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  The reason Basel III is an ideal test for the power of material interests during the Great Recession is that the distribution of preferences reveals clear, cross-national preference divergence between the financial sector and governments.36 The public pressure to re-regulate financial institutions following the 2008 crisis was powerful.37 Hostility to large financial institutions spiked during the crash. Global public opinion polls showed strong, transnational demand for greater regulation of banks and other financial institutions. In July 2009, for example, majorities in seventeen of nineteen countries polled wanted a more powerful global financial regulator.38 At the same time, financial sectors in almost every country were implacably opposed to more rigorous standards. In the short term, banks were concerned about being asked to comply with tougher standards for liquidity and solvency at the exact moment when their balance sheets were the most precarious. In the long term, financial institutions opposed any regulatory requirements that would reduce their profitability.39 As the president of one US banking lobby characterized the financial sector’s attitude toward new regulation, “The gut reaction of the entire industry was of course we have to oppose, oppose, oppose, because it’s going to mean more regulatory burden on us all.”40 US Treasury secretary Timothy Geithner articulated governments’ preference divergence on financial regulation quite clearly in a 2013 interview with the Wall Street Journal, “We were changing the economics of finance in a very significant way. We thought it in the interest of the country; they thought otherwise.”41

  If sectoral material interests really explain what happened, then the financial sector should have been able to push global economic governance to maintain openness on its terms: light regulatory standards at both the global and national level. Indeed, this represents an “easy test” of the power of interest groups on global governance. As previously noted, both the OEP and historical institutionalism paradigms would predict the financial sector to exert an outsized influence over global financial governance. The financial sector is one of the most concentrated and well-organized interest groups in modern societies.42 According to Simon Johnson and James Kwak, this was particularly true in the United States: “By March 2009, the Wall Street banks were not just any interest group. Over the past thirty years, they had become one of the wealthiest industries in the history of the American economy, and one of the most powerful political forces in Washington.”43 In the other great powers, such as the European Union and China, the role of banks in the economy is even more outsized, and their strenuous lobbying efforts are not hard to identify. Furthermore, the revolving door of individuals moving between government and the financial sector has been well documented.44 Even in the absence of outright corruption, the promise of a lucrative private-sector position gives the government’s banking regulators an incentive to avoid offending the sector they regulate. Multiple scholars have argued that the Basel Committee on Banking Supervision was a regime that had long suffered from regulatory capture by the big banks.45 One would therefore expect this sector to capture the negotiation process and exercise significant sway over any new financial regulation. If, on the other hand, Basel III contravenes the financial sector’s policy preferences, it suggests that there are hard constraints on the ability of even powerful sectoral interests to alone explain how global economic governance functioned after 2008.

  The Basel III Negotiations

  Discussions on how to fix global banking standards began during the depths of the 2008 crisis. As early as the November 2008 G20 summit in Washington, leaders recognized that something needed to be done to address financial-sector regulation. The summit communiqué noted that “unsound risk management practices, increasingly complex and opaque financial products, and consequent excessive leverage combined to create vulnerabilities in the system. Policy makers, regulators and supervisors, in some advanced countries, did not adequately appreciate and address the risks building up in financial markets, keep pace with financial innovation, or take into account the systemic ramifications of domestic regulatory actions.” The G20 call for action was equally clear: “We will implement reforms that will strengthen financial markets and regulatory regimes so as to avoid future crises.” This included “intensified international cooperation among regulators and strengthening of international standards.”46 Every subsequent G20 communiqué included an explicit call to strengthen global financial standards.47 Even officials and bankers who had resisted more stringent capital market regulation before 2008 recognized that something had to be done. As former Goldman Sachs chief executive and US Treasury secretary Henry Paulson acknowledged in his memoirs, “Virtually everyone agrees that we have had inadequate regulation of banks and capital markets.”48 The question was: what regulations would be imposed to address this deficit?

  By July 2009, the Basel Committee had already proposed revisions to the Basel II framework to address post-crisis concerns about financial stability.49 At the Pittsburgh summit in September 2009, the G20 leaders’ communiqué called on the Basel Committee to augment the Basel II standard with additional provisions to ensure “internationally agreed rules to improve both the quantity and quality of bank capital and to discourage excessive leverage … with strengthened liquidity risk requirements and forward-looking provisioning.” That same month, the Basel Committee issued a press release articulating the “comprehensive steps” the BCBS would take to set new standards for banking regulation and supervision. Beginning in December 2009, the BCBS began issuing draft documents and requesting feedback as negotiations took place among the regulators.50

  The issues before the regulators were formidable. One question concerned how much additional capital banks would need to hold in reserve to guard against insolvency should another crisis unfold. In its initial press release, the Basel Committee stressed the need for a higher “quality, consistency and transparency” of the “Tier 1” capital held by banks. Tier 1 capital consists of retained earnings and funds raised from the issuance of equity. Under Basel II, banks were required to hold only 2 percent of their assets as Tier 1 capital. Regulators wanted to see enough of an increase in reserve requirements to prevent panic during another downturn. The larger a bank’s capital adequacy, the less likely it would find itself under duress if another financial institution went bankrupt. The lower the likelihood of contagion, the lower the level of systemic risk. Regulators also wanted to create countercyclical buffers of additional capital during boom times, as a check against excessive lending. Not surprisingly, banks wanted as minimal an increase in capital adequacy as possible, so as to maximize profits. Capital held in reserve cannot be loaned out or invested; the more banks have in reserve, the smaller their profits. On capital adequacy, banks and regulators had diametrically opposing preferences.

  A second issue concerned the relative liquidity of a financial institution’s capital buffer. During the 2008 crisis, a lot of bank assets that were nominally part of the capital buffer—such as mortgage-backed securities—proved to be useless because the market for them had dried up completely. As the Basel Committee noted in its December 2009 draft document on liquidity coverage, “The crisis illustrated how quickly and severely liquidity risks can crystallize and certain sources of funding can evaporate, compounding concerns related to the valuation of assets and capital adequacy.”51 Regulators wanted to ensure that banks held more liquid forms of capital—such as cash and government bonds—to hedge against a crisis. Liquidity comes at a cost to the financial institutions, however. The more liquid an asset, the lower the rate of return. Financial institutions therefore preferred holding as much of their capital in higher-yield, if less liquid, assets.

  By late 2009, the Basel Committee had crafted a basic framework for how to improve the regulatory framework. They proposed a strengthening of Tier 1 capital to be held by banks—although the draft document was silent on what the precise increase in capital adequacy should be. The BCBS also proposed additional countercyclical capital buffers during boom times to ward off procy
clical lending. They further proposed two new standards. The first was a leverage ratio to “contain the build-up of excessive leverage in the banking system.” The second new proposal was a global minimum-liquidity standard. This was designed to ensure that banks had enough liquid forms of capital to sell these assets and raise cash in markets even during a severe financial downturn.52

  Both the leverage ratio and the liquidity standard were new innovations for the BCBS. In pushing for these new standards, as well as for countercyclical capital buffers, the Basel Committee signaled a philosophical shift in its approach to financial regulation. In Basel I and Basel II, the emphasis had been on “microprudential” regulation—the principle that if each individual bank took steps to ensure the soundness of its own balance sheets, the entire financial system would be secure. The 2008 crisis had revealed the flaws in this approach. It was possible for each financial institution to act prudently at the firm level while promoting the buildup of risk at the systemic level. The procyclicality of the Basel II accord suggested the need for macroprudential regulation. The proposals for liquidity standards and countercyclical capital buffers were significant steps in this direction.53

  The evidence that the financial sector opposed Basel III en masse is straightforward. According to multiple surveys in the industry journal The Banker, the preferences of financial sector representatives shifted dramatically after the crisis. For the three years prior to October 2008, an average 44 percent of respondents held a negative attitude toward the expected output of financial regulations. In the four years after the collapse of Lehman Brothers, the bankers’ negative attitudes jumped to 73 percent.54 Five months after the BCBS first issued its proposed draft regulations, more than 270 comments had been received, and more than 95 percent of them came from financial institutions.55 Prominent banks, including J. P. Morgan Chase, BNP Paribas, Deutsche Bank, and Standard Chartered, warned that the draft standards would impose crippling costs on their firms and on the economy writ large.56 For example, Wells Fargo’s chief financial officer warned that “the cumulative financial impact represents a level of conservatism so extreme that it will harm the banking sector, banking customers and national economies.”57

  After the Basel Committee issued its preliminary draft regulations, financial sectors across the developed world responded by lobbying fiercely to dilute every element of the proposal. BCBS officials held multiple meetings with private banking representatives, coordinated by the banks’ principal lobbying group, the Institute for International Finance (IIF).58 The Economist characterized the negotiations at Basel as “the most vicious and least public skirmish between banks and their regulators.”59 In her memoirs, Sheila Bair, former chairperson of the Federal Deposit Insurance Coorporation (FDIC), characterized it as “a major battle” between the BCBS and the banking industry.60 Interviews with BCBS officials confirm that the banks devoted significant effort to influencing Basel III. In the United States alone, securities and investment firms spent a record $101.6 million on lobbying in 2010, attempting to water down the regulations in the proposed Dodd-Frank legislation as well as in Basel III.61

  Beyond private lobbying, the IIF also tried to frame the public debate by being the first to estimate the expected economic costs of Basel III.62 In June 2010, the institute issued an interim report, predicting that the macroeconomic impact of Basel III would reduce GDP by significantly raising interest rates. In the United States, Japan, and Europe, interest rates would rise by more than 130 basis points in the first five years after implementation. This spike in interest rates would create a deep drag on economic growth in the affected countries. The IIF estimated that annual growth in the first five years would be reduced by 0.6 percent, and that the cumulative impact over the first decade of implementation would equal a deadweight loss of 3 percent of the developed world’s output over the decade. Total job losses were estimated at 9.7 million people. In other words, the IIF predicted a massive hit for economies that were already weakened by the 2008 financial crisis. Some national lobbying groups went even further than the IIF. The French banking association, for example, claimed Basel III would lead to a 6 percent drop in France’s economic output.63

  But contrary to the regulatory capture argument, it appears that bank lobbying had almost no effect on the Basel III negotiations. In July 2010, the BCBS staff submitted its list of recommendations for review by its oversight body, the central bank governors, and heads of financial supervision. Later that month, the supervisors approved the changes. In September 2010, the BCBS approved the higher capital adequacy standards. The G20 signed off on the new standards at its November 2010 Seoul leaders’ summit, trumpeting the approval of Basel III as the summit’s primary achievement. At that point, private-sector analysts acknowledged that the core principles of Basel III were “here to stay.”64

  Basel III requires banks to retain 4.5 percent of assets as Tier 1 capital by the year 2019—a 125 percent increase over Basel II. It also calls for an additional 2.5 percent as a capital conservation buffer. National banking authorities were further encouraged to suggest that large banks hold an additional 2.5 percent as a “discretionary” capital buffer during periods of significant credit expansion. Basel III also created a leverage ratio—the ratio of Tier 1 capital to a bank’s total exposure—of more than 3 percent by 2018. Finally, the new standard created global liquidity standards designed to ensure that banks could function even when asset markets seized up. By 2019, banks would be expected to have a 100 percent “liquidity coverage ratio”—the proportion of “high-quality liquid assets” to the estimated net liquidity outflows over a thirty-day period of market stress. A net stable funding ratio proposed a similar 100 percent ratio of a bank’s available stable funding to cover estimated outflows over a calendar year.65

  On the whole, the approved Basel III accord does not jibe with a regulatory capture argument. To be sure, some national regulators wanted even higher capital adequacy levels than Basel III.66 Other, more radical proposals—such as a tax on international financial transactions—also fell by the wayside.67 Nevertheless, the final Basel III regulations approved by the G20 remained largely unchanged from the draft proposals of a year earlier, despite the intense bank lobbying. The IIF’s analysis of the new rules came to the same conclusion.68 One BCBS official told me about the IIF’s lobbying: “In all honesty I can’t point to any one area where they had any influence.” The media coverage also reflected a narrative at odds with interest-group capture. In September 2010, Felix Salmon of Reuters blogged that Basel III would reduce systemic risk and strengthen the international banking system, noting that “the Basel committees did a masterful job of depoliticizing the process as much as possible.”69 By October 2011, the Wall Street Journal concluded, “The tug-of-war between banks and regulators over post-crisis financial rules has so far moved in the watchdogs’ favor with banks largely failing to upend the tougher proposals in the U.S. and Europe.”70 Financial analysts concurred, noting that with the approval of Basel III, financial markets would punish banks that failed to boost their capital adequacy beyond the minimum standard.71 Numerous scholars agreed, concluding that the new Basel III standards represented an improvement over the Basel II standards in terms of preventing bank failures.72

  Market reactions to Basel III announcements also suggest that the financial sector did not get what it wanted during consultations with the Basel Committee. Meredith Wilf examined the stock market reaction at five major junctures in the formation of Basel III, from the initial announcement of new reforms in September 2009 to the issuance of the final set of rules in December 2010. She found statistically significant negative effects on the stock prices of the US banks that would be affected by Basel III. She concluded that “despite enormous lobbying pressure from the banking industry, this study suggests that banks were not able to capture the regulatory process in 2009 and 2010.”73 Given that US banks were better positioned to comply with Basel III than their European or Japanese counterparts,
it would be safe to conclude that the transnational financial lobby lost on Basel III.

  Why did the financial sector have such limited influence? Part of the reason is that global financial governance had significant reservoirs of expertise as well, which they were able to convert into greater authority.74 While the Basel Committee needed the banks’ proprietary data, they did not need the bankers’ expertise for most dimensions of banking regulation. For example, in interviews, Basel Committee staffers were very dubious about the quality of the IIF’s June 2010 impact study on Basel III. Other analysts report similar reactions from regulators, noting that American and European finance officials quickly discounted the IIF’s impact study.75 In contrast, when the Basel Committee’s Macroeconomic Assessment Group subsequently came out with its own quantitative impact study, national regulators viewed it as more credible. The BCBS committee’s study relied on more-sophisticated economic models and more-granular data than the IIF analysis, and had a larger staff. The conclusions of the Basel study also contrasted sharply with those of the IIF analysis. The BCBS estimated that the total cost of Basel III would be 0.34 percent in lost economic growth, a marginal amount compared to the estimated 2.5 percent gain in economic growth that would result from the financial sector’s reduced exposure to another systemic crisis.76 Independent public and think-tank analyses produced results that were much closer to the BCBS position than to the IIF position, further eroding the latter’s credibility on the issue. One BCBS official was particularly blunt in comparing the IIF and Basel Committee analyses: “We creamed them.”77