Banks and the Coronavirus Crisis: A Study in the Success of Soft Law

By Saranya Das Sharma
​Saranya Das Sharma​ is a junior studying English in the College of Arts & Sciences and Operations, Information and Decisions at Wharton.

Twelve years ago, the world was in the throes of a similar crisis as the one before us today. Although there was no global pandemic, the recessionary scenes seem eerily familiar: staggering unemployment, government bailouts and an uncertain economic recovery. However there is one key difference- no major bank has become insolvent. A large part of this can be attributed to one of the world’s largest soft law mechanisms- the Basel III Capital Accords, which are a product of the aftermath of the previous crisis.

The Basel Accords are a set of financial regulatory mechanisms set by the Basel Committee on Banking Supervision in 1980 and has faced three sets of modifications since then [1]. What’s unique about the Basel Accords are that they are a soft-law framework. Soft law is defined as a set of “principles, agreements and declarations that are not legally binding” [2]. Despite functionally acting as a recommendation, the Basel Accords have been adopted by around 100 jurisdictions, including major financial powerhouses like the United States and EU, as well as other G20 countries [3]. Soft Law has often faced the criticism of being unenforceable and flimsy, however Basel III has proved this wrong.

The current form of the Basel Accords, known as Basel III, is the most stringent of its predecessors. It includes various risk management requirements, such as a minimum leverage ratio (equity/assets) of 3%, different capital adequacy ratios (equity/risk weighted assets) for different categories of debt, based on how risky they are, as well as ratios for long and short term debt to make sure that banks stay liquid [4]. Moreover, globally, systemically important financial institutions (G-SIFIS) must retain additional capital requirements. Such requirements did not exist in 2008, which meant that G-SIFIS like Lehman Brothers defaulted, which further led smaller banks that didn’t have enough liquidity to also fail.

One of the most unique elements of Basel III is the inclusion of a ‘stress test’, where banks are given a hypothetical worst-case scenario and have to remain adequately capitalized enough under that scenario to pass the test [5]. Situations similar to or worse than the 2008 financial crisis are given to banks who must ensure that they can pass. This is one of the elements that helped them weather the financial storm brought about by the coronavirus pandemic, since they were already practicing for these worst-case scenarios. Moreover, the largest banks that were most likely to cause a financial contagion had a larger cushion to fall back on. Interestingly, the Fed insisted on stress tests even this year, albeit with different requirements. 

Why is this legally significant? In essence, it is a soft law regulation which has long been distrusted. Critics of soft law state that it fails to work because of the lack of enforceability. The GATT, perhaps the largest example of soft law, has been violated many times. However, international financial regulation is dominated by soft law. Basel III seems to show that in times of crisis, soft law works. Hard law, with its complex web of regulations, is often difficult to implement and stifling when international in reach, as a country like Indonesia will have very different needs than the United States. Soft law creates principles that are universally applicable, thus encouraging global collaboration and industrial competitiveness by creating a more certain landscape for foreign companies. Moreover, implementation of soft law can be uniquely adapted to the needs of each country that has signed on, thereby allowing regulation and economic growth to go hand in hand. One of the most difficult parts of a soft law regime is retaining trust, because countries are not legally bound to comply with its codes - a component frequently abused. However, soft law gives countries frameworks that would otherwise take domestic banks ages to craft on their own, as well as help make their financial institutions more internationally competitive. These deals are almost always too good to pass up. Basel III’s success in preventing major contagion is a vote of confidence for soft law, increasing people’s trust in financial regulation, financial institutions and the system at large.

So perhaps the future of international soft law lies in frameworks like Basel III that consist of more stringent guidelines rather than the broad recommendations often found in UN principles. Regardless, the soft law core is just as important and can often have a much greater impact than hard law.

​​​​​​​​The opinions and views expressed in this publication are the opinions of the designated authors and do not reflect the opinions or views of the Penn Undergraduate Law Journal, our staff, or our clients.​

References
[1] “Basel Accords - Overview, Basel I, Basel II, Basel III,” Corporate Finance Institute, accessed December 1, 2020, https://corporatefinanceinstitute.com/resources/knowledge/finance/basel-accords/.

[2] “Hard Law/Soft Law,” ECCHR, December 1, 2020, https://www.ecchr.eu/en/glossary/hard-law-soft-law/.

[3] Stefan Hohl et al., “The Basel Framework in 100 Jurisdictions: Implementation Status and Proportionality Practices,” The Bank for International Settlements, November 23, 2018, https://www.bis.org/fsi/publ/insights11.htm.

[4] “Basel III: International Regulatory Framework for Banks,” The Bank for International Settlements, December 7, 2017, https://www.bis.org/bcbs/basel3.htm.

[5] “Federal Reserve Bank of Atlanta,” Federal Reserve Bank of Atlanta, accessed December 1, 2020, https://www.frbatlanta.org/cenfis/publications/notesfromthevault/1312.

​Photo by Scott Graham on Unsplash