The next version, Basel II, came in 2004 and was more extensive and refined, but also contained a source of the instability that ensued, at least in Europe. The new framework allowed the denominator of the capital adequacy ratio to shrink if the banks themselves estimated loss probability as low. And they did. The reported capital ratio could rise without increasing the real capital base. The financial crisis of 2008 was the biggest global economic setback since the 1930s. The banking sector had contributed to fuelling the economic upturn in the years leading up to the crisis, but triggered and amplified the downturn. The financial crisis brought with it a fiscal crisis in many countries, following the exact pattern of earlier crises as described by Reinhart and Rogoff.3 Euro area GDP is still below the pre-crisis level, and in some countries far below that level. The course of history should then be that we are now facing a new paradigm shift in the field of economics. So far, the Basel II framework has been replaced by Basel III. That is something, but can hardly be called a paradigm shift. That does not, however, exclude the possibility that greater concepts are in the making. It is food for thought that paradigm shifts –  2  Getz Wold, Knut, “Norges Banks samarbeid med statsmaktene, bankene og utlandet” (Norges Bank’s cooperation with the government authorities, banks and abroad), Kristofer Lehmkuhl Lecture, 1972.
Profitable projects no longer receive funding and the real economic costs may prove substantial. Individual borrowers do not take into account how collateral values will affect other economic agents, or in other words do not take into account the increased systemic risk they inflict on others. The parallel with environmental economics fits well here. When pollution has no cost, it becomes excessive. In addition to the contagion effects through loan collateral, costs may arise from the market failure that occurs in a crisis when some economic agents deleverage substantially and the real interest rate cannot be set sufficiently low to underpin aggregate demand for goods and services among other economic agents. This theory seems to fit well with the situation in the US and Europe after the financial crisis, where it has been difficult to set policy rates below zero. The result is amplification of the real economic costs associated with a financial crisis. Individual borrowers do not take into account that more credit during good times increases the risk that the economy ends up in such a situation. 4  BIS central bankers’ speeches  The theory can be briefly summarised. The financial system left to its own devices creates excessive debt and excessive risk in upturns and insufficient credit in downturns, giving rise to credit cycles that amplify fluctuations in the economy. That is the background for macroprudential policy of banks. Regulation should be tightened during goods times and relaxed during bad times. The mechanisms I have described are not new or unfamiliar.