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Basel II by the Numbers: Q1 2006
July 24, 2006

Basel II by the Numbers: Q1 2006

Institutional Risk Analytics has released its latest report, Basel II By the Numbers, for Q1 2006. This report presents public data Basel II credit benchmarks derived from the IRA Bank Monitor for more than 360 US bank holding companies ("BHC"). The IRA Bank Monitor provides 18 years of historical, portfolio-level performance and Basel II benchmarks for all federally insured depository institutions and includes BHCs which operated in the US market as of March 31, 2006.

Copies of the report, as well as individual profiles for all federally insured depository institutions featured in Basel II by the Numbers, are available for purchase on the IRA web site. The report delivered in Adobe Acrobat is $250.

Click here to register for an IRA Bank Monitor Cart account
and purchase the report.

The metrics presented in the Basel II By the Numbers report are based on "as filed" data from the Research Information Service ("RIS") of the Federal Deposit Insurance Corp and aggregate financial results for the subsidiary banks of the BHC, rolled-up into a "bank only" profile. The results of the Basel II and performance benchmarks in this report are grouped into four subsets based upon the BHC's asset size:

Large Holding Companies Over $10 Billion Assets

Mid-Size Holding Companies $1B to $10B Assets

Small Holding Companies $500M to $1B Assets

Micro Holding Companies Under $500M Assets

Of note, thrifts are not listed in this edition of the Basel II by the Numbers series. The Office of Thrift Supervision's policy controlling the FDIC research feed prevents transmission of portfolio and aggregate maturity data for thrifts in electronic form - even though the data is public. This makes it impossible to calculate a key Basel metric - weighted average maturity or WAM. We are addressing our observations to the OTS and look forward including this class of institutions in future editions of Basel II by the Numbers.

As with IRA's previous report, we are again using a test methodology that sets a very high hurdle in terms of capital adequacy by measuring the amount of Economic Capital ("EC") a firm needs and comparing this result with the bank's regulatory capital requirement. Under Basel II, EC is broadly considered to be the amount of capital a financial services firm's own internal risk assessment determines it should hold. Our benchmarking efforts continue to focus on a perspective that is an apparent opposite of that selected in the Quantitative Impact Survey 4 conducted by US regulators during 2005.

Specifically, this Basel II simulation poses the key question: How much Economic Capital does a given banking organization need in order to sustain severe losses on its risk bearing trading book and yet keep its external credit ratings stable? By focusing on the stressed scenario rather than the "best case" scenario highlighted in QIS 4, issue, we hope to shed light on the assumptions in the current debate over Basel II.

Here are some highlights:

** Whereas surveys conducted by US bank regulators suggest that under the Basel II proposal some of the largest US banks would need less EC than current regulatory minimum capital levels, the "fully stressed" simulation presented in this report suggests that some of the largest US banks would require significantly more EC than current minimum levels of Tier One Risk Based Capital ("RBC"), particularly during an economic downturn.

** For example, JP Morgan Chase (NYSE:JPM) would require EC equal to 5.4x current Tier One RBC in order to maintain its credit rating during a period of extreme stress -- which is defined as the institution sustaining significant, high double-digit percentage losses to the risk bearing portion of the trading and investment books. Under this same scenario, Citigroup (NYSE:C) would require 3.4x Tier One RBC, Bank of America 1.6x Tier One RBC and Wachovia Corp (NYSE:WB) 2.1x Tier One RBC.

The table below shows the results for the ratio of EC to Tier One RBC for the top ten largest BHCs in the US market as of March 31, 2006. The average ratio of EC to Tier One RBC for this group is 1.94, the median is 1.26 and the STDEV is 1.66.

Holding Company EC to Tier One RBC





















Source: IRA Bank Monitor

Notice that some of the largest banks in the US, such as US Bancorp (NYSE:USB), the subsidiaries of Royal Bank of Scotland (NYSE:RBS) and National City Corp (NYSE:NCC) were assigned a significantly lower ratio of EC to Tier One RBC in this simulation than some of their peers, perhaps suggesting that these franchises are pursuing different business model goals than the large bank group as a whole.

This methodology may seem arbitrary - and it is, intentionally so. The point of the simulation presented in this report is not to test compliance with the notional rules of Basel II, rules which are still not finalized at this writing, but instead to examine the safety and soundness of an institution compared with its peers using the valuable concepts upon which Basel II is meant to be based. This is, after all, what the risk management process is really about; understanding individual subject behavior, not to auto correlate a notional target point as seems to have been the result - if not the intention -- of the QIS 4 survey.

The good news is that the US banking industry does not seem to be suffering a capital crisis, as many of the opponents of Basel II would argue. As you would expect, our Basel II survey seemingly confirms that larger banks are riskier than mid-size, small and micro institutions. Indeed, the test results suggest that smaller banks are far better capitalized than their larger peers relative to the risks they take. These results also call into question current regulatory attention on enhancing risk management practices in smaller institutions. The attention of regulators would seem to be better allocated to the largest banks that are playing far beyond the margin in terms of the adequacy of their current capital.

The bad news is that the smaller banks especially and all US banks generally are probably more risky than their current Basel II profiles suggest. Despite the very low loan loss rates reported by US banks during Q1 2006, we continue to believe that bank loan default rates reflected in the FDIC RIS understate the economic reality by at least two full letter default rating grades. Thus an exploration of the possible EC requirements for banks during a future period of above-normal loan default rates seems both timely and of great significance to the risk community, regulators and the banking public.

Questions? Comments? [email protected]

The Institutional Risk Analyst is published by Lord, Whalen LLC (LW) and may not be reproduced, disseminated, or distributed, in part or in whole, by any means, outside of the recipient's organization without express written authorization from LW. It is a violation of federal copyright law to reproduce all or part of this publication or its contents by any means. This material does not constitute a solicitation for the purchase or sale of any securities or investments. The opinions expressed herein are based on publicly available information and are considered reliable. However, LW makes NO WARRANTIES OR REPRESENTATIONS OF ANY SORT with respect to this report. Any person using this material does so solely at their own risk and LW and/or its employees shall be under no liability whatsoever in any respect thereof.

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