WASHINGTON - Over the next two months the world's top banking regulators will put the finishing touches on an international risk-based capital agreement that has been in the works since 1998.
The road has been long, and success is not a given.
But Jaime Caruana, the chairman of the Basel Committee on Banking Supervision, said in a recent interview that he is confident that the so-called Basel II rules will become a reality.
"What we have done is a tremendous leap forward - a tremendous improvement - in what we had," he said.
While bitter fights on particular provisions have erupted over the years, the broad goals of Basel II have consistently been supported by both supervisors and executives as a way to more closely align regulatory capital with the risks being taken by individual banks.
"It's hard to like the whole package ... but it's going to change life as we know it in banking," said Andrew Kuritzkes, a managing director at Mercer Oliver Wyman & Co. "It's already having an impact on how banks think about risk and capital and profitability."
Maurice H. Hartigan 2d, the president and chief executive of RMA, the Risk Management Association, said Basel II will affect strategic decision-making. "For example, financial institutions will ask themselves, 'Do we want to buy this mortgage company, or do we want to sell it?' "
Citing "Basel fatigue," Mr. Hartigan urged the regulators to pick up the pace. "Everybody should sit down, square off on the differences, and come to a consensus view - the sooner the better," he said.
The next steps are two meetings in Basel, Switzerland, one scheduled for May 11 and 12 and then another in June, in which the 13 countries comprising the committee aim to resolve the remaining outstanding issues - the thorniest of which is how much capital ought to back unused credit card lines.
Soon after, the Basel Committee plans to release a "framework" outlining the new rule's parameters.
"When the framework is provided there will be a big sigh of relief among those who worked on it," said Roger T. Cole, a senior associate director in the Federal Reserve Board's division of banking supervision and regulation.
"But there's also a realization that there is a tremendous amount of work that needs to be done to implement the framework in this country."
While the rules will be similar across borders, each country will be allowed some customization.
For example, here in the United States regulators plan to adopt only the most complicated of Basel II's three options and only require compliance from banking companies with more than $250 billion of assets or more than $10 billion of total on-balance-sheet foreign exposure.
But before the U.S. regulators write their proposal, they will conduct their fourth study of the expected impact on bank capital levels. This "quantitative impact study" will occur in the third and fourth quarters. Using the results, the U.S. regulators plan to propose a new capital rule in late 2005 or early 2006, and accept comments on it until mid-2006. A final rule here is not expected until late 2006 at the earliest.
While the Basel Committee continues to insist implementation will occur in early 2007, that deadline seems destined to slip.
The U.S. agencies "have recognized the possibility that, even in the late stages, public comments might reveal flaws in the proposal that will need to be addressed before we can issue final implementing regulations," Comptroller of the Currency John D. Hawke Jr. recently told Congress.
Mr. Hawke has been a persistent critic of Basel II, arguing that it is too complicated.
Fed Vice Chairman Roger W. Ferguson Jr. has countered that the rule is only as complicated as the problem it is intended to solve.
The Federal Deposit Insurance Corp. and the Office of Thrift Supervision have also raised concerns, namely that the large banks' capital requirements should not be lowered so much that they pose a risk to the insurance funds or put smaller banks at a competitive disadvantage.
Disagreement among the agencies sparked interest in Congress, which has held hearings on the coming rule.
The Basel Committee has issued three drafts of Basel II over the past few years, making revisions based on feedback from the industry. The third version, called CP-3, came out a year ago. Comments were due last July, and the plan then was to have a "final rule" by yearend 2003. That deadline slipped to this June, but now the idea of a final rule has been replaced by this "framework."
Working on a parallel track, the U.S. agencies issued a 178-page "advanced notice of proposed rulemaking" in July 2003. They also issued 125 pages of guidelines on how to structure bank internal ratings systems for corporate loans and internal operational risk management systems.
Comments were due on the draft plan last November. But in October, in response to criticism from the industry, the Basel Committee agreed to make a fundamental change.
Until that point, the committee had insisted capital requirements had to cover both expected and unexpected losses. The industry had argued that expected losses were already reflected in the price of a loan. The regulators finally backed down and agreed to restrict capital calculations to unexpected losses only.
Basel II is an update of the 1988 Basel Capital Accord, which is considered ineffective in light of the advances in risk management made over the past decade. The updated rule is designed to rely more on banks' internal risk models to determine how much capital they must hold. It also will require capital to be held against operational risks for the first time.
Under the "advanced internal ratings-based" approach, or advanced IRB as it is called, some 10 to 20 U.S. institutions would calculate the following values for their various credit exposures: probability of default, expected loss in the event of default, expected exposure at time of default, and maturity.
Banks plug these values into models to calculate capital requirements. How they are applied depend on the type of credit. For example, retail exposures under the last draft would be divided into three categories: those backed by residential mortgages; unsecured revolving credits, including most credit card loans; and all other retail credits. But lenders have been pushing for changes, which the Basel Committee will consider at the May meeting.
Capital levels are actually just one of the three "pillars" that serve as a foundation for Basel II. The other two are supervision by examiners and new public disclosures designed to help investors impose more market discipline on the industry.
Here in the United States, regulators are still debating whether the banks that adopt Basel II must also continue to adhere to the minimum leverage ratio. That's a pure capital-to-assets ratio, and the current minimum is 4%. An FDIC study released in December found that Basel II would allow some banks to hold less than that. At a recent Senate Banking Committee hearing, Mr. Hawke backed the FDIC in arguing the leverage ratio should be maintained.
But testifying at the same hearing, Fed Chairman Alan Greenspan disagreed. "At the end of the day, they are mutually exclusive," he said of Basel II and the leverage ratio. But he noted there will be a transition period.
Basel II calls for a floor for the first two years of implementation, guarding against an immediate, dramatic dip in capital levels.
Bankers are hoping that after shelling out huge sums of money to build sophisticated risk-management systems, regulators will reward them with lower capital requirements. But supervisors have consistently said - and Mr. Caruana repeated it in the interview - that Basel II will not change the overall level of capital in the banking system.
Chris Maher, a partner in the financial services advisory practice at Ernst & Young, said banks will have a better fix once regulators finish the impact study. "It's premature to speculate what [Basel II] is going to do to capital levels," he said. "Until they finalize what the risk weights are, how do we know?"
Thursday: Five of the U.S. regulators working on Basel II.
