In 2004, the Basel Committee—the bank regulators from the major industrial nations—finished its revision of the international capital rules. That is, the old “Basel I” capital standard was officially replaced with “Basel II,” at the international level. Since then, participating nations have been developing national rules to implement the international accord. Bankers here have been awaiting U.S. rules, interested to see the impact on their banks.

What’s the same. It is important to first recognize what will not change. There will continue to be three capital standards: one for leverage (capital/assets); one for Tier 1 capital (capital/risk-weighted assets); and one for total risk-based capital (expanded capital/risk-weighted assets). The minimum requirements to be considered “adequately capitalized” for these three standards will remain at 4%, 5%, and 8%, respectively (5%, 6%, and 10%, to be classified as “well capitalized”). What qualifies as capital will remain unchanged. Finally, the leverage standard will not change in any way.

What’s different. What will change is that all banks will be given three options as to how to calculate risk-weighted assets. (Risk-weighted assets serves as the denominator for Tier 1 and total risk-based capital standards.) The options include: the existing Basel I approach; the Standardized Approach; and the Advanced Approach.

This menu of options will allow each bank to select a capital rule that best fits its operations.

A critical point of this new capital regime is the potential for disparity. Different banks with similar portfolios could, in fact, be authorized to hold unequal amounts of capital. This could create advantages for banks with lower capital requirements.

Advanced Approach debuts
U.S. regulators are now implementing the Advanced Approach for the dozen or so large U.S. banks operating internationally, which will be required to adopt this rule. These institutions will use their own internal models to risk-weight assets and other exposures. However, examiners will critically review each bank’s model and its results under strict guidelines. Each institution will also undergo critical supervisory evaluation of its need for capital in times of turmoil as well as its need for capital to protect against certain types of risk, such as market and reputational risks. Moreover, these institutions will have to make public some results from their internal models as a means for enhancing market discipline.

The U.S. rules for the Advanced Approach were finalized near the end of 2007. This year, the banking firms that adopt them can start a four-quarter “parallel run.” During that they will use both the old and new risk-weighted asset calculations under critical supervisory review. After that, with permission from supervisors, the banks can proceed through a three-year transition period, with capital decrements limited relative to the current capital standard. (In the first year, a bank’s risk-based capital requirement can decline by no more than 5%, relative to the Basel I rule, then 10% and 15% in the second and third, respectively.)

Though not required to adopt the Advanced Approach, other large institutions may. However, the cost of developing the requisite systems is very high—in the hundreds of millions—so most of the large banking firms that are not required to adopt the Advanced Approach are waiting.

Competitive effects weighed
A test run of the Advanced Approach was conducted in 2004. The results suggest that institutions that adopt this standard may be able to significantly lower their capital requirements for good quality credits when they are able to fully adopt the system starting in 2012. However, this test ran in a very benign economy; updated models using data from the current turmoil could lead to much higher capital requirements. Many bankers price off of capital costs, so there is concern that the large Advanced Approach banks could undercut the competition.

Bankers and ABA have pressed the regulators to proactively address this issue before the Advanced Approach rules go into effect. In response, the regulators came out with proposals for a modified Basel I system, nicknamed “Basel IA,” in 2005 and again in late 2006. In part, this version would have used loan-to-value ratios to risk-weight residential mortgages and rating agency ratings to risk-weight other exposures. After reviewing the proposals, few bankers saw enough there to be worth the trouble—although some appreciated factoring loan-to-value ratios for residential mortgages. Basel IA was scrapped.

Standardized Approach assessed
After abandoning their Basel IA plan, the regulators promised to develop the “Standardized Approach” out of the international Basel II accord. This is the standard that community banks in other countries will employ. U.S. regulators have promised to propose the new rules by March, consider responses, and have final rules in place before 2009.

Bankers will want to consider the proposal carefully. The international accord offers several national discretions. It will be important to tell the regulators how these should be incorporated into U.S. rules. If done effectively, the Standardized Approach can be an attractive alternative to Basel I that offers a more risk-sensitive capital requirement while avoiding much of the cost and complexity of the Advanced Approach.

As presented in the international accord, the Standardized Approach is similar to Basel I in that it calculates the credit risk part of risk-weighted assets by allocating assets and off-balance-sheet exposures among a fixed set of risk weights. The Standardized Approach differs by recognizing that different counterparties within the same credit category can present different risk profiles. It offers lower risk weights for: consumer and small business loans (in a well-diversified portfolio); prudently underwritten residential, multi-family, and commercial mortgages; and securities, loans, and guarantees from other banks, states, municipalities, and government-sponsored enterprises. Credits and other exposures to corporations are risk-weighted, based on rating agency ratings. Off-balance-sheet items are treated as under Basel I, but with the relevant exposure risk-weighted by the new rules.

An important add-on is a capital charge for operational risk. While this charge can be computed fairly simply as a fraction of net gross income, it remains to be seen whether the net result of the Standardized Approach allows banks with strong portfolios to reduce capital with minimal additional reporting burdens.

Outlook for regulatory changes
Bankers and ABA certainly support the development of a workable risked-based capital regime that more accurately aligns regulatory capital with risk. To this end, a menu of capital options is appealing. It gives all banks flexibility to choose among capital rules that suit their business needs and risk profiles.

Yet, it is important to minimize competitive inequalities that may result from different capital regimes. The regulators have promised to vigilantly watch for such inequalities, including a study in 2010, before the large banks fully implement the Advanced Approach in 2012.

Bankers and ABA will need to carefully review the forthcoming Standardized Approach to ensure these goals are met. BJ

The electronic version of this article available at: http://lb.ec2.nxtbook.com/nxtbooks/sb/ababj0108/index.php?startid=6

 

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