Auditing and bank capital regulation

C apital regulations for banks are based on the idea that the riskier abank’s assets are, the more capital it should hold. The international1988 Basel Accord among bank regulators set bank capital require-ments to be a fixed percentage of the face value of assets. The only risk variation between assets was based on easily identifiable characteristics, such as whether it was a commercial loan or a government debt. The proposed revision to the Accord, commonly called Basel II, is an attempt to improve upon the crude risk measures of the 1988 Accord. Under Basel II, banks use their internal information systems to determine the risk of an asset and report this number to regulators.1 In an ideal sense, the proposal is eminently sensible. After all, who knows the risks of a bank’s asset better than the bank itself? But a serious problem exists in implementation. What incentive does a bank have to report the true risks of its assets? Without adequate supervision and appropriate penalties, the answer is, “Not much.” Analysis of Basel II has been primarily focused on setting the capital requirements, commonly referred to as Pillar One of the proposal. But good capital requirements mean little if they cannot be enforced. For this reason