The Institutional Risk Analyst: Community Bankers on Basel II: Foxtrot Oscar

The parochial political reaction in the US against the Basel II proposal has put Washington in the unenviable position of being a follower - at best -- in the global movement to craft a new bank capital adequacy framework. The reason is the basic reality of election-year politics and the growing likelihood of GOP rout next November.

For the same reasons that the Bush Administration is secretly preparing to declare victory and withdraw militarily from Iraq before next year's mid-term election, members of Congress are falling over themselves to defend powerful community bankers from the alleged predations of foreign banks, a threat supposedly enabled by Basel II.

In last week's hearings before the Senate Banking Committee, witnesses and members alike wrung their hands over the possibility of large foreign banks, advantaged by the Basel II proposal, picking off better capitalized community banks in the US. "Exhibit A" of the indictment against Basel II is the latest Quantitative Impact Statement ("QIS") 4 survey, which shows sharp decreases in US bank capital were Basel II adopted.� Click here to view a copy of the summary results of QIS 4 published by the FDIC�last month.

What few members of Congress or regulators seem to know or at least articulate is that most banks, inside or outside the US, will never qualify for the Advanced Ratings Based ("IRB") standard that would justify significant reductions in capital from Basel I levels. Even were the reductions in minimum levels of bank capital suggested by the QIS 4 survey correct, and most observers believe they are not, it seems fair to say that most banks outside the US would never experience such reductions.

Neither do the critics apparently notice that community banks in the US are very expensive at the moment and that foreign banks have an abysmal investment record in making acquisitions in the US banking market. The recent example of Banco Santander (NYSE:STD) taking a stake in underperforming Sovereign Bancorp (NYSE:SOV) hardly qualifies as a full-scale assault on America's community banks.

Yet many of the critics miss the practical reality driving adoption�of Basel II globally, namely that all banks around the world need to improve risk management standards. For some years now, regulators have been trying to quietly encourage smaller banks to improve risk management methods - the true purpose of Basel II.� The response so far from the US community bank lobby and their partisans in the Congress�is "Foxtrot Oscar."

Smaller US banks that do not embrace at least the foundation IRB approach of Basel II, however, are going to be canon fodder in the global marketplace for financial services. US community banks which refuse to adopt even the most basic, foundation IRB approach of Basel II will not just be at a disadvantage vis-�-vis the largest global institutions, but also relative to their smaller peers outside the US.

In the EU and other major industrial economies, all banks are being effectively required to adopt the foundation IRB approach so that a general improvement in risk management standards occurs over a period of 5-10 years. Indeed, if the US decides not to adopt Basel II at all - a very real possibility - the equally real disparity will be between, for example, smaller EU banks that are foundation IRB compliant vs. their peers among US community and regional banks which continue to adhere to Basel I.

Lower capital requirements is the ultimate reason why some of the largest banks pursue Basel II, but the benefit from a national interest perspective is improving risk management among all US banks and aligning capital levels with actual risks. As Federal Reserve Board Chairman-designate Ben Bernanke told the Senate Banking Committee today, "Basel II or something like it appears to be necessary," but the Congress appears to be a long way from allowing�adoption of the current Basel II proposal.

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