WASHINGTON — In a slow, painful process of revelation that stretched from January to May, bankers and regulators this year were forced to face an unpleasant truth: The crown jewel of the long-awaited proposal to revamp international bank capital rules is deeply flawed.

The Basel Committee on Banking Supervision, which has been working for three years to rewrite outdated bank capital standards, put forward in January a complex, three-tiered plan to make the capital banks hold against credit losses more sensitive to their actual risk and to bring economic and regulatory capital into better alignment.

The proposal updated a 1988 rule that sorted credits into “risk buckets” of borrowers in the same broad categories on the assumption that they posed similar potential for default and resulting loss to banks. Each bucket was assigned a risk weight, which represented a fraction of the 8% capital requirement that the committee somewhat arbitrarily defined as “well capitalized.”

Over the years, bankers learned to arbitrage their way around the requirements, concentrating their assets in the riskiest ends of each bucket to reduce their capital charge, and making the rules largely ineffective — if not counterproductive. The January proposal was designed to make arbitrage more difficult, by expanding the number of buckets, and relying on the judgement of ratings agencies, such as Standard & Poor’s and Moody’s Investor Services, to determine which bucket a particular borrower belonged.

But the committee did not stop there. To encourage banks to improve their risk management abilities, it proposed allowing banks for the first time to use their internal systems to gauge credit risk and set capital levels.

The risk-bucket approach was dubbed the “standardized” method, and two other options of increasing sophistication, the “foundation” and “advanced” internal ratings-based approaches, were introduced. Under the foundation approach, banks would assess borrowers’ risk of default themselves, and would apply a formula devised by the regulators to determine the loss they would suffer in the event of default and the resulting capital requirement. More sophisticated banks, eligible to use the advanced approach, would determine loss-given-default themselves, subject to regulatory approval of their methods.

The promise the committee made banks was that the more sophisticated they became, the lower their capital levels could be. At first glance, the proposal seemed like a dream come true to executives of large U.S. institutions, who for years had been clamoring for permission to use their own risk assessment techniques in setting capital.

But when bankers dug into the proposal’s details, delight turned to frustration.

It soon became apparent that the committee had used such conservative estimates of credit risk exposure that the proposed rules would drive capital up across the entire industry, and that institutions with the most sophisticated risk management systems would face the largest increases.

Comment letters, which arrived in the hundreds on and around the May 31 deadline, were highly critical of the plan.

CAPITAL TO INCREASE

“We have been in contact with a large number of banks, and we are yet to come across a bank that will see a reduction in its overall capital charge,” wrote Charles Ilako, a partner with the accounting firm PriceWaterhouseCoopers. “By contrast, almost all will see potentially significant increases.”

Mr. Ilako and others said the committee had failed at the most basic level in its attempt to trade lower capital charges for better internal risk management systems. “The experience of our clients and our own modeling suggest that, far from there being regulatory incentives for banks to use more sophisticated methods of risk measurement, they are penalized by a higher charge,” he wrote.

The problem is twofold. First, the committee began with the premise that capital should be held at a level that would protect a bank against both expected and unexpected losses – a break from common practice that bankers claim would drive capital levels skyward. Second, apparently concerned about giving banks the authority to assess borrowers’ probability of default on their own, the committee built in so many safeguards against fraud and general incompetence that the benefits of the more sophisticated approach disappeared.

Regulators estimated that the majority of U.S. banks would attempt to qualify for the “foundation” internal ratings-based, or IRB, approach, in which they would determine probability of default and the regulators would supply a formula to determine their likely losses in the event of default. In fact, Federal Reserve Board Governor Laurence H. Meyer has expressed skepticism that any U.S. bank has sufficiently sophisticated risk management systems to qualify for the advanced IRB approach.

Bankers initially disputed Mr. Meyer’s claim. But as institutions began applying the committee’s proposal to their own portfolios, the question of who qualified for the advanced approach became temporarily moot. As risk management improved, capital rose, removing any incentive to qualify for the advanced approach.

“Members have found that in many cases the IRB approaches for sophisticated banks actually result in higher capital relative to the standardized model, directly contrary to the significant reduction intended by the committee in order to provide incentives for adoption of the IRB,” wrote Financial Services Roundtable executive director Richard M. Whiting.

UNEXPECTED LOSSES

A chief concern was the committee’s decision that banks should hold capital to cover both the expected and unexpected losses in their portfolios.

“We are disappointed that the committee has constructed a definition of economic capital that covers both expected and unexpected losses, which is in contrast to the generally accepted notion that capital is only needed to cover unexpected losses,” wrote Bank One Corp. chief financial officer Charles W. Scharf.

Bankers argued that they can and do predict the likely level of loss in their loan portfolios, and that they protect themselves against those expected losses it by adjusting loan spreads and by holding reserves. They hold capital as a cushion against unexpected losses.

By requiring their risk-based capital to cover expected losses, bankers argued, the committee was effectively double-counting a large portion of an institution’s risk profile and requiring excessive capital as a result.

A letter from the International Institute of Finance signed by numerous members including P. Jan Kalff, who heads the group’s capital committee and is a member of ABN Amro Bank’s supervisory board, called that element of the proposal “fundamentally misguided.”

“The result is a systematic overstatement of risk and capital for each obligor,” the IIF wrote, urging that if the committee was not willing to remove expected losses from the capital charge, it should at least allow banks to report the charges for unexpected losses separately and let banks’ loan-loss reserves count toward Tier 2 capital.

Commentors also complained that the committee, while allowing banks to estimate probability of default in the IRB approaches, seemed to build assumptions of bad management and poor risk measurement into its formula. The IRB approach effectively requires banks to take their best estimate of probable losses in a portfolio and multiply them by 1.5 before applying the formula to determine likely losses in the event of default. The add-on is supposed to protect against incorrect predictions of loss probability, which the committee estimated might happen in half of all cases.

Bankers were indignant. “One cannot avoid the impression that the current Basel II proposal is oriented toward the ‘black sheep’ or worst behavior benchmark,” Credit Suisse Group wrote. “The consequences for all banks are higher costs, lower earnings, less focus on ‘good risks,’ and reduced financial health of regulated institutions.”

Many commentors noted that any measurement of default probability that consistently underestimated borrower defaults half the time should automatically disqualify a bank from using internal ratings and should therefore not be considered in the committee’s formula.

Others criticized the proposal’s “granularity” requirements, which would bar a bank from using internal ratings if 30% or more of its loans fall into a single risk grade. Eugene M. McQuade, vice chairman and chief financial officer of FleetBoston Financial Corp., complained that the granularity requirements are unfair because they fail to recognize “a capital benefit for the positive effects of business line diversification.”

Jay S. Fishman, Citigroup Inc.’s chief operating officer for finance and risk, agreed. “The new accord does not adequately recognize the importance of diversification in assessing capital requirements,” he wrote.

Most commentors acknowledged that concentration of assets in a particular area can increase risk, because of possible correlation between borrowers. But they disputed the committee’s logic in measuring that increase solely through probability of default. Loans with the same probability of default might be to different firms in different industries or different countries, factors that would decrease, not increase, the likelihood of correlation, and that the committee did not consider.

THE ‘W FACTOR’ The proposal allows banks use credit risk mitigation tools, such as collateral and credit derivatives, to reduce their credit risk and their risk-based capital. However, it introduced what it referred to as a “w factor” — effectively an automatic haircut on the value of specific collateral instruments — that many commentors found objectionable.

The w factor would reduce the value of some collateral, including credit derivatives and, in some cases, cash, by 15% for purposes of calculating regulatory capital.

Writing for First Union Corp., senior vice president William P. Alexander suggested that the w factor has no place in the assessment of credit risk. “Arguably, ‘w’ is actually adjusting for operating risk (i.e. the failure of collateral or guarantees to be implemented properly), since any credit risk concerns would have been considered in the haircut calculations for collateral and the assignment of risk weights for the guarantors,” he wrote.

Mr. Kalff and others at the IIF also objected. “The w factor should either be eliminated and concerns with collateral enforceability reflected in loss given default haircuts, or at a minimum it should be adjusted to avoid the anomalous situation where collateral such as cash receives a haircut.”

Stepping back from the details, many of the commentors protested that as banks face increasing competition from nonbank financial services firms, subjecting them to the proposal’s stringent capital requirements would create a serious competitive disadvantage.

“Nonbank competition from investment banks, brokers, asset managers, and finance companies etc. is an increasingly serious issue. These competitors are as much ‘systemic risk relevant’ as banks, especially in the context of convergence of products, markets, and clients,” wrote Credit Suisse Group.

“As many competitors in the financial services industry do not fall under the purview of this accord, we encourage the committee to work with appropriate supervisory authorities to ensure an equitable application of the proposal across the financial services industry,” wrote Mr. Scharf of Bank One Corp.

The question of how the rule will be applied by various countries was also raised. “The new accord does not assure equal regulatory treatment between banking organizations and nonbank financial services providers and across national jurisdictions,” wrote Mr. Fishman of Citigroup.

BREATHING ROOM

The volume of comments and the seriousness of banks’ objections appear to have bought the industry more time and forced the Basel Committee to consider changes to, among other things, the credit risk element of the proposal.

On June 25, the committee announced that it would abandon its original goal of implementation by 2004, giving the industry an extra year to make the adjustments necessary to comply with it. In response to the comments, the committee will issue another proposal for comment in the first quarter of 2002.

The committee also indicated that it was considering changes to the credit risk element of the accord. In a press release announcing the delay, the committee restated its commitment to creating a system that encourages banks to strive for better credit risk management, and acknowledged that the proposal in its current form failed to do that.

“The evidence obtained by the committee thus far, including an initial review of the comments, strongly suggests that the committee’s proposals need further adjustment to meet these objectives. In particular, the committee anticipates the need for reductions in the basic calibration of the foundation IRB approach,” the release said.


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