Breaking ranks with the international banking community, U.S. banking agencies announced in late 2005 that U.S. banks will be granted an extension to the January 2007 deadline for Basel II compliance by the Bank for International Settlements, the governing body of the world's central banks.
In May, the Basel Committee announced plans to maintain the most recently proposed capital-adequacy guidelines, which will decrease reserve levels for internationally active, diversified institutions based on the adopted approach to credit and operational risk. U.S. banks now have until January 2008 to adhere to the new cross-border capital adequacy mandates, plus an additional three-year transition period, while other global institutions will be required to comply by early 2007. The staggered compliance dates introduces a host of complex issues and competing interests for regulators and financial market participants.
Embraced as a common policy initiative among Group of 10 countries, the Basel I accord was proposed in 1988 to harmonize cross-jurisdictional credit risk in traditional commercial banking, and to establish a basis for the calculation of regulatory bank capital to be maintained against this risk. In the nearly two decades since Basel was introduced, global banking has undergone seismic change in size, geographic scope, technology use and breadth of available products and services. Basel is being expanded to cover credit, market and operational risk. Basel II brings a much greater level of granularity in the assessment of creditworthiness among obligors.
The goal is to align global capitalization standards with current banking practices. This, in turn, will help minimize the potential for regulatory arbitrage-including known instances in which banks have leveraged certain assets, such as credit derivatives, to exploit weaknesses in Basel I's risk weighting system. Ultimately, it is envisioned that a similar system will be extended to other financial intermediaries, such as insurance companies.
Basel II promotes three mutually reinforcing standards: 1. Minimum risk-based capital set-asides; 2. Supervisory review of an institution's capital adequacy and internal risk measurement methodologies; and 3. Market discipline through disclosure in order to promote sound banking practices.
In countries outside the U.S., all banks will be required to comply. In the U.S., guidelines will be mandatory for financial institutions with $250 billion or more in assets or $10 billion or more in foreign exposure. A second tier of U.S. banks that meet the Basel standards may have the option of participating. And regulators have proposed a more limited set of requirements, termed Basel Ia, which will apply to all other banks.
When Basel II was first proposed, it was presumed that the world's largest banks would have a leg up given their vast resources, including historical risk databases. In fact, the biggest banks faced the greatest challenge because of the difficulty aggregating enterprise data like default rates and loss-given-default statistics, particularly in the wake of U.S. banking deregulation. Indeed, participating global banks have spent millions of dollars scaling the Basel II implementation curve, and compliance costs will undoubtedly rise as Basel II applies new methods for measuring and managing risk across a firm's varied business lines.
In late 2005, the Basel committee issued an updated and ostensibly "final" Basel II framework, as well as a modified version of the amendment to the capital accord. The revised guidelines will rely on banks' internal risk systems as well as data supplemented and verified by regulators and credible third parties. For instance, the proposed modifications include expanding the use of external credit ratings as an indicator of credit risk for externally rated exposures.
Regulators are still addressing competitive concerns raised by smaller banks with fewer resources to implement Basel II's more complex risk-based methodologies. Many of the same smaller U.S. institutions contend they will be placed at a competitive disadvantage due to lower capital requirements of the large institutions adopting Basel II. U.S. banking authorities have indicated they will closely monitor any reduction in regulatory capital arising from Basel II for the larger banks and say the intermediate framework of Basel Ia and a phased-in implementation schedule will allow firms with simpler organizational structures to take advantage of emerging vendor models to bolster internal efforts at significantly lower costs.
In Basel II, the committee elevated the role that external credit ratings and ratings information will play in determining appropriate capital reserve levels for financial institutions. The committee proposed incorporating banks' internal ratings and external bond ratings to calculate bank risk-weighted capital requirements.
For instance, Standard & Poor's uses a number of methodologies to rate the creditworthiness of obligors and debt issues, which can be applied to assess unrated obligors to enhance visibility across a bank's balance sheet. This makes extensive credit and risk databases more powerful by increasing transparency, reflecting the way credit officers think, and helping to solve their validation problems in accordance with new guidelines.
As firms begin the necessary legwork to implement systems and processes in keeping with the new accord, one major factor contributing to the revised U.S. plan was the most recent in a series of authentic impact studies sponsored by the Basel committee on banking supervision. The initial studies found that most banks would require more capital to cover credit, operational and market risk, results that were heavily dependent on the specific mix of credits in each bank's portfolio. Some banks protested the results, which implied less cash that could be put to work in the markets. Quantitative impact study four, sponsored by the committee, recalibrated the risk-weighting curves. Based on the revised calculations, the majority of international banking supervisors found the need for regulatory capital wasn't as high as projected.
Some market participants say that in trying to satisfy banks that will be required to participate in the accord, Basel committee members may have overreached their mark. The lowered capital-adequacy threshold appears low against S&P's default experience based on the weighting and credit quality of assets.
Some U.S. regulators agree. Speaking before the U.S. Senate Banking Committee in mid-November, U.S. Federal Reserve Board governor Susan Schmidt Bies says QIS4 was fundamentally flawed because data was collected at a particularly favorable point in the business cycle, and reflected asset portfolio, risk-management information and models during one of the best periods of credit quality in recent years.
U.S. regulators further contend that Basel II fails to leverage appropriate risk-measurement methodologies, including distinct risk weights for diversified assets. This point is key, given the complex nature of global banking.
In addition to lowered capital reserve levels, QIS4 found a much greater-than-expected dispersion of risk across banks with similar portfolios. This counterintuitive result called into question the efficacy of Basel II for calculating and weighting risk, particularly vis-?-vis concentrated versus diversified portfolios.
U.S. broker-dealers that fall within the aegis of the new banking law will be required to adopt Basel-compliant capitalization standards under the purview of the SEC. Brokerage reserve levels were initially set at 99 percent or more of 10-day value-at-risk. Some argue the proposed VaR-based models are already outdated, and that more sophisticated methodologies are needed.
With the lines between the banking and trading book increasingly blurred, one challenge will be assessing risk that straddles multiple risk categories in the Basel regime, such as credit, market and operational risk. Take, for instance, a "fat finger" trade, which is when a trader intends to buy one currency and sell another, but presses a button and inadvertently executes the wrong trade. Before he can reverse it, the market may move against him. Is this a market or operational risk event? Regulators are working to resolve Basel's diversification and risk-allocation issues.
As Basel members continue to collaborate in refining Basel's risk-measurement and risk-management methodologies, some complain that the emerging standards are so arcane, it will be exceedingly difficult to implement them. Countering these concerns, regulators say Basel II must reflect the technologically advanced and sophisticated quantitative solutions used in many of today's global banks.
U.S. compliance rules are set to be finalized by the third quarter. Supervised testing of the Basel II guidelines is scheduled to begin in the U.S .in January 2008. In the meantime, banks continue to lack clarity on what will be expected of them.
Even regulators concede that making the necessary enhancements to risk-measurement and risk-management systems, including developing robust historical databases, is all the more challenging in the absence of final supervisory guidance.
Notwithstanding the challenges, the outcome for firms that implement the new banking standards will be an improved risk-management profile and potentially better bottom-line results. For instance, more reliable customer credit-risk information can help a bank make more profitable lending decisions.
If financial firms reap long-term gains despite the near-term pains of putting Basel II in place, it will be bitter medicine-but well worth the effort in the end.
