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<!-- left column start --> <td width=17 bgcolor="#FFFFFF"> <img src="/images/clear_dot.gif" width=17 height=1 alt="" border="0"> </td> <td width=400 bgcolor="#FFFFFF"> <font face="Arial, Helvetica" size="-1"> &nbsp<p> <FONT COLOR="#00000" SIZE="2" FACE="arial"><h3>Risk Capital Rules: Basel IA heralds change in direction</h3> <FONT COLOR="#000000" SIZE="2" FACE="arial">by <a href="mailto:edblount@astecgroup.com?subject=Padoa-Schioppa_March04_ABABJ">Ed Blount</a>, contributing editor </FONT><p>

Facing a rising chorus of “whoa” from bankers and Congress, the regulators agree to try to level the Basel II landscape with revisions to Basel I

<FONT COLOR="#000000" SIZE="2" FACE="arial">To the European banking establishment, 2005 will be known as the year of the American community bank. At a fork in the road toward capital reform, America’s 8,000 or so small bankers turned the wheel of their regulatory bus off the autobahn down which European bankers had been leading them ever since the introduction of the Basel II reforms in 1999. At the same time, American community bankers also succeeded in changing bus drivers, as they took the keys from the regulators and handed them over to members of the U. S. Congress. <p> And just as the European Parliament was shifting into high gear by enacting the Capital Requirements Directive on Sept. 28, 2005, thereby requiring each of its banks and investment firms to adopt the Basel II standards starting in January 2007, Congress decided to take it’s foot off the gas pedal. <p> Not that America’s bankers had been snoozing during the five-year journey and suddenly awakened: the number and intensity of their questions had been rising almost from the outset. A few banking leaders stood in the aisles and demanded a Congressional review of the Basel reform process just as soon as the results of the third “field test” or Quantitative Impact Study (QIS 3) were announced in early 2003. A year later, when Ohio congressman Michael Oxley chaired oversight hearings in the House Committee on Financial Services, their numbers had grown to many more than a few bankers, including some at large banks with specialized, fee-based service lines, and they complained vehemently that federal regulators were ignoring the competitive implications of the proposed rules. Stung, federal regulators agreed to stage their own U.S.-based test of the proposed global capital adequacy standards, known as QIS 4.<p> The results were also stunning. Just as community bankers had feared, the regulators found that global banks, those who would be following Basel II, might be able to slash their capital requirements on residential mortgage and small business loans by as much as four-fifths. Great concern was voiced by industry leaders about smaller banks’ ability to protect their markets in competition with global banks. In his April 14 letter to the four U.S. federal banking regulators, James D. McLaughlin, director of ABA’s Regulatory & Trust Affairs division, wrote:<p> “While the banking industry is generally supportive of the Basel II improvements, this new standard is likely to lead to significant competitive advantages for the large banking firms that adopt them. To maintain competitive balance within the industry, an appropriate update of the capital rule for the other approximately 7,800 banking firms is called for.”<p> The regulators agreed to update the 1988 risk-based capital guidelines (Basel I), by which all banks not covered by Basel II are governed. Changes to be considered were included in an Advance Notice of Proposed Rulemaking issued Oct. 20 with comments requested by Jan. 18.<p> The regulators proposal is meant to link capital levels to credit risk metrics by using a finer caliper for balance sheet assets. For example, the proposal adds four new risk weights to the current five, while recognizing collateral, loan-to-value ratios and external ratings; pushes the top risk weight to 350% from 200%; and moves certain late and non-accrual loans into the higher risk-weight categories. (The 26-page proposal can be viewed at the Federal Reserve website, at http://www.federalreserve.gov/boarddocs/press/bcreg/2005) The month before, on Sept, 30th, the U.S. regulators announced that implementation of the Basel II standards in the United States would be delayed for at least a year. In addition, a three-year transition period, instead of the originally planned period of two years, would be accompanied by more restrictive limits on the permitted capital savings reduction. As a hedge against catastrophic collapse of the industry’s capital base, the U.S. leverage ratio would be retained and no Basel II bank would be permitted to book year-to-year savings of more than 5% in required capital.<p> Way too complicated
 When the federal banking supervisors were summoned back to Congress on Nov. 10, 2005, this time to testify before the Senate Banking Committee, it was clear that everyone was of a single mind about the need for a new direction. In his testimony, Comptroller of the Currency John C. Dugan said that the QIS 4 test results had “raised real concerns among the agencies because it forecast substantial reductions in capital for Basel II banks, and substantial differences in capital requirements for very similar credits.” Smaller banks in urban and suburban markets explained to senators that global banks could easily undercut their prices, armed with the advantage of lower Basel II capital requirements. <p> There were also fears expressed in Senate testimony that dramatic consolidation in the banking industry could follow, if global banks were to use their newfound competitive advantages to begin swallowing local U. S. banks. Clearly, they argued, investors would allocate their own capital to the financial institutions that could generate the best risk-adjusted returns. Destruction of the world’s greatest banking system would follow in short order. <p> Witness after witness pointed out to Senators the impossibility of predicting the impact of such sweeping changes to banks’ minimum capital solvency rules. One witness pointed out that the regulators, in working the field tests, had themselves been lost for two months in trying to find a misplaced square root sign within the worksheets. Basel II, he said, is just too complicated. <p> With that, Congress drove right off the exit ramp, taking the entire Basel process in the United States, according to insiders, into a state of limbo. <p> When the public comment period on Basel IA ends this month, U.S. regulators will be faced with yet another challenge. They will have to determine the degree to which the elements of reform that they have positioned in the Basel IA regime will actually close the competitive gap with those banks that may be operating in the still-to-be-finalized Basel II regime. They will also have to decide if the resulting capital levels for the industry are sufficient to protect taxpayers in the next cyclical downturn. To help them decide, the regulators will conduct still another quantitative impact study (QIS 5), to be based on fourth quarter 2005 data, for which the results are expected in spring 2006. <p> Do we really want less capital?
The proposed solution to the problem of competitive imbalance seems to be one of providing access to similar capital savings for smaller banks, rather than adjusting the solvency rules to eliminate those savings for all banks. That’s because the savings in Basel II have been proposed as an incentive for the global banks to adopt more advanced risk management techniques. At this point, however, it’s unclear as to what degree, or even whether, smaller banks will be expected to adopt specific risk management techniques and technologies if they are to aspire to the same benefits. For those community bankers who argued that “capital requirements should be a function of risks taken,” senators may have wondered if the risk management function was only a secondary consideration. However, any such view would be unlikely to survive the regulators’ hand in the final equation. Nor would any member of Congress with memories of the U.S. thrift bailout or of the crises in less-developed countries be expected to underweight the importance of risk management.<p> In addition to shifting the political center of capital reform gravity to Congress, American bankers have succeeded in redefining the terms of the debate. The time-honored, asset-to-equity leverage ratio, a uniquely American regulatory instrument, is being proposed not only for Basel IA, but also for Basel II. In part, that’s because community bankers have argued successfully that the widely varying results of the field tests show that a leverage ratio is needed to “mitigate the imprecision inherent in IRB [internal rules-based] systems.” Between the lines, in passing, bankers have also dismissed the regulators’ original assumption, indeed a cardinal precept of Basel II, that bankers apply their economic and regulatory capital in separate, independent spheres of banking activity.<p> There’s now a general concession that, in the flex-balance-sheet world of 21st century banking, the metrics of regulatory capital can precede, influence, or perhaps even dictate the level of economic capital for some banks. Such a view alters the existing foundation of capital solvency supervision almost completely. <p> In earlier discussions of the possibility of competitive dislocations, supervisors have argued that banks set their strategies based solely on economic capital, which was assumed to be tied closely to the actual risks being taken by the bank. Regulatory capital, while a bulwark against financial disaster, had little direct influence on the competitive activities of banks. That’s a much more difficult position to defend in view of the huge capital reductions forecast by the results of QIS 4. Similarly, the original view of regulators that the new rules would reallocate, but not reduce the aggregate levels of industry capital is no longer considered defensible. These aren’t just academic considerations, even for global bankers, since the pendulum of change may swing heaviest and cut deepest in their own backyards. <p> 30 years later, it’s deja vu<p> In many ways, this is a twice-told story. After years of fruitless negotiations on a common set of capital standards, the original Basel accord was accepted only after a concerned U.S. Congress uneasily sensed risks to be rising in the domestic strategies of U.S. banks who had begun taking on risky assets to compete with global competitors “on a level playing field.” Then, after the 1984 collapse of giant Continental Illinois Bank, a landmark deal was struck by the Federal Reserve, Bank of England, and Bank of Japan which resulted four years later in the standardization of capital requirements for all global banks in G10 countries. That deal, originally known as the Basel Accord, and now called Basel I, was built around a standard formula for calculating banks’ capital ratios, relative to their risk-weighted assets. It is nothing short of ironic that an inability to close the deal on Basel II in the United States is based on a growing perception of similar global threats to domestic banks. Yet, the Basel process was supposed to end, not create, competitive imbalances. <p> The thread of paradox does not end there. In what may indeed be the ultimate irony, America’s community bankers are now voicing the same rhetoric about the possibility of competitive dislocations as that being heard from a most unexpected comrade-in-arms: the Finance Minister of the Russian Federation.<p> According to November testimony by community bankers, “Nothing could be more important to the future of the U.S. banking system than the capital requirements necessary to ensure the safety and soundness and economic health of the banking industry and in turn the broader economy.” Using almost the same words, Finance Minister Alexi Kudrin of the Russian Federation has opposed the customary World Trade Organization rules on open banking markets. <p> Russia has no limit on foreign banks’ ownership of subsidiaries in the Russian banking system, since those subsidiaries become Russian banks subject to domestic banking requirements—including the capital solvency rules. But Kudrin has asked American WTO negotiators to accept a ten-year phase-in of open branching by foreign banks, to permit domestic market adjustment after Russia joins the WTO. He believes that open branching would allow global banks, with their dynamic balance sheets and broader array of products, to exert undue competitive pressures on the embryonic Russian community banking system. As proof, Russians point to the neighboring eastern European banking systems, some of which are entirely dominated by foreign banks. <p> What is that old saying? “Politics makes strange bedfellows.” And so, evidently, do the global rules about competition in banking. <p> <strong><em>BJ</p></em></strong> </FONT><P> <hr> </td> </tr> </table> </body> </html>