The 496-page Basel II proposal contains two sentences that amount to a trapdoor for regulators.
Under the plan, regulators could freeze the required minimum risk-based capital at the nation's largest banks if in the aggregate it dropped 10%.
"The agencies are, in short, identifying a numerical benchmark," according to page 84 of the proposal's preamble. Regulators "will view a 10% or greater decline in aggregate minimum required risk-based capital … as a material reduction warranting modifications to the supervisory risk functions or other aspects of this framework."
So what's a "modification"?
In interviews, officials from three of the four agencies - the Federal Reserve Board, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corp. - agreed that they could freeze the minimum risk-based capital level required of the banks that will be forced to comply with Basel II.
While regulatory capital levels were frozen, the regulators would rewrite Basel II to strengthen it.
"The proposal expresses the commitment by the agencies to make regulatory changes during the 2009 to 2011 transition period if aggregate minimum risk-based capital requirements of Basel II banks fall by 10% or more," said George French, a deputy director of the FDIC's division of supervision and consumer protection. "Furthermore, at the end of the transition period, the agencies would reevaluate Basel II's impact on capital and be prepared to make additional adjustments if necessary to preserve capital levels and maintain competitive equity between Basel II banks and other banks."
Steven M. Roberts, a senior adviser in the Fed's division of banking supervision and regulation, compared the 10% limit to a warning light on a dashboard that indicates a car needs service.
Writing the Basel II rules has been anything but easy for the agencies.
Ten years ago the Fed started the process of updating the original Basel accord, which was adopted in 1988 by most of the world's developed countries. Named after the Swiss town where the committee of international banking regulators meets, Basel was the first capital rule to base required levels on the amount of risk a particular institution took.
But as banking grew in sophistication, Basel became a crude tool companies learned to circumvent. Everyone agreed a new model was needed, and the Fed began its work. A few years ago the OCC and then the FDIC began to raise concerns that the new rule, known as Basel II, would let capital levels fall too far, giving the large banks a competitive advantage over banks that were not using Basel II. The new rules are intended to cover just those banking companies with more than $250 billion of assets or $10 billion of assets abroad. Banks nearing these thresholds would be allowed to comply voluntarily.
To address the competitive issue, regulators decided to write a simpler update for all other banks. This is known as Basel IA. The Basel II proposal was released March 30 and the IA plan is expected in May.
Last month's release is a revision to a proposal that came out in August 2003. Large banks are resigned to the idea that Basel II will not be a path to lower capital requirements, but many consider this latest version to be even worse, and the 10% ceiling on how much capital can fall is one reason why. Two more are extra capital to cover "operational" risks like a natural disaster or employee fraud and a proposed 1.06 "multiplier" that would require banks to figure out how much capital they needed under the rule's formulas and then add 6%.
"This is not a sensible standard," said Adam Gilbert, the managing director of risk management at JPMorgan Chase & Co. "Banks have a fundamental problem with trying to make capital risk sensitive while at the same time holding required capital roughly constant. Something has to give."
Most bankers would not speak on the record because they were afraid of angering their supervisors, but an executive at one of the banks on the bubble said, "We may be doing a lot of work and not gaining any flexibility."
"Are we really trying to get to risk-based capital?" another executive at a similarly situated bank asked. "You can have less capital, less risk, and less volatility," he said, but if regulators require banks to hold too much capital, they will simply take more risk and be more volatile.
Kim Olson, a co-head and a managing director of Algo Capital, a unit of Algorithmics in New York, said regulators are overreaching. The proposal "sets out so many other safeguards against banks' shedding capital that regulators should have taken comfort with the rules already in place," she said.
Regulators expect to finish writing the Basel II rule by yearend and have banks begin to comply with both Basel and Basel II in 2008. This "parallel run" is another belts-and-suspenders move designed to ensure capital does not drop too much too fast.
True compliance will begin in 2009, and a bank's actual capital - as opposed to its regulatory minimum - will be allowed to fall only 5% that year. It will be allowed to fall 5% more in 2010 and 5% more in 2011. So any one bank's actual capital could decline by 15% from 2009 through 2011.
This is separate from the 10% ceiling, which applies to the aggregate regulatory minimum capital held by all complying banks.
Regulators could trigger the review called for by a 10% drop as early as spring 2008 - at the end of the first quarter of the banking industry's parallel run. If the 10% trip wire is hit at the end of the transition period in 2011, regulators said that the transition may be extended.
The 10% ceiling represents a compromise between the Fed and the FDIC, which as the industry's insurer does not want capital levels at the big banks to plunge. A Basel II trial run in late 2004 showed that was a real possibility. Experts disagree how precise the fourth so-called Quantitative Impact Study was, but it provided enough ammunition for the FDIC to demand this 10% limit on a reduction in aggregate regulatory minimum capital.
