WASHINGTON - When Paul Calem and James Follain previewed a paper on the competitive effects of Basel II at an academic conference in Philadelphia a week ago, the brief spotlight signaled the end of a tunnel.
The two economists began work on the paper in 2003, while they were at the Federal Reserve Board, and the paper was widely anticipated once word had gotten out that it contradicted statements of Vice Chairman Roger W. Ferguson Jr. and other Fed officials.
In the year-plus since then, some things changed - the Fed decided not to publish the paper, and the economists left the central bank at separate times last year.
"It just didn't work out," Mr. Follain said at the Allied Social Science Association's annual meeting.
However, their conclusion - that there is a high probability Basel II will put the more than 7,000 banks and thrifts that do not adopt the new international capital standards at a disadvantage - has not changed.
Mr. Follain is now a private consultant, and Mr. Calem is a vice president for product research at LoanPerformance, a privately held residential mortgage data research company in San Francisco. They said they are in negotiations with an academic journal to publish the paper.
A Fed spokesman said it would not talk about the paper, nor would it publicly discuss personnel matters. He said the central bank has begun a study on the same topic, and it is due in several months.
When working at the Fed, Mr. Calem and Mr. Follain interviewed officials in late 2003 and early 2004 from at least seven different banking companies, including Citigroup Inc. and Bank of America Corp., about the competitive effects of Basel II, according to records on the Fed's Web site.
Their paper, tentatively titled "Potential Competitive Impacts of Basel II's Treatment of Residential Mortgages," says that residential mortgage portfolio capital levels will drop so significantly at the 20 or so U.S. banks that adopt Basel II that they will hold a major competitive advantage over all the other U.S. banks. The economists used the Basel formulas to calculate the new capital thresholds.
The 60-page paper even makes reference to a comment by Mr. Ferguson in 2003 that prices would change "not very much, if at all," in response to the revisions to regulatory capital standards.
In the paper, the former Fed economists argued that Mr. Ferguson's "thinking may be mistaken" regarding residential mortgages.
Mr. Follain and Mr. Calem argue that Basel II will drop the capital requirements for residential mortgage portfolios from 4% to around 0.5%. Banks that adopt Basel II will be able to use this reduction to lower prices on their loans, the paper says.
The economists also say the banks that do not adopt Basel II could lose $1 billion each year of net income because of a drop in market share and lower earnings because Basel II banks, such as Citi and B of A, will be able to lower their capital.
"Mortgage specialists would seem to be among those especially at risk of competition from adopters under the proposed implementation plan," they wrote. The specialists may end up taking on riskier asset categories or consolidating, the paper said.
In June, international bank regulators agreed on the new capital standards, and now domestic regulators have to decide how to implement them.
Basel II updates rules crafted in 1988 by making the capital requirements more risk sensitive. It is supposed to align regulatory capital more closely to the economic capital levels bankers hold based on internal models. Almost 10 banks will be required to adopt Basel II because of their size, and another 10 are expected to adopt it voluntarily.
Whether the adopting banks will gain an unfair upper hand when the new standards take effect in 2008 remains a hot question.
"I was really startled with their conclusions," Chris Cole, a regulatory counsel for the Independent Community Bankers of America, said after reading a summary of their findings. "I think that this dramatically shows the competitive edge that Basel II banks will have over the Basel I banks. I think it makes a strong case that changes need to be made to Basel II," as well as to the rules for banks that do not adopt it, "to achieve some sort of competitive equality."
Though Mr. Follain and Mr. Calem argue that Basel II will put small mortgage lenders at a disadvantage, many say the effect is too hard to measure.
James Wiener, a managing director at Mercer Oliver Wyman in New York, said other factors, such as the leverage ratio and the scrutiny of ratings agencies, could still keep Basel II banks from dropping their economic capital levels much lower.
"Given that the economic capital is more in line with regulatory capital, … [Basel II] will now be more in line with banks' own internal risk decisions," he said. "Changes will be less significant, because banks are already thinking along these lines. … But I do think it's inevitable that new risk-based capital regulations will change profitability and the industry dynamic."
The Federal Deposit Insurance Corp. and the Office of Thrift Supervision have argued for more than a year that banks that do not adopt Basel II could be at a competitive disadvantage if Basel II caused capital levels to drop.
A study the Fed published in February found that banks that adopt Basel II could hold a competitive advantage over regional banks in small-business lending, because of a potential drop in capital levels. The Basel II adopters might gain market share from regional banks, because they compete for many of the same customers and the Basel II adopters could have lower prices, the study said.
Small banks probably would not be hurt, because they have a more local customer base, the study argued.
But Fed officials have said several times that if competitive inequities surface, they would seek changes to Basel II. In June, the Fed and the Office of the Comptroller of the Currency agreed to revisit the existing rules, which will still apply to banks that do not adopt Basel II.
Regulators hope to propose the changes this summer at the same time that they propose regulations to implement Basel II in the United States.
But some say doing that will be difficult, because the agencies are devoting so many resources to Basel II.
"If the regulators were to wait for hard evidence that there was a disparity and for business to flow to the Basel II banks, it would be too late to make changes to reverse that disadvantage," said Jim Chessen, the chief economist at the American Bankers Association. "Business will have already been lost."
Almost 30 banks are participating in a study by bank and thrift regulators to measure the new capital levels, and many banks are expected to use the results to decide whether to adopt Basel II. Regulators have also said that they expect the study, called the quantitative impact study (or QIS-4), to reveal competitive problems.
