The Basel II rules and, in particular, the way the United States proposes to implement them will have serious, unintended competitiveness and risk management consequences.
This is not to say that Basel I should be retained - it should not. Rather, it is to argue for a gradual approach to rewriting Basel II so that improvements are well understood, implemented across the board, and tested before additional refinements are made.
The current effort to do a complete rewrite of the risk-based-capital (RBC) rules that deals with almost every variation of all banking products around the world at one time is a classic instance of the perfect proving to be the enemy of the good.
This problem - best beating better - is of particular concern in the United States. The banking agencies on April 29 delayed Basel II implementation because of worries raised during the most recent quantitative impact survey. This delay is also postponing release of the rewrite of Basel I intended to allay growing fears about competitiveness.
Despite the Basel II and Basel I hold, banks are still being told in no uncertain terms to get ready for Basel II and decide if they want to opt in. Incredibly detailed guidance on even minor Basel II points is being issued, even though the entire rule remains up in the air. Frankly, this is the worst of all options; agencies are demanding readiness for a rule not yet written because of an effort to get all its details totally right, while all the market distortions from the current requirements - leverage first among them - remain unaltered.
Pick the low-hanging fruit. There needs to be quick implementation of the well-understood, agreed-upon parts of Basel II for all U.S. banks - not just the big ones. If the U.S. lags Basel II adoption abroad - as now seems likely - U.S. banks will face a serious competitiveness threat. Federal Reserve Governor Bies, in fact, noted this concern in testimony before Congress on May 11.
Analysts abroad are already characterizing capital as the "weapon of choice" in bank consolidation. Of course, a "bifurcated" adoption of Basel II here in the United States will pose comparable competitiveness problems for banks left out of the new capital accord. If Basel II has meaning - and one must think regulators believe it does, given the huge effort behind it and the billions it will cost - then it will meaningfully affect bank pricing and profitability, with concomitant competitiveness impact.
Some Basel II advocates have argued that the new rules will have no impact on merger-and-acquisition activity. This argument is even riskier than the one that regulatory capital doesn't affect line-of-business decisions.
After a bank gets out of a line of business because of RBC anomalies, it may be years before it reenters the business, if it can do so at all. However, once a bank franchise is gone, it's gone for good. Thus, any errors in bank RBC that result in consolidation mean that the banking system will stay as restructured, even if major policy objectives are jeopardized by this consolidation.
Lose the leverage standard. A leverage standard is incompatible with risk-based-capital requirements. It is understandable that banking agencies may wish to leave one in place as the complex, untested Basel II models are introduced, and some in the agencies appear committed to retaining the 10% prompt-corrective-action (PCA) risk-based requirement that also defines a "well capitalized" bank.
However, the current leverage and prompt-corrective-action thresholds are far above the right capital ratios for low-risk institutions and well beyond ratios that make sense as safeguards during Basel II implementation. If these ratios are retained under Basel II, then they should be considerably reduced under the authority already possessed by the banking agencies.
If the current leverage and PCA ratios are retained, a low-risk bank - one that held nothing but U.S. Treasury obligations or gold, for example - would run its Basel II numbers and arrive at an RBC ratio of 1%, but it would still have to hold the 5% and 10% ratios.
This would clearly be bad for competition. No other nation requires these ratios, so low-risk banks around the world would realize Basel II benefits. A Securities and Exchange Commission rule designed to impose Basel II on internationally active investment banks expressly ignores the leverage and PCA standards, so nonbanks would get a major edge over their big-bank competitors in asset management and other key lines of business.
These unique U.S. ratios also do not promote the safety-and-soundness incentives argued by their advocates. A high-risk bank would still be "well capitalized" in the United States if it met these ratios regardless of whether it otherwise complied with the higher Basel II RBC requirements.
Banks that stayed under Basel I, of course, would not even be subject to any higher RBC, permitting high-risk institutions to portray themselves as sound even though risk-based capital in fact was far below economic allocations or market expectations.
Recent studies have suggested that Basel II will lead to wide variability among bank RBC ratios, with some institutions experiencing significant drops and others coming under far higher regulatory capital requirements.
This is as it should be if the big reductions are at low-risk institutions. The underlying purpose of Basel II is to make regulatory capital promote safety and soundness. Thus, low-risk banks should experience low RBC. Trying to "top off" Basel II with fixes to the formulas or additional capital charges - like the proposed one for operational risk - undermines its important goals. The large drops in capital at some banks in the recent quantitative-impact survey must be understood in light of the limitations of that study (current strong economic conditions and the lack of stress testing, for example).
The big ouch in ORBC. The proposed operational-risk-based-capital charge (ORBC) is problematic not only because of its "topping off" role, but also because there is as yet no agreed-upon methodology to measure and manage operational risk.
Thus, an RBC charge for it would be arbitrary and unduly costly. In addition, these costs would create perverse incentives against proven forms of operational risk management - disaster preparedness and contingency planning, for example. Banks should not be diverted from vital qualitative risk management improvements into a quantitative exercise designed to make the Basel II numbers add up to 8%.
The proposed RBC charge for operational risk is problematic from a methodological and competitiveness perspective in addition to raising the serious risk of becoming a perverse incentive to effective operational-risk management. Operational risk management is, of course, critical to safe and sound banking - and it has become even more so in these post-9/11 days when threats to financial infrastructure have come from frightening new sources.
The first and most important way to ensure effective operational-risk management is a sound set of supervisory standards (Pillar 2 in the Basel framework). These can and should include an economic capital allocation for those forms of operational risk for which such a charge is meaningful, and disclosures can provide useful information to investors on this allocation and on overall operational risk- management (adding Pillar 3, market discipline, to the mix).
Advocates of the current Basel rules have argued that the "advanced measurement approach" is, in effect, a "Pillar 1.8." However, the fact that this approach excludes most risk mitigation - and that it is based on untested, debatable data - belies the certainty that must support a regulatory capital charge.
The more flexible framework finally included in the Basel rules also poses serious problems given the U.S. system of tough enforcement for institutions that do not pass muster as "well capitalized." No such standard applies elsewhere, with supervisors providing considerable latitude in the way RBC is measured and in what happens when totals fall below required amounts.
Supervisors should get considerably more experience with ORBC and ensure that international standards are comparable before U.S. banks are subject to a charge that - even while still at variance with economic capital - can carry a serious wallop.
