Abstract: When Precision Turns Dangerous: Regulation, Knowledge, and the Financial Collapse of 2008

Marc Levinson

Abstract

International cooperation in financial regulation had disastrous consequences in the crisis that unfolded in 2007 and 2008. That cooperation began in 1975 with discussions between national regulators about ways to collaborate in overseeing international financial institutions. This process resulted in the Basel Accord of 1988, the first-ever international agreement on bank regulation. Around 1990, however, cooperation took a different turn, driven by the assumption that regulation was a scientific process and that careful analysis would reveal the optimal way to do it. The ensuing international agreement, known as Basel II, which was completed in 2004, contained very detailed rules linking banks' capital requirements to the riskiness of their activities, based on the assumption that regulators knew which types of activities were riskier than others. Large banks were allowed to determine their own capital requirements using proprietary models, which were thought able accurately to capture risks and potential losses from trading activities. All of this went badly wrong in 2008. Regulation driven by the exaggerated belief in scientific risk assessment made the financial crisis far more painful than it might otherwise have been.