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Basel II: The Gang of Four Shifts the Agenda
August 7, 2006

Basel II: The Gang of Four Shifts the Agenda

News reports suggest that the long delayed Basel II proposal will not be published for comment at the earliest before September of this year. The immediate reason for the latest holdup? The Federal Deposit Insurance Corp reportedly cannot manage to put the draft proposal on its docket for consideration before next month.

Global Risk Regulator reports that September 5 "is now penciled in as the date for the key Federal Deposit Insurance Corporation (FDIC) board meeting to consider the draft notice of proposed rulemaking, or NPR, on Basel II in the US." But sources close to the matter say that even a�September approval�may now be optimistic because of growing opposition from the largest US banks to the proposal's most ambitious requirements.

Last week, Citigroup (NYSE:C), JPMorgan Chase (NYSE:JPM), Wachovia (NYSE:WB) and Washington Mutual (NYSE:WM) met with officials at the Fed to press their case for adopting the simplest version of the Basel II proposal, what is known as the Standardized approach. The argument advanced by the "Gang of Four," as the four institutions are now known, was initially advanced in a joint letter to the Federal Reserve Board. Their position has been backed by the American Bankers Association, which is throwing its considerable political clout behind the simplified version of the Basel II proposal.

The original Basel II proposal permitted banks to select from three different implementation options: Standardized, Foundation, and Advanced. The Standardized approach is the least demanding of the three broad approaches to credit risk measurement enumerated in the original Basel II document and, as today, places the bulk of the burden for risk estimation on external credit bureaus. At present, there are only five Nationally Recognized Statistical Rating Organizations or "NRSROs" in the United States.

The most complex option, known as the Advanced Internal Ratings Based approach, essentially requires the largest banks to operate internal credit rating agencies in order to take full advantage of capital advantages that may accrue from Basel II. This is a costly and complicated analytical task many banks now consider to be below the cost-to-profit cutoff point. Whereas the Basel Committee originally thought only smaller banks would rely on the Standardized approach, it now appears that most US banks, if given the choice, would opt for the�Standardized approach that shifts the risk of credit analysis accuracy to third parties.

One official close to the situation�opines that the Fed initially thought that the letter from the Gang of Four was a bargaining ploy, a way to win concessions on the more complex Advanced IRB approach. But as late as Friday, several officials involved in the dialog between the Fed and the Gang of Four told The IRA that the Advanced IRB approach may be a dead issue, at least in the US.

The situation facing the Fed and other regulators with respect to Basel II seems to be going from bad to worse. The Fed clearly has political problems on Capitol Hill in gaining approval of the Basel II proposal, but many of these difficulties ultimately stem from the fact that the new capital accord is difficult to define and even more difficult to implement, particularly in terms that are meaningful to risk professionals.

The key point made by the Gang of Four to the Fed is the same issue we have highlighted over the past two years, namely that the Basel II framework is incompatible with the risk management procedures actually used on a day-to-day basis inside banks. As one senior industry observer told The IRA on Friday: "Basel II, as currently proposed, is so far behind the state of the art practiced by the largest banks as to be irrelevant."

The same official tells The IRA that were the Fed and other regulators to relent and allow the largest banks to opt for the Standardized approach, it might take several more months for the specific requirements to be codified and agreed by the three main US regulators. Such a delay could prove fatal to the entire process, our source continues, especially if the Democrats win control of the House of Representatives in November.

So how can the Fed regain the initiative and get the Basel II process approved? Assuming that US banks are allowed to adopt the Standardized approach, here are four principles that we recommend that the Fed manage as it tries to move the ball across the goal line:


The chief technical obstacle to approval of Basel II is that the proposal is complex and, at times, contradictory. The enables a woeful state where the community of academics and the self-interests of institutions have devolved into each bank arguing for unique treatment under the rules. That makes calculating a bank's capital needs and assessing it's operational safety and soundness entirely subjective.

Consider the dichotomy: The QIS 4 survey data indicates almost perfect risk cadence among institutions. Meanwhile, IRA's quarterly Basel II survey, Basel II by the Numbers, �based on data from the FDIC, portrays a banking industry that is a vast collection of differing business strategies. Somewhere in between these two analytical approaches lies a practical compromise that the banks and the regulators can accept.

To make Basel II work, the Fed needs to bring order to measuring�the four most significant areas of risk: trading, lending, investing and operations, and fashion a capital adequacy formula based on these different "buckets" that is easy to understand, validate and most important, explain.� Once this foundation is in place, the regulators can then work with the banks to fine tune the framework.

Public Transparency

The biggest obstacle to political approval of Basel II,�in our view,�is the accord's reliance on privileged, non-public financial data to gauge compliance and measure capital adequacy. If regulators, investors and risk professionals can't see the Basel II metrics or the data used to produce them, then there is no validation and no market discipline. And that means there is no Pillar III process, the element that the Bank for International Settlements�has always identified as being critical to making the framework viable as a global economic rationale.

While critical to regulatory compliance, investigation and enforcement, non-public data renders Basel II unwieldy to the point that the allied forces of compliance, markets, auditors, insurers are unable to play their assigned roles in enabling the framework.. US regulators should start the process by�moving towards the greater use of public, portfolio level data available from the FDIC and make the necessary connections to the other regulatory regimes so that a self-sustaining Pillar III process loop comes into existence.

Apples-to-Apples Comparability

Once regulators accept the concept of public data benchmarking for Basel II and establish public methods for calculating the key credit metrics such as Probability of Default, Loss Given Default, Exposure at Default and Maturity, the regulators can then calculate and publish preliminary Basel II benchmarks for the entire US banking industry. IRA's tests analyzing public data indicates that universal surveillance and benchmarking is achievable without imposing additional cost or administrative burden on the banks.� Indeed, the�automation of their reporting procedures via�the modernization of the Federal Financial Institutions Examination Council's�Central Data Repository �arguably enables this capability. Such an approach would not only greatly enhance the ability of the Fed to gain industry support for the proposal but would also head-off political opposition in Washington.

Expanding the Population of Qualified NRSROs

In our view, Advanced IRB Basel II in the United States remains a valuable national policy goal because it has the net effect of increasing the number and diversity of ratings bureaus by two orders of magnitude. There are serious issues that stem from too few sources of accredited credit benchmarking that we believe Basel II in Advanced IRB form would remedy.

As the US economy evolves�towards a greater proportion of sub-prime obligors in the total population, we continue to believe that a national mission exists for the SEC to broaden the population of NRSRO's to increase analytical accuracy and systemic adaptability and thereby�keep pace with�a changing�economy. This tool to promote safety and soundness and ensure the�solvency of the Bank Insurance Fund (BIF) is what we as a nation�really risk if Basel II fails.

Basel II Delayed: Complexity is Not Clarity

As we noted some time ago in The IRA, complexity is not clarity. Trying to gain approval of a Basel II proposal that relies on non-public data and is therefore difficult to illustrate in concrete, dollars and cents terms, strikes us as a tall order. It is not too late for the Fed to change course and adopt a proposal that enhances the current Basel I framework, using portfolio-level data already being collected by regulators.

Such a truly "foundation approach" would provide a framework that could be enhanced and expanded as new data sources and analytics tools were developed by the risk management community and the banks themselves. New regulatory disclosure such as Shared National Credits and expanded portfolio-level data could be gradually included in the capital framework to achieve many if not most of the objectives of the original Basel II proposal. By taking this route, the Fed would continue to rely on the principles of transparency and comparability which have made the US bank capital adequacy framework the envy of the industrialized world for over�a century and thereby save the Basel II process from what seems to be a increasingly doubtful future.

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