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Basel II Delayed: Complexity is Not Clarity
May 2, 2005

The legal implementation of the new Basel II capital accord has been delayed, according to a statement released by US bank regulators on Friday. The four federal banking agencies (the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, and the Office of Thrift Supervision) said that "additional analysis is needed before publishing a notice of proposed rulemaking (NPR) with respect to the U.S. implementation of the 'International Convergence of Capital Measurement and Capital Standards: A Revised Framework,' generally known as the Basel II Framework."

The announcement, which was first reported in the American Banker, took many bankers and investors by surprise and, in some minds, calls into question the assumption that Basel II will proceed at all. But officials at several of the regulatory agencies told The IRA late Friday that any delay in publishing the notice of proposed rulemaking for Basel II will be minimal - that is, weeks rather than months.

The delay seems to have been caused by the fact that several banks which reponded to the recently completed quantitative impact study (QIS4) showed required capital levels significantly below current Basel levels. According to the statement, the results "evidence material reductions in the aggregate minimum required capital for the QIS4 participant population and significant dispersion of results across institutions and portfolio types." We can guess which banks were the outliers in the study, but in deference to our sources, we'll let readers figure it out for themselves. Click here to read the statement.

The results of the QIS4 study illustrates the problem we have been predicting for some time, namely that the excess complexity of the Basel II risk measures is giving participating institutions a free hand to present their risk profiles in ways that understate their required capital levels, while at the same time affording critics an opportunity to attack the many admirable aspects of the Basel II Framework.

One key insider tells The IRA: "The QIS4 study is meant to be a starting point for assessing capital adequacy. But some partisans in Washington, who work for some big banks that are not advantaged under Basel II, are trying to use the QIS4 results as a pretext for killing the whole deal. The capital levels indicated by QIS4 are meant to be a minimum, not the maximum, but opponents of Basel II see blood in the water and are doing a good job of obfuscating these details in order to further a larger agenda."

The Basel regulators, driven by the academic economists at the Fed's Board of Governors and the Bank for International Settelements, have created a reporting structure that is so complex (and, at times, internally inconsistent) that it gives the more aggressive members of the banking community free reign to game the system. In this regard, at least, critics such as former Comptroller John D. Hawke Jr. are correct when they say that the models used to generate the QIS4 results "have not been tested."

Risk Measures vs. Transaction Specific Factors

Consider an example from the Basel II template of how the regulators and the banks themselves are turning the process of measuring credit risk into a hopelessly muddled mess - precisely the outcome that some of the largest banks hoped to achieve. The regulatory guidance for calculating Exposure at Default or EAD is shown below:

EAD = max {0, (CE + .4 * PFE + .6 * NGR * PFE - CA)}

CE = current exposure
C = current value of collateral
CA = volatility adjusted collateral amount = (C-C*HC)
PFE=Potential future exposure.
HC = haircut appropriate for the collateral type, adjusted for minimum holding period, 10 days for OTC derivatives.
NGR = net replacement cost to gross replacement cost ratio.

EAD measures how much a bank can loose when a borrower defaults, essentially the remaining unused percentage of the committed credit line. The risk to the bank is that a borrower could access these amounts and expose the institution to additional losses just before filing bankruptcy, for example. A bank's ability to contain this exposure via contractual covenants varies by loan or line of credit type, but the basic exposure is quantified by the CE measure.

Even though EAD is one of the more straight-forward calculations in the Basel II framework, the addition of the "risk adjusted" factors to the basic CE measure gives banks enormous leeway to manipulate their risk profile to suit their business needs. For institutions heavily involved in CDOs or sub-prime lending, a serious outlier in terms of EAD can be "managed" by manipulating what are essentially secondary factors to give regulators an innacuate picture of the bank's overall risk profile. While the regulators are guilty of over-complicating the Basel II template, it is the large banks which have added the additional factors to calculations such as EAD in an attempt to gain maximum advantage, thus last week's announcement of a delay in publishing the Basel II notice of rule making in the Federal Register.

IRA's Bank Monitor benchmark for EAD uses the simpler CE definition tracking exposure based on measuring outstanding unused commitments that all classes of obligors can access the day before they belly up. Allowing banks to include transaction-specific measures in the basic calculation of risk mesasures such as EAD is like allowing EDGAR filers to "adjust" their reported financial results using data that belongs in the footnotes. Instead of allowing banks to muddy the risk picture by including the additional factors shown above, regulators should instead start with the basic CE measure, then allow banks to privately make their case regarding the final treatment for capital adequacy purposes. To do otherwise is not only bad risk methodology, but bad public policy.

Click here to see the year-end 2004 Basel II factors for the largest US banks using the current data from the Federal Deposit Insurance Corp. Note that Citibank and Fleet National Bank are the only two banks with assets > $100 billion with EADs over 100% (using the CE measure without including any mitigating factors). In our view, CE has a far greater value to regulators and investors as a measure of risk when displayed alone, without the inclusion of mitigating factors. This same comment can be applied with equal force to the entire Basel II proposal.

Bachus Legislation Gains Momentum

Some observers in Washington are trying to use the delay in Basel II as a pretext to suggest to gulible members of the media that Basel II will be killed. More significant and worrisome to the regulatory and investment communities, however, is the possibility that Basel II will proceed with the current level of complexity, but with the added dimension of political interference by the Congress. Unless the proponents of Basel II adjust their strategy and focus on getting the basic risk measures in place in simple, easily understandable terms, then we believe that the opponents will use the unduly complex structure of the current proposal to attempt to block adoption of the entire Basel Framework or politicize it in such a way as to make the end result useless or worse.

Representative Spencer Bachus (R-AL), chairman of the House Subcommittee on Financial Institutions and Consumer Credit, has introduced legislation in the House (H.R. 1226 ) "To establish a mechanism for developing uniform United States positions on issues before the Basel Committee on Banking Supervision at the Bank for International Settlements, to require a review on the most recent recommendation of the Basel Committee for an accord on capital standards."

Passage of the Bachus legislation, which already has 34 co-sponsors, will essentially kill Basel II and make the entire process of reporting bank risk factors an expression of how much money the big banks pour into the pockets of politicians. Under the bill, if the various bank regulators are unable to agree on a common position on Basel II, then the views of the Secretary of the Treasury would prevail, a possibility that should frighten even the most vociferous opponents of the new capital accord.

Proponents argue that the legislation is necessary to ensure that all of the regulators have an equal voice in the Basel II process, but the reality is that the criteria listed in the review sections of the bill would effectively kill the process. For example, the legislation mandates that the Office of Thrift Supervision would have an equal voice in the Basel process, this even though no thrifts are likely to participate overtly in Basel II (however, all banks that participate in Shared National Credits will be required to report internally using the Basel II credit metrics).

With the rest of the world working feverishly to align their banking systems to work together under Basel II it seems foolishly insular for the Republican-controlled Congress to pursue legislation that is not ultimately in the national interest. Further decoupling our bank regulatory system from the rest of the world only serves to accelerate the day when America's ability to influence international regulatory policy comes to a screeching halt.

Of course, it may be that Bachus and his colleagues from both parties may just be grandstanding so that they can induce the various constituencies involved, including the community banks and S&Ls;, to fill up the collection plate for the 2006 mid-term election. Such is the logic of Washington. To summarize our view of the current atmosphere on Capitol Hill, we quote Mark Twain: "Suppose you were an idiot. And suppose you were a member of Congress. But I repeat myself."

The full Committee is expected to hold hearings on the Bachus legislation on Basel II on May 11th and the co-sponsors include the ranking members of both parties. Unfortunately, we doubt whether any members of Congress or their staff understand risk management or the Basel II proposal well enough to argue these points. Our sister publication, Washington & Wall Street, will attend the hearing and report on the event in full.

Questions? [email protected]

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