The Three Pillars of Basel II: Optimizing the Mix in a Continuous-time Model

The on-going reform of the Basel Accord relies on three “pillars”: capital adequacy requirements, centralized supervision and market discipline. This article develops a simple continuous-time model of commercial banks’ behavior where the articulation between these three instruments can be analyzed. We show that market discipline can reduce the minimum capital requirements needed to prevent moral hazard. We also discuss regulatory forbearance and procyclicality issues.

Jean-Paul Decamps, Jean-Charles Rochet, and Benoît Roger

Bank of International Settlements

April 2002

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