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Basel II or Ia? Questions Fed Chairman Ben Bernanke May Face
October 25, 2005

First, congratulations to CEA Chairman and former Fed Governor Ben Bernanke for being nominated to be the next Chairman of the Board of Governors of the Federal Reserve System. Our only comment on the nomination is that we hope that when President George Bush fills the two other open seats on the BOG, he will pick as well and at least one senior banker, preferably someone who has taken risk and understands the financial markets as a practitioner. Bernanke's colleagues on the Fed BOG have taken a beating on Basel II and could use reinforcement in the area of financial expertise, preferably a former CEO/CFO/CRO of a major financial institution.

During our swing through DC last week, we heard a lot of speculation as to when the next set of congressional hearings on the stalled Basel II capital accord would be held. We use the word "stalled" because officials of the Fed privately say that they are not sure whether Basel II will ever actually become regulation in the US due to heavy opposition on Capitol Hill and from the community bank lobby.

Several people on Capitol Hill asked what questions we'd ask federal regulators in the hearings on Basel II to be held in both the House and Senate, especially in the context of the debate between the hurriedly contrived Basel Ia proposal and the original Basel II capital accord that is being implemented by most major industrial nations. Our reponse is below along with some other comments.

What Basel II is and Is Not

To review, Basel II offers the largest banks an opportunity to reduce their capital requirements if - emphasis, if - they demonstrate competency in managing their businesses so as to accurately track projections for credit metrics such as Probability of Default ("P(D)"), Loss Given Default ("LGD"), Exposure at Default ("EAD"), Maturity ("M"), as well as a host of operational risk factors. The largest banks have spent the past three years and tens of millions of dollars developing new ways to measure these factors, including developing ways to internally rate each commercial or retail customer much as an outside rating agency or credit reporting bureau does today.

In short, gaining access to lower capital requirments under Basel II is not free nor easy, nor is it permanent. Under the Basel II proposal, the largest banks are given a reduction in the capital required under the Basel I floor if they demonstrate competency in modeling the credit and operations risks experienced by the bank, what is known as the Advanced Internal Ratings Based ("IRB") Approach. The Advanced IRB approach will be tested each quarter and subject to adjustment if the bank fails to accurately model its financial results.

Basel Ia is the poor man's version of the same exercise. It seeks to increase the risk-sensitivity of the capital measures which apply to smaller banks, using the same public data from the FDIC and Federal Reserve Board that IRA uses to generate the proxy Basel II indicators in the IRA Bank Monitor. The Basel Ia rule seeks to give smaller banks some additional leeway in terms of capital weightings by using external ratings and existing bank data to optimize risk sensitivity.

At the recent FDIC hearing on the proposal, Democrats on the FDIC board opposed the Basel II proposal on the grounds that it would drastically reduce capital requirements for the largest banks and place those not adopting Basel II at a serious competitive disadvantage. The regulators plan to develop and implement Basel Ia and Basel II in parallel and to narrow any differences between them "over time."

On October 20, 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--published an interagency advance notice of proposed rulemaking (ANPR) regarding potential revisions to the existing risk-based capital framework. IRA will be responding to the ANPR regarding Basel Ia, but in the meantime, here are some questions we think members of the Congress should ask the regulators, starting with the Federal Reserve Board:

Capital Adequacy

  • Do you believe Basel II should reduce the overall level of capital in the international banking system, reallocate the existing level among banks according to risk, or pursue come other macro capital objective?

  • If adopted into regulation, both Basel II and Basel Ia anticipate a reduction in the overall capital levels of banks, large and small. Isn't it true that tangible capital levels in banks, large and small, already have fallen in recent years and are near the floor of Basel I today?

  • Why do regulators believe that enacting rules that would reduce the amount of tangible capital required to support the business of all banks is advisable at this point in the economic cycle? Isn't it true that in 2005, executives of some the largest US banks have indicated a desire to "manage up" the level of tangible capital in their respective institutions?

Risk Management

    • Is it really possible for banks not participating in Basel II to achieve the kinds of improvement in risk management and financial results via Basel Ia that would justify a reduction in minimum capital levels?

    • Since the outside rating agencies generally only rate P(D) for public companies and then only to a 20% P(D), how as a practical matter do regulators expect the smaller banks to improve in areas such as P(D), LGD and EAD?

    • Is Basel Ia merely a political sop created by the regulators to placate the community bankers or is it really an effective way to improve bank risk management techniques?

    Basel Ia vs. Basel II

    • Are the concerns voiced by some of the smaller banks really valid when it comes to the regulatory burden of Basel II? What is the difference between a bank electing to adopt the foundation layer of Basel II and the Basel Ia proposal? Isn't it the case that all banks in the EU and Asia are going to be required to adopt the Foundation layer of Basel II?

    • How do regulators assess the long-term competitive impact on smaller US banks of allowing these institutions to opt-out of the Basel II process entirely?

    • Will a smaller US bank that does not adopt the Foundation level credit risk management practices in Basel II or the similar provisions of Basel Ia be more or less likely to be aquired by a foreign bank that is compliant with Basel II?

    Basel II: Advanced Internal Ratings Approach

    • Under the Basel II proposal, the largest banks are given a reduction in the capital required under the Basel I floor if they demonstrate competency in modeling the credit and operations risks experienced by the bank, what is known as the Advanced Internal Ratings Based Approach. How long do regulators expect that it will take for a Basel II institution to qualify for this Advanced IRB Approach?

    • What are the criteria which will be used to gauge initial and continuing compliance with the Advanced IRB Approach?

    • Is it possible that a bank qualifying for the Advanced IRB Approach could subsequently lose that rating if it does not accurately predict the P(D), LGD, EAD and operational risk factors affecting the bank's capital?

    National Interest: Large Banks vs. Small

    • Isn't it true that large, publicly owned banks are generally interested in reducing capital to assets ratios in order to increase ROE to infinity? Meanwhile, smaller banks seems to care less about ROE. Can you comment on these two world views and indicate which perspective should ultimately guide the Congress and other parts of the US government?

    The Sound of Inevitability

    There's a little bit of semantics at work here. We note that Europeans call the external ratings based version of Basel II "Foundation IRB" (FIRB). The level of compliance the EU is aiming for in 2007 and for global alignment not a bad model for a U.S. under Basel Ia given the fact that most of the smaller EU institutions will never graduate to Advanced IRB either. Nearest we can tell, globally the big fish are all on track to arrive at Advanced IRB at about the same time just before the end of the decade. The bottom line is still that in the end, the larger Advanced IRB institutions worldwide will have an equal and global advantage over their lesser foes. No amount of gerrymandering changes this.

    Questions? Comments? Or for additional information, please contact us.

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