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Perspectives on Basel II: It's Time to Collaborate
November 15, 2006

Perspectives on Basel II: It's Time to Collaborate

Yesterday's on-the-record discussion at American Enterprise Institute �regarding Basel II presented a rare opportunity for some of Washington's policy makers and advocates to get together and talk. Between the panel and the three dozen or more current and former bankers and regulators in the room, this out of a crowd five times that number (including 50 plus attendees�from the DC and New York area chapters of Professional Risk Managers International Association), we heard a number of views that question whether Basel II as an exercise in enhanced risk based measurement ever will happen. But there also were expressed some very positive views that might lead to a solution to the current muddle.

George French from the FDIC presented the position of the most conservative of the federal bank regulatory agencies, making the twin points that the widely disparate results of the QIS 4 survey and a more general concern about the efficacy of contemporary modeling methods mitigates in favor of retaining a static leverage ratio to ensure "safety and soundness," the statutory language through which Congress�provides regulators authority�to restrain the business model choices of banks.

Given the FDIC's special role as guardian of the deposit insurance fund, one might expect them to take this view, but the hawkish perspective of this agency more and more approximates the center of the federal regulatory mindset.� Consistency and comparability of financial data are essential for effective supervision, thus French asks the obvious question about whether regulators could or should push convergence of risk modeling methods to the point necessary to achieve the benefits of comparability and consistency without being too prescriptive. But he then went on to note that validation of internal methods is a necessary condition for all banks to meet. Validation, it seems,�implies a certain degree of prescription.

Mark Tenhundfeld of the American Bankers Association echoed his organization's comments to the Congress that making banks retain more capital than their businesses require would lead to greater risk taking among banks and competitive inequality as high-risk banks gobble up smaller, higher quality community banks. We have trouble envisioning many foreign banks gobbling up smaller US institutions, especially�given the dismal record of such investments over the past half century, but at more than 3 times book value,�who is complaining?

When we hear members of the banking industry warning about greater risk taking by banks should static capital requirements be maintained, requirements that theoretically would be higher than the economic capital levels calculated by the bank's own management, our response is compared to what?

We think it hard to believe that banks would accelerate their risk taking beyond those ambitious initiatives already visible in the marketplace. �The shift in focus from the banking book to the trading book seems to us a secular trend driven by pressure from investors and a dearth of attractive asset allocation choices. Might retaining a leverage ratio influence this trend? Perhaps, but we can't buy the view that retaining a leverage ratio will, in and off itself,�result in a significant increase in the already pronounced shift by banks, large and small, toward the trading book.

Tenhundfeld also repeated the ABA's position that banks should have a range of choices in terms of regulatory flavors of Basel II, a position that we have trouble supporting. If the US cannot come up with a single, well-considered methodology for calculating economic capital that gives large banks credit for sophistication and smaller, conservative banks credit for being prudent, then we should forget this entire effort to revise Basel II. Like the rest of the world, we believe that the US should be moving forward with the implementation of the standardized approach to Basel II for all banks using public data as a point of analytical departure.

Gary Wilhite, Chief Credit Officer of Wachovia, took a similar line to Tenhundfeld and noted that confusion over the QIS 4 results�makes banks "very nervous" about how regulators are going to implement Basel II.� He likewise made the argument that with the retention of a static leverage ratio, smaller banks with higher relative capital levels would be gradually squeezed out of the US market in favor of a high-risk model. He calls this the natural result of setting an artificial economic threshold for bank capital levels.

Wilhite also made what we see as a stronger point that capital models always tend to err on the side of caution because banks don't want to be in the market when their stock prices are under pressure -- or see�regulators�impose prompt corrective action limits on their flexibility to manage their business. Skillfully using various climatic metaphors, he argued that setting adequate economic capital levels is about knowing in general what type of clothing you need to wear, both as a function of geographic location and the time of year. Predicting the temperature tomorrow, argues Wilhite, is less important than understanding the average temperature for the entire winter season in say WI vs FL.�

Peter Wallison of AEI argued in favor of using subordinated debt as a means of benchmarking bank credit quality, a proposal he earlier applied to the issue of assessing GSE financial condition.�� He�agreed with French's skepticism regarding the QIS 4 results and the models which underlie those results, and asked as a matter of national interest whether the regulators could in good faith embrace a modeling methodology that allows for the divergence of results apparent in the QIS 4.

With the banks as a group ultimately backing the deposit insurance fund, Wallison sees no rational argument to allow lower capital levels in banks so long as the existing models allow such huge apparent variability in results for bank risk assessments.� He noted in this regard regarding a slide in the French presentation showing�the QIS 4 survey that "7 banks in one test showed huge differences in how they rated the risk of the same portfolio (80% LTV ARMs of mortgagors with 660 credit scores). The range was 1% to more than 60%"

Perhaps the most important observation made by the group, though, came from Wachovia's�Gary Wilhite in response to a question about how to standardize the metrics to be used in Basel II and thereby ensure some degree of comparability and consistency. In response, the CCO of one of America's largest banks read through the list of collaborative working groups established between the EU regulators and the institutions they supervise�to work though the details of Basel II implementation. He then noted quite sadly that no such cooperative effort exists between US bank regulators and the institutions which they oversee.

We've been arguing for some time now that US regulators need to lead a public effort to understand and define the terms of Basel II, at first using public call report data to start the analytical process. Banks could then include non-public data in their privileged negotiations with regulators to finally reach an economic capital level that made sense to both sides and had been validated using a commonly agreed, consistent process. Some of these top level risk metrics developed using privileged data�would be disclosed publicly�in regulatory filings.

To us, if the Basel II effort is to be saved from technical irrelevancy and political discord, then we believe that the US regulators need to engage the banks in a far more aggressive fashion and start to work in a transparent, public way to establish some common expectations for the benefits of adoption and the metrics that will be used to establish capital requirements. This implies, we suggest, a collaborative public effort to model the Basel II framework for all to see and debate. The only question is this: do the US bank regulators based in Washington have the courage and skill to lead this discussion in the full glare of public scrutiny?

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