WASHINGTON — For a rule with such a tortured past, it only seems fitting that the complex Basel II capital plan will begin implementation on April Fool's Day.
The process of finalizing the rule may have seemed like a cruel prank to many bankers, as negotiations between the industry and regulators have dragged on for almost a decade. The discussions nearly derailed this year before regulators issued the outline of a final rule in July.
And just when it seemed Basel II was heading toward a smooth landing, the subprime mortgage crisis and ensuing liquidity crunch have raised important questions about the new capital rules. Industry hopes for big capital cuts seem like distant wishful thinking as regulators grapple with bank models that have proven faulty. Now the agencies are considering whether capital should be held against off-balance-sheet assets, such as structured investment vehicles, that could create reputational risks for banks as the market continues to sour.
"The whole way in which the subprime mess evolved, and the flaws it exposed in risk management and supervision, has got to lead to some reconsideration of Basel II," said Daniel Tarullo, a professor at Georgetown University Law Center and a former economic adviser to President Clinton. "There has to be more scrutiny attached to how it's being implemented. The need for various safeguards has never been more apparent."
Despite the new concerns, regulators are determined to move forward.
"We've got a great outcome, and that's really the key as far as I'm concerned," Gov. Randall Kroszner of the Federal Reserve Board said in an interview. "Under Basel II, banks must hold capital commensurate with their actual risks. Different types of mortgages have different risk characteristics, and under Basel II, institutions have to take that into account. This sophisticated approach is exactly the right way to go in this time of tumult."
Comptroller of the Currency John Dugan also was enthusiastic about the final version of Basel II and said its phased implementation reassures him that the subprime meltdown and credit crunch will not threaten the plan.
"At the end of the day, I think we made real forward progress and got to a very good result," he said. "The fact that it's phased in with these safeguards is what gives me the confidence to say it's an appropriate way to proceed with what's going on immediately in today's market. It's not going to happen overnight."
Though Federal Deposit Insurance Corp. Chairman Sheila Bair has expressed concern that Basel II may not address all market woes, she says she "fully supports" the final product.
"There are outstanding issues, but we recognize the important role that strong capital plays. None of us want to damage that," she said.
The banking agencies signed off on the final version this month. It calls on the 12 largest domestic banks to use the so-called advanced approach to determine their capital requirements, despite industry efforts to use the less complex standardized approach.
Bankers will begin using Basel II in April on an experimental basis before abandoning Basel I entirely as soon as January 2009. Regulators must approve each bank individually before it begins to transition fully to Basel II in 2009, but even then institutions would be subject to safeguards aimed at preventing capital drops.
The advanced approach is intended to be more risk-sensitive than the Basel I framework, which gives simple risk weights to categories of assets. Banks will be able to use their internal models — which regulators must approve — to determine the level of capital an asset deserves according to the level of risk it carries.
The idea is that riskier assets should require more capital, while bankers should be rewarded for safer holdings with lower capital requirements.
That idea seemed attractive to bankers arguing for Basel II, but the credit crunch has exposed flaws in the validity of their models. Critics note that most models used data only from the past 10 to 15 years, ignoring periods when the economy was teetering as significantly as it is today.
"The fundamental problem is we are betting our financial system on models that are not tested and not reliable," said former FDIC Chairman William Isaac. "We've got very significant problems in real estate throughout the world that stem from everyone using models that didn't work very well. … What more bad things have to happen before we realize that models aren't working this year? Models are guides, but that's all they are."
Though they acknowledge that bank models are flawed, industry representatives say Basel II actually will improve the process by giving institutions the chance to gather data from the current problems to strengthen their capital formulas.
"If this recent experience does anything for us, it will give us data on what a stress situation is like, and it will make the models better," said Rob Strand, the senior economist at the American Bankers Association.
Regulators are well aware of the problems surrounding bank models and likely will exercise their supervisory authority to ensure the formulas result in adequate capital holdings.
"The whole point of this is we have a whole risk analysis division of Ph.D economists and others whose job it is to make sure the banks are using a rigorous process to validate their own models," Mr. Dugan said. "We have quite a hands-on, significant approach to that … which is one of the reasons we think that Basel II is a good thing."
Meanwhile, small banks remain concerned that Basel II may disrupt the competitive landscape.
For years the concern has been that Basel II would give large banks the chance to lower their capital levels dramatically, while small banks would be stuck with a less risk-sensitive approach. Regulators responded by developing Basel IA, which served as a type of middle ground between the established capital rules and Basel II. But the agencies killed Basel IA in July and are developing a rule that is expected to be released early next year and would allow small banks to use Basel II's standardized approach.
That plan seems to have done little to eliminate the competitive concerns. Chris Cole, a regulatory counsel with the Independent Community Bankers of America, said small banks are upset that, unlike Basel IA, the standardized approach would require capital for operational risk.
"My concern is the operational risk charge will negate any benefit community banks will have in using" the standardized approach, he said. "The Basel IA experience was disappointing. The regulators put a lot of work into it, and then they ended up just pitching it."
Regulators say that they remain sensitive to the competitive concerns, and that they would work to ensure small banks are not disadvantaged.
"Capital is a source for strength, not weakness, but we do need to be aware of that and provide a parity of treatment," Ms. Bair said.
The standardized approach presents another concern to banks and regulators, because of its reliance on rating agencies, which have come under fire for giving high grades to securities that proved more sensitive to the subprime meltdown than the ratings indicated.
Most observers acknowledge that dependence on rating agencies is problematic, but how it should be handled seems less clear.
"That's a really good question," Ms. Bair said. "In the near term, we have to deal with it through the supervisory process."
Others say they are equally concerned about how rating agencies will be used but are unsure alternatives exist.
"The problem … is what else do you do? 100% risk weighting for everything?" asked Karen Shaw Petrou, the managing partner for Federal Financial Analytics Inc.
Despite the growing list of concerns, most parties seem focused on finally implementing Basel II.
"The worst possible outcome would have been retaining Basel I, so in the as-compared-to-what department, everything is better," Ms. Petrou said.
That sentiment is understandable, considering that a final version of the rule originally was expected by the spring of last year at the latest. But the rule has been consistently dogged by delays, including an Office of Management and Budget review last year and several spats between regulators.
For years the Fed argued that the largest domestic banks subject to Basel II should be forced to use the advanced approach, while others, including several large institutions and the FDIC, appeared open to allowing the standardized approach.
Meanwhile, the FDIC strongly defended a provision that would have limited the industry's aggregate capital level from initially dropping more than 10%. That plan was scrapped, but the FDIC won agreement to study Basel II's impact on capital in 2010. The agreement likely will ensure that debate over the need and success of Basel II will continue for years to come.
The holdups also have left regulators divided on whether this year would be ending differently if Basel II were already in place.
Mr. Kroszner argued that Basel II's ability to distinguish between risky and safe assets would have helped banks identify troubled mortgages and capitalize against them. "Having a more risk-sensitive approach where, for example, not all types of mortgages are treated equally … probably would have been a positive thing."
Mr. Dugan was more circumspect.
"To the extent that Basel II improves risk management generally, it would be helpful to address the kinds of situations we've seen, but I can't tell you it's a panacea," he said.
Ms. Bair said she was pleased regulators were cautious in finalizing Basel II, and she indicated the industry's problems might have been worse if the rule were already in place.
If the most recent quantitative impact study in February of last year, "was an accurate predictor, we would have had huge capital reductions, which would not have served us well," she said.
