Watch Out for European Regulators' Basel Exams – of U.S. Banks

Basel has been the birth place of many bad ideas.

The inclusion of unrealized gains and losses into capital and the deduction of mortgage-servicing assets are prime examples of how the Basel Committee has jumped the rails of reason. But one critically flawed idea that could fundamentally alter how the U.S. interacts with international regulators has drawn surprisingly little attention: the Basel peer review program.

In the past, the Basel Committee has shied away from anything that looks like an enforcement role, such as robustly monitoring the capital positions of banks within the Basel countries. Unfortunately, this hands-off approach is starting to change. With little press attention, the Basel Committee agreed to put in place a rigorous framework to monitor and review members' implementation of Basel standards. In their own words, this peer review program is designed to "ensure" that Basel standards are adopted.

Even though few details are publicly available, the concept of this framework was endorsed by the finance ministers of the G-20 in October of last year. The monitoring framework’s first step was to issue a very general report on Basel implementation in member nations. The next steps are far more intrusive. A June 2012 report from the Basel Committee to the G-20 indicated that the peer review program will include foreign regulators conducting "on-site visits" to U.S. banks on U.S. soil.

In the past, I’ve taken comfort that U.S. regulators were generally reasonable and approachable. I believed they were a force that tempered the zeal of Basel academics and translated international regulatory theory into the realities on the ground in the U.S. I had faith that U.S. regulators would impose regulations that fit the diverse U.S. banking sector and our economy. This would all seem absent in the Basel peer review program.

There is a nagging problem driving the peer review program: Regulators on different sides of the ocean interpret the same rules differently. A more level playing field is important for internationally active banks. For years bankers have observed that the European approaches to risk-weighting assets grossly underestimates the risk of their portfolios. We have been watching that play out over the last few years.

Although this initial phase of the peer review program may seem beneficial because it seeks to keep European competitors honest, enforced convergence is a double-edged sword that raises worrisome issues for our country.

The Basel agreement is not a treaty. It was never ratified by the Senate or subjected to legislative review and sanction. The initiative to extend authority to examine U.S. banks to a team of foreign inspectors is not one that can be comfortably taken without congressional action.

I find it extremely troubling that foreign regulators will be in U.S. banks on U.S. soil to ensure they are complying with foreign standards, just because U.S. regulators felt it was OK. Technically, banks can opt out of foreign examiners entering their banks. However, when U.S. regulators have endorsed the program and even chair the Basel group running the program, few banks will view participation as voluntary.

Let us look at this from another, immediately practical aspect. Banking regulators recently received thousands of letters commenting on the proposed Basel rules. And members of Congress continue to weigh in. To what extent are those voices competing in the minds of U.S. regulators with foreign views of "peer" examiners who will have their own ideas about how much our country should be able to deviate from European counterparts in fashioning the final rules? Which sensible comments from U.S. voices will lose their emphasis among regulators who know that international teams will regularly arrive to examine how closely Americans are following the Basel line? Finally, how concerned will foreign examiners be with encouraging the competitiveness of the U.S. banking industry?

Maybe it’s time for someone other than U.S. regulators who have extended the invitation to foreign examiners to consider these critical questions.

Hugh Carney is senior counsel for the American Bankers Association.