Willing suspension of disbelief delayed response to financial dangers.

Public filings of 20 big banks disclosed as early as October 2007 the large quantities of subprime mortgages on their balance sheets and the asset-backed securities in the special investment vehicles ("SIVs") that kept assets off their balance sheets in a technical sense. No later than December 2007 it should have been clear that write-downs of these assets in the range of at least 20% would be required and that that would seriously threaten the solvency of some banks. In the case of Citi, a 41% write-down of these assets would make it insolvent. Neither regulators nor investors seem to take notice or to care. Michael Pomerleano has the story in this Financial Times post.

Pomerleano also points out that international agreements "virtually encourage the creation of off-balance sheet instruments that contributed to the subprime crisis." A recent PBS special hosted by Niall Ferguson, The Ascent of Money, makes the point that SIVs were pioneered by Enron, made its financial statements opaque, and led to its spectacular downfall.

Pomerleano continues:

Until recently I was not fully aware of the glaring deficiencies of Basel II. In December 2008 I read a compelling book written by Daniel Tarullo, President-elect Barack Obama's nominee to the board of governors of the Federal Reserve.

In Banking on Basel- the Future of International Financial Regulation (Institute of International Economics, October 2008) [book summary here], he points out that: "Thus, there is a strong possibility that the Basel II paradigm might eventually produce the worst of both worlds—a highly complicated and impenetrable process (except perhaps for a handful of people in the banks and regulatory agencies) for calculating capital but one that nonetheless fails to achieve high levels of actual risk sensitivity".

Tarullo notes as well that the Basel Committee itself implicitly acknowledged in spring 2008 that the revised framework would not have been adequate to contain the risks exposed by the subprime crisis.

To add to the irony, it appears that the institutions that failed were Basel II compliant.