Though the coming Basel II rules are expected to let large banks hold less capital behind mortgage loans, a new Federal Reserve Board study concludes that small banks would not be put at a competitive disadvantage.
The study, by Wayne Passmore, Diana Hancock, and two other Fed economists, asserts that large banks set their mortgage-loan pricing not by regulatory capital rules but by secondary market requirements. Fannie Mae and Freddie Mac buy mortgages from banks, and the government-sponsored enterprises will only purchase the loans if they meet certain standards, including specific capital levels.
The Basel II rules, in the works since 1998, are an attempt by regulators around the world to update the original capital standards that were issued in 1988 by the Bank for International Settlement’s Basel Committee on Banking Supervision.
Only the 20 largest U.S. banks are expected to use the new rules when they go into effect in 2008, but officials from smaller banks have argued that Basel II would lower regulatory capital levels, giving big banks a leg up. So last June, the banking agencies said they would consider making simultaneous changes to the original Basel standard to address those competitive concerns.
The new 79-page study’s conclusion fits squarely with Fed Vice Chairman Roger W. Ferguson’s 2003 comments that capital rules play little role in how loans are priced, but some observers are not convinced, especially when it comes to the price-sensitive mortgage business.
“If one group of banks has a significant competitive advantage over others, they will exploit it,” said Rob Strand, the chief economist at the American Bankers Association. “The problem with that approach is, by the time … [regulators] realize it, one group of banks has been able to grab another group of banks’ customers, and they are very hard to get back.”
“The typical community banker still suspects that there will be a cost advantage to Basel II,” said Chris Cole, the regulatory counsel at the Independent Community Bankers of America. “I don’t think that the fact that we’ve had a recent Fed study is going to diminish that skepticism or concern, particularly as there are two other studies that seem to contradict it.”
One study, out in January, was written by two former Fed researchers, Paul Calem and Jim Follain, who left the central bank last year, shortly after senior officials rejected their initial findings. Mr. Follain and Mr. Calem concluded that lost market share could cost smaller banks $1 billion a year of net income. They predict that mortgage specialists will be hit hardest, because it will not be as easy for them to diversify.
In their 60-page study, Mr. Calem and Mr. Follain pointed to Mr. Ferguson’s comments that Basel II would cause loan prices to change “not very much, if at all.” The paper argued that Mr. Ferguson “may be mistaken.”
Mr. Calem and Mr. Follain declined to discuss the new Fed study. Mr. Passmore did not respond to an e-mail requesting comment, and a Fed spokesman would not comment.
Finally, three economists at the Federal Reserve Bank of St. Louis wrote an article for the April edition of its Regional Economist magazine that said community banks should pay attention to Basel II because of the potential mortgage price disparity. The article was not a full-fledged study like the other papers, but it does track the Calem/Follain conclusion.
In the magazine’s introduction, William Poole, the St. Louis Fed’s president, wrote that Basel II banks “may be able to offer more competitive lending rates” than other banks. “Banks not operating under Basel II, then, may have to look for loan opportunities that are not affected as much by the new approach.”
Depending on how risky the loan is, Basel II could require capital backing equal to 2% to 4% of the loan balance, or roughly one-quarter to half as much as current rules require. But Basel II could lift the capital required behind other types of assets, such as commercial loans, and these larger banks would have to hold additional capital for operational risks. Still, trade groups say small banks specializing in mortgage lending might not be able to reposition themselves quickly enough to absorb price changes.
Kathleen Marinangel, the president and chief executive of McHenry Savings Bank in Illinois, said the new Fed study may be a sign that regulators will make nothing but minor changes to the original Basel Accord. “I think that could happen, but I hope it does not.”
Throughout the new Fed study, “they say Basel II banks will have a few basis points’ advantage,” she said. “This is such a highly competitive business. An analogy would be having four gas stations on a street corner. If gas at one is a few cents cheaper, how many people are going to go to the higher-priced gas stations?”
Ms. Marinangel said regulators have been tight-lipped about how they plan on changing Basel I, despite attempts from the industry to mold the standards. Mr. Strand predicted that regulators would be more likely to wait until they see actual evidence of a competitive disparity before they change the rule.
The agencies are slated to release next month the findings of their fourth survey of Basel II’s expected impact. Then in June they will propose the final Basel II rules as well as whatever changes may be made to the original Basel rules, or a Basel 1.5. Comments on both will be due this year, and a final rule is expected in the summer of 2006.
Small banks do have allies at the other agencies, the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency.
Though the Fed plays a bigger role in Basel II negotiations — it has two Basel Committee seats to one each for the FDIC and OCC — when it comes to revising the original Basel rules, the other agencies have an equal say. And some officials have already sided with the smaller banks.
FDIC Chairman Don Powell has questioned the wisdom of “requiring very different capital across banks for identical assets.”
“As the head of an agency that … supervises many of our nation’s community banks, you can be sure I feel responsible for the quality of the overall package of proposed regulations that comes forward this summer,” he said at an industry conference last month. “You can and should hold me accountable for it.”
