Basel III and Banking Efficiency

The regulation of an industry is generally motivated by market imperfections and/or (the risk of) market failures that can be extremely costly for the society. This implies that there are ‘gains’ associated with such regulation. However, regulation is not costless, and it is vital that the ‘cost’ of regulation does not exceed its expected gain. The deregulation of financial markets in many countries in the eighties was driven by this matter of course. Then the objective was to increase market efficiency by removing regulatory constraints. Even though new regulations in the form of capital adequacy requirements (i.e. the Basel I and II accords) were subsequently imposed, it is important to bear this in mind when further re-regulation of the banking industry is on the agenda in the aftermath of the 2008 financial crisis. Regulation of the banking industry is a balancing act! On one hand, as for example Lind (2005) points out, there are strong reasons for the prudential regulation of banks in order to mitigate their adoption of overly risky strategies; banks’ asset transformation through credit and liquidity creating activities is intrinsically vulnerable, and when the risk exposures of banks are high even minor disturbances in this transformation process can jeopardize the overall financial stability of the system. Moreover, as banks are the major providers of payment services, the solidity and soundness of these institutions are also crucial for trade and other payment- related activities in an economy.