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Basel II: Not Yet a Done Deal
December 15, 2003

The internecine wars over the proposed Basel II capital standards between the various bank regulators in Washington is boiling over. The Federal Reserve Board and the 30 or so largest banks constitute the pro-Basel II tendency, while the smaller banks (representing 99 percent of all depository institutions) are increasingly allied with the FDIC and Comptroller of the Currency in opposing the new capital standards.

The anti-Basel tendency led by the FDIC believes, quite correctly, that the new rules will leave the big banks undercapitalized and thus give them an unfair advantage over the community and regional banks.

The FDIC published a report last week saying that the Basel II regime will sharply reduce bank capital and hurt the ability of US officials to ensure the solvency of the largest banks. The FDIC suggests bluntly that the public interest is best served by retaining some sort of minimum capital requirement.

The crux of the debate is the fact that Basel II allows the largest banks to use their own internal risk models to establish the amount of capital required to support a given activity. This is like allowing the patients in the asylum set their own medication levels, but that is the stated intention of Basel II. The Fed, which has always been the apologist for the largest banks, is pushing the Basel II proposal as a way to boost profitability at the money centers by increasing the leverage they can carry on a given capital base.

A November 3, 2003 letter from the Independent Bankers Association to regulators states: �Community banks are concerned that Basel II may place them at a competitive disadvantage because the A-IRB approach will yield lower capital charges for residential mortgage, retail and small business loans, which are the bread and butter credits of community banks.� The letter confirms our belief that most U.S. banks will never implement Basel II and that a new wave of bank consolidation will result.

By no small coincidence, on November 3rd House Financial Services Committee Chairman Mike Oxley (ROH) and a number of other Republicans and Democrats also sent a letter to Fed Chairman Alan Greenspan and the other regulators. The 13-page correspondence echoes the concerns of the Independent Bankers, one of the most powerful industry groups in Washington, and threatens to block the proposal with �additional steps� if the Fed does not address the Committee�s concerns.

Other than the Financial Times, the big media has ignored the brewing dispute between the Fed and its clients among the large banks (including Fannie Mae and Freddie Mac), on the one hand, and the FDIC, OCC and the allies of the smaller banks on Capitol Hill. Fed Vice Chairman Roger Ferguson has been deputized by the Board of Governors as the public point-man in this political debate, while Chairman Greenspan has stayed above the public fray � a possibly fatal mistake.

Ferguson has assured the larger banks and European leaders that the objections raised by Chairman Oxley and other House members will not stall the �timely� implementation of the Basel II guidelines. But a spokesman for Oxley says that Fergusson and the Fed are mistaken. �We will insist that the concerns we have raised are addressed,� says the senior Committee staffer. The letter is signed by all of the Republican subcommittee chairmen as well as all of the ranking Democrats on the Committee. Expect hearings by the Committee on Basel II early in the New Year.

Opines one observer: �The Oxley Committee is trying to intervene on behalf of smaller banks in order to get more lenient treatment than they deserve. The Fed, on the other hand, looks like itʹs trying to satisfy its largest clients, including the GSEs, by validating the concept that the banksʹ internal risk models should be accepted at face value. This is a really dangerous idea. What comes through in the Oxley letter is that the Committee is more concerned with �competitive equity� than getting workable capital standards. Baring some compromise by the Fed, there is a good chance that Basel II will be killed by the Congress and replaced by modifications to Basel I.�

The Fed has apparently misjudged the mood of Chairman Oxley. While domestic concerns continue to play out in Washington, the EU�s banking sector moves slowly but steadily forward with Basel II. If the U.S. effort is stalled by big bank vs. little bank bickering, the structural advantage of European banks in terms of capital allocations versus U.S. institutions will be significant. And if Washington fails to equip the largest American financial institutions to compete globally, it won't be anyoneʹs fault but Alan Greenspan�s.

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