Rebalancing the Three Pillars of Basel II

[...]This paper aims to fill that gap by providing a simpleframework for analyzing the interactions between the threepillars of Basel II. We start by offering a critical assessment ofthe academic literature on the three pillars,5 and argue thatnone of the existing models allows for a satisfactory integration of these pillars. We therefore develop in Section 3a new formal model that tries to incorporate the mostimportant criticisms of existing theoretical models of bankregulation. Section 4 shows that minimum capital ratios canbe justified by a classical agency problem, à la Holmström(1979), between bankers and regulators, even in the absenceof mispriced deposit insurance. We demonstrate in Section 5that, under restrictive conditions, these capital requirementscan be reduced if banks are mandated to issue subordinateddebt on a regular basis (direct market discipline). Finally,Section 6 explores the interactions between market disciplineand supervisory action and shows that they are complementaryrather than substitutes.