Accord (BCBS, 2000a: 1–2; 2001a: 1; corroborated in interviews with regulators 77R, 95R). The data that lobbying efforts provided helped to convince the Models Task Force that credit risk could be a continuous function of parametric risk drivers. However, while this private sector influence was clear in form, it was not in content. As part of the BCBS interactions with the IIF, the ISDA and the surveying of various banks on an individual basis, the Models Task Force actually found new reasons to doubt the extent to which internal rating could be utilized. This research revealed that while banks seemed to be able to estimate their borrowers’ probability of default (PD), and their exposure at the time of default (EAD), another key risk parameter, ‘loss given default’ (LGD) was seen as highly suspect (BCBS, 2000b: 4, 9, 25, 27). In the words of one BCBS delegate, in terms of the ability to adequately and consistently model risk, ‘the banks were clearly vastly over-optimistic about what their capabilities were’ (interview with regulator 19R). As such, banks using the simpler IRB approach (the ‘Foundation IRB’) were not permitted to estimate their own LGDs, and more sophisticated banks were only permitted to estimate their LGDs under very specific conditions (BCBS, 2001a: 18). This outcome was the opposite of what the IIF had advocated, which was for all banks employing internal ratings to be able to estimate their own LGDs (see IIF, 2000b: 23). As critical components of the complex capital requirement calculations that banks had to make under a regulatory model, LGDs formed a significant component of regulatory capital requirements.13 The result was that the regulatory model the BCBS employed was designed to be consistently more stringent than banks’ own estimates of risk. Table 1 illustrates the differences between the regulatory capital requirements for the Advanced IRB model within Basel II, and the model proposed by the IIF–ISDA mentioned above, for comparable levels of risk. For a benchmark asset, the BCBS designed Basel II to require an 8 per cent regulatory capital requirement – 8 cents on every dollar exposure. Because Basel II was risk-sensitive, for lower-rated exposures banks were required to hold more, and banks could hold less capital for high-rated exposures. As the second column illustrates, while the IIF–ISDA proposal followed this theme of risk sensitivity, it did so by calculating capital requirements which were lower at every level of risk. As the final column demonstrates, the regulatory capital assumptions that the BCBS employed in Basel II at this time were considerably larger than estimates that private sector groups had advocated, in particular at the 676

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Table 1 Basel II’s advanced internal ratings based approach and the IIF–ISDA proposal compared Level of risk

BCBS

IIF–ISDA

Percentage difference

AAA AA A BBB Benchmark BB B CCC

0.56 1.12 1.34 3.83 8 9.87 27.4 50

0.22 0.43 0.57 1.95 4.41 5.34 17.74 50

155 160 135 96 81 84 54 0

Calculated from data in Crouchy et al. (2005: 210).

higher end of the risk spectrum. The success of the transnational campaign was thus a very mixed one from the perspective of those involved. It is hardly surprising, then, that groups like the IIF and the ISDA criticized Basel II as being excessively costly, and replete with regulatory capital add-ons (IIF, 2001a: 6–7; 2001b: 43; ISDA, 2001). Many of the largest banks in the world saw the situation as a positive step in the desired direction, but at the same time, as ‘so unsatisfying in so many ways’ (interview with lobbyist 86P; Helk, 2001). Case study 3: The operational risk Pillar I capital charge In the first draft of Basel II in June 1999, the BCBS proposed an explicit regulatory capital charge for what is known as ‘operational risk’. In contrast to credit risk, which involves risks associated with extending and managing credit relations, operational risk refers to risks related to the potential failure of banks’ internal processes, or to those produced by external events (BCBS, 1999a; Power, 2005). This policy effectively meant that banks would have to develop formal internal procedures for how to manage this form of risk, and that such procedures would be binding in the form of an explicit ‘Pillar I’ capital charge. Perhaps not surprisingly, groups like the IIF and the ISDA launched an extensive transnational lobbying campaign to oppose the explicit ‘Pillar 1’ capital charge for operational risk. Both groups argued that banks already managed operational risk sufficiently through qualitative mechanisms of oversight and internal controls. A Pillar 1 capital charge would divert this focus to unnecessarily crude and costly measures which would lag behind best practice, and slow the innovation of risk management (IIF, 2001a: 19; ISDA, 2000a: 40, 42–43, 46; 2000c). The ISDA worked extensively with their membership to make a detailed, analytical, and information-rich case which justified their position, drawing data from 21 of their largest 677

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member banks across the world and by critiquing 12 different possible methodologies through which an operational risk capital charge might be calculated (ISDA, 2000a: 43; 2000c). The IIF went even further in its critique. In January 2000, it established its own Working Group on Operational Risk, which was composed of 40 large transnationally active banks (interview with lobbyist 69P). Private sector actors enjoyed close access to the BCBS members working on the operational risk policy. Specifically, the IIF and its members met directly with the BCBS ‘Risk Management Group’ (RMG), the subgroup within the BCBS that was designing the operational risk policy. As implied by the IPE literature discussed above, such engagements were actively sought out by regulators, and the RMG sought to use transnational baking opinion to gauge operational risk practices within the banking industry (interview with regulator 77R). To realize such ends, the RMG held workshops with banks, met with the IIF in several discussion forums which took place alongside BCBS meetings, and conducted a survey of G10 banks on their operational loss experiences during this period (BCBS, 1999b; interviews with regulators 66R; 77R). While regulators were bombarded with information-rich critiques, they were skeptical of changing their original position. On the one hand, both the RMG and the BCBS as a whole saw the operational risk policy as useful in increasing overall regulatory capital where it might fall in other areas – an important preference of Continental European members especially (interviews with regulators 90R; 95R). But even members like the US Federal Reserve, who had a more permissive position on regulatory capital, saw a need for an operational risk capital charge in order to ensure that the banking community would take operational risk management seriously, and develop new and sophisticated technologies for it in the future (interviews with regulators 18R; 65R, 77R, 95R). On the other hand, an internecine conflict emerged within the international banking community itself. Specifically, a small number of individuals participating within the IIF’s Working Group on Operational Risk began to develop a supportive position to the policy. In response, the dissidents within the IIF began to organize their own working group called the International Technical Working Group (ITWG), an informal group of operational risk experts who met on a frequent basis, often in tandem with IIF and BCBS meetings, to formulate positions, conduct research and regularly engage with the BCBS RMG (interviews with Lobbyist 68P, 69P). Because it emerged from within the ranks of the IIF, its membership was very highly transnational, comprised of individuals from 10 different banks from the US, Canada, Germany, Japan and the Netherlands.14 The difference in regulatory preferences that the ITWG exhibited can be understood through two simple factors. First, the banks that ITWG members came from were much more advanced in their operational risk 678

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management practices than other banks. As such, they saw the operational risk policy as a regulatory cost that would disadvantage their competitors much more relative to whatever costs it would impose on them. The second factor was equally strategic, but more associated with internal bank bureaucracies at the time. ITWG members were all operational risk managers within their banks, and saw the operational risk policy as a way of establishing the credibility, prestige, and further funding for their area of expertise (see Power, 2005 for an analysis of risk managers within banks’ departments in this regard). Shortly after its creation, the ITWG began meeting with the BCBS RMG, who were more than happy to receive input that helped them with their objectives. The BCBS viewed the ITWG as a trusted interlocutor, given that it was an informal group of operational risk professionals whose members were not vetting their positions through the senior managements of their banks (interview with regulator 77R). Through in-person meetings and teleconferences with ITWG members, the BCBS RMG were able to use the information provided by the ITWG to both defend their existing policy stance on operational risk and to craft the technical elements of the Accord which helped them achieve their desired regulatory objective. In this regard the ITWG demonstrated the analytical foundations for quantifying operational risk, using models drawn from the actuary tradition of insurance pricing and by giving the RMG a first-hand glimpse at their own bank’s operational risk practices (interview with lobbyist 68P). Through such interactions, the RMG increasingly discovered the size and content of major operational risk losses within large banking organizations, and even forms of risk that they had not considered before, such as litigation risk. Under these conditions, the IIF and the ISDA were unable to veto the operational risk Pillar I capital charge, and the policy exceeded most expectations in terms of its stringency (BCBS, 2001a: 94; 2001b). Despite other technical adjustments made later in Basel II’s development, the operational risk policy remained by far the most conservative policy in the entire Accord, effectively ‘plugging’ the ability for capital to fall too far as a result of risk sensitivities in other parts of the Accord. While this case certainly speaks to an instance of private sector influence, it does not conform well to a dominant narrative within the IPE literature whereby ‘regulatory capture’ led to a weakening of regulation. On the contrary, the BCBS used private sector groups to their advantage – acknowledging, but effectively ignoring the oppositional groups, and embracing a minority fringe group of bankers who shared regulators’ initial preferences for a stringent regulatory capital charge. Summarizing findings from case studies Table 2 summarizes the findings from the above case studied. In none of these case studies is there evidence of regulatory capture as it has been 679

Operational risk capital charge

Internal risk ratings

2

3

Full internal models

Lobbying concerned

1

Case study

Opposers sought to veto the policy; supporters sought to ensure it came about.

Reacting to regulators’ call for information

Agenda-setting

Private sector objective(s)

Helping the policy come about

Lobbying was successful in putting their idea on the agenda Regulators used part of a proposal

What was successful?

680 Vetoing orweakeningthe policy

The proposal to allow banks to estimate all of their risk parameters

The policy did not materialize

What was unsuccessful? Researched and then discounted private sector arguments Used some information to verify the new approach; modified proposals to make them more restrictive Rejected arguments in favor of a removed or weaker regulation; used only information conducive to their original objectives.

How did the BCBS react to informational lobbying?

Table 2 Summary of cases exploring transnational private sector influence

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No – they helped to increase their stringency.

Yes, but mixed.

No.

Success in weakening regulatory capital requirements?

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represented in the existing literature, despite the fact that each of these case studies featured the use of intensive ‘informational lobbying’, in a socio-institutional setting and context where contact between banks and their regulators was frequent, and inducting from private sector ‘best practice’ was seen in an uncritical light. While this shared ‘intellectual bubble’ afforded transnational lobbyists a great degree of access to the regulatory policymaking process, this access did not directly translate into influence in the manner expected within the IPE literature. The BCBS certainly allowed private sector perspectives to bear upon the regulatory policymaking agenda, and the information that banks provided was, in some instances, used. However, the use of private sector information was highly selective: its use, therefore, does not reflect a wholesale purchase of private sector arguments. While the initial decision to consult with private sector groups may be a product of informational dependence and the close relationships between bankers and regulators during this period, when it comes to making actual policy decisions on the basis of such consultation, a different picture seems to emerge – one of discretion available to regulators. 5. CONCLUSION This article has examined claims concerning the regulatory capture of an important transnational standard-setting body, the Basel Committee on Banking Supervision (BCBS), during the design of the Basel II Accord. Process tracing analysis of three different case studies of transnational lobbying attempts revealed the complexity and variability in the results of these efforts. The character of the financial regulatory policy network at the time allowed transnational lobbyists to not only push their agenda, but to do so with close access to policymakers. The BCBS certainly made use of information provided by banks, but this was a more selective and inductive process than a wholesale purchase of private sector arguments. Rather than being systematically vulnerable to influence by transnationally organized special interests, the process of constructing Basel II’s main risk models featured more resistance to private sector pressures than is commonly appreciated within the IPE literature. Herein I have not challenged the notion that the relations between private sector actors and the BCBS constituted a very closed and insular policy community prior to the crisis. It might be said that the existing claims of ‘regulatory capture’ exist at a level of descriptive generalization that it is not subject to challenge. In this vein, some private sector influence (from a normative perspective) may be ‘too much’. This argument is completely reasonable. However, such an argument is of a different type than the strong empirical assertions actually made within the IPE literature, which claim that Basel II is the prime example of ‘capture of the regulatory 681

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process by the industry it is supposed to regulate’; that Basel II signifies ‘the capture of regulation by large multinational banks’; that the ‘private sector is writing its own script’; that the BCBS ‘fell victim to regulatory capture by large international banks’; and that Basel II is ‘the perfect example of regulatory and supervisory capture’ or illustrates ‘the domination of global financial supervision and regulation by private actors’ (Goldin and Vogel, 2010: 13; Helleiner and Porter, 2009: 20; Ocampo, 2009: 10; Tsingou, 2004: 11; 2010: 24; Underhill and Zhang, 2008: 533). While the concept of transnational regulatory capture offers a powerful narrative of the relationship between regulatory policymakers and private sector groups, it cannot explain the variability in regulatory policy outcomes. Pervasive neo-liberal confidence in market-based practices, cozy relationships between bankers and regulators, and uncritically examined technocratic discourses of financial regulation were all present in the cases explored above. While they may have facilitated the successful exercise of private sector influence when it occurred, these features did not ensure regulatory capture of the process and a weakening of regulatory standards in all cases. Many scholars emphasize that a hard dividing line between public and private is problematic, given the actual social interrelationships and mutual dependencies in the real world of policymaking (see Baker, 2010; Woll, 2007). While this article does not seek to challenge this general depiction, the findings presented here do suggest that despite the shared norms and interdependency between regulators and regulated, the line between public and private can indeed be drawn. In the cases presented here, the line between public and private was drawn with the word discretion: regulators had discretion to choose unpopular decisions; discretion to say no to bankers’ demands; discretion to pick and choose which information to utilize from private sector groups, and which to reject. This finding does not suggest that a ‘state-market condomonium’ ¨ (Mugge, 2010; Underhill and Zhang, 2005) does not exist, or that the financial ‘policy network’ of this period was not problematic. But it does suggest that there was more scope for public agencies, at least when organized transnationally, to resist and reject private sector demands than has been depicted in the existing IPE literature. While it is true that the BCBS during this period was non-transparent and unaccountable, it importantly possessed the independent authority to make decisions against the demands of the international banking community. There is a strong tendency when discussing private interests in financial policymaking to focus exclusively on private sector resources and the congenial environment in which they operate. While critical, this is only one side of a dynamic equation and, by omitting the resources available to regulators – in particular the discretion available to them when 682

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organized transnationally – we risk misrepresenting the extensity of one group’s power. Rather than an all-or-nothing depiction of regulatory capture, scholars of IPE might pursue an approach which seeks to trace the conditions under which private sector groups are successful in their lobbying efforts, and those in which they are unsuccessful. Two points are most immediately relevant in this regard. First, future scholarship might take more seriously the heterogeneity within the private sector itself – even among large banks and their transnational associations. In this regard, what existing depictions often elide is the extent to which conflict within the private sector may affect lobbying outcomes (such as in case study 3 above). There is a rich emerging literature on ‘business conflict’ within IPE which might be usefully tapped for insights by scholars of financial governance, as it has within the trade and environment literature (see, for example, Cerny 2010; Falkner, 2007).15 While regulatory preference heterogeneity flies in the face of our typical understanding (even our language) of private sector advocacy, it may be a crucial component of regulatory policymaking. Examining the persistence of business conflict around financial regulatory issues, and the ways in which policymakers utilize this dynamic, are promising avenues for future research. Second, if we really want to acquire a substantive understanding of private sector influence in global financial governance, it is not sufficient to only examine instances when private sector groups appear to get what they want. We need to consider a fuller range of cases other than just those that neatly conform to a popular narrative. The existing literature has done an excellent job of specifying the power resources available to private financial sector lobbyists, in particular the role of informational lobbying and close policy networks. Inasmuch as these power resources might be important necessary conditions for private sector influence, they are not necessarily sufficient ones. Scholarship on private sector influence in financial governance is still relatively underdeveloped and, in moving forward, scholars of IPE would do well to explore relationships within the financial regulatory community in more empirical depth in the future – and in so doing avoid what Underhill (2009: 350–351) has recently called ‘template theorizing’ whereby conclusions are normatively driven and pre-established (see also Blyth, 2009: 334). Such efforts would go a long way toward Watson’s (2007: 212) recent call to ‘look inside the “black box” of international finance’, through detailed empirical enquiry rather than simply remaining satisfied with existing narratives, as seductive and simple as they might be. ACKNOWLEDGEMENTS I must acknowledge the helpful feedback of Christopher Gandrud, Randall Germain, Robert O. Keohane, Kirsten Leng, Stefano Pagliari, Hans Trees 683

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and Robert Wade. I am grateful for the support of both the Social Sciences and Humanities Research Council (SSHRC) and the Centre for Analysis of Risk and Regulation (CARR) for financial assistance which enabled my interview-based evidence.

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NOTES 1 Interview subjects are referenced here anonymously, with either a ‘P’ indicating a private sector representative, or ‘R’ for an individual from a regulatory agency. 2 Spain was invited to the BCBS in 2000, and did not formally participate in the BCBS before this point. 3 I note that their study consists of not only the BCBS, but also the IOSCO. 4 For a definition of capture emphasizing the systematic nature of influence, see Baker (2010: 628). 5 On the other hand, Basel II was not fully implemented in the US, i.e. at the epicenter of the crisis – though it was in other significant countries, such as the UK and Germany. 6 While some accounts depict a national level of influence transmission (e.g. Baker, 2010; Wood, 2005), this particular pathway of influence is not explored in this article because the intention here is to focus exclusively on the transnational level of influence. 7 Based on interviews with regulators 36R, 74R, 79R, 82R. Some of this research was later published in Jones and Mingo (1999). See also English and Nelson (1998). 8 This contention had existed within the IIF since at least 1995. See IIF (2007: 61–62). 9 Interviews with regulators 95R, 79R, 73R. There were also problems within the predictability of these models. 10 Interview with regulator 93R. However, within the Bundesbank the spirit of inducting from private sector practices was clearly being entertained around this time (see Blochwitz et al., 2000). 11 There simply was not enough convincing data on credit risk models’ sensitivity to structural assumptions and parameter estimates. See BCBS (1999a: 1–2). 12 Thus, for example, for a AAA-rated exposure, the Basel II IRB model required almost 100 per cent more regulatory capital compared to the bank’s own internal models, such as that of CreditRisk+; for AA this figure was 80 per cent, etc. 13 For an illustration, see BCBS (2004: 60). 14 I note that these banks were not generally of a different tier than the rest of the IIF; indeed, the 10 banks in the ITWG were on average slightly smaller than the largest 10 banks in the rest of the IIF Working Group on Operational Risk at the time, in terms of an average of total assets. 15 Indeed, early progenitors of regulatory capture (e.g. Stigler, 1971) posited suggested that business unity was condition. I am grateful to an anonymous reviewer for pointing this out.

NOTES ON CONTRIBUTOR Kevin L. Young is currently a Postdoctoral Research Scholar at the Niehaus Center for Globalization and Governance at Princeton University. His research focuses

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on global economic governance, the politics of financial regulation, and economic interest groups in public policy.

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