2. Financial Innovation and Basel II

The authors argue that the Basel capital rules not only were unable to contain the pressures building from globalisation, but they actually contributed leverage via off-bank-balance-sheet activity and the use of derivatives. The authors provide insights on the history of securitisation and how it works; and the history of derivatives and how the main derivative contracts operate. They then turn to how innovations with these instruments were used to exploit regulatory and tax arbitrage opportunities as banks ‘gamed’ the system to maximise their return on equity. The authors point out that finance is a system of promises and that it is the inability of regulators to treat promises in the same way that gives the banks endless opportunities to shift them around to create unacceptable risk.