Basel II: A Contracting Perspective

Financial safety nets are incomplete social contracts that assign responsibility to various economic sectors for preventing, detecting, and paying for potentially crippling losses at financial institutions. Basel II forces signatory countries to reopen safety-net bargaining across affected sectors. This paper uses the theories of incomplete contracts and sequential bargaining to interpret the Basel Accords as a framework for endlessly renegotiating minimal duties and standards of safety-net management across the community of nations. Modelling the stakes and stakeholders represented by different regulators helps us to understand that inconsistencies were bound to exist in prior understandings about the range of sectoral effects that the 2004 Basel II agreement might produce. The analysis seeks to explain why, in the U.S., attempting to resolve what turned out to be intolerable inconsistencies spawned an embarrassingly fractious debate and repeatedly pushed back Basel II’s scheduled implementation.