WASHINGTON - If you don't know what "exposure at default" means, you will soon enough.
Until now acronyms like E.A.D. were slung around only by the industry's risk management gurus and regulators rewriting the Basel Accord. Most everyone else figured Basel II was either too complicated or too far off in the future to worry about.
But by yearend the chance for institutions to meaningfully affect its provisions will be gone. Over the next nine months federal regulators plan to polish off the final version of the complex rule.
"This is the time that really matters, when the U.S. banks can focus on exactly what they want to live with," Federal Reserve Board Vice Chairman Roger W. Ferguson Jr. said in an interview last week. "Any of the details might change based on the comment period."
"Comment period" - words that make bankers' eyes roll.
But Mr. Ferguson and his counterpart on this project, Comptroller of the Currency John D. Hawke Jr., are under fire from Congress to listen to bankers' criticisms. That means changes are likely.
"It is my expectation that when all is said and done - and I literally mean when all is said and we've listened to comments and made adjustments - the banking industry will find this is something that they can live with," Mr. Ferguson said.
True, Basel II is not slated to take effect until 2007, but by then it will be too late to influence whether the rule mirrors a bank's own economic capital calculations or whether a bank will face the costly and burdensome prospect of running a second, parallel system to figure regulatory capital.
Myriad details have been raised by the gurus who have been tracking this project since 1998, but the broad industry concerns include how much U.S. regulators will customize the rule, which banks will have to comply with it, and whether Basel II will evolve as best practices advance.
But before diving in to all that, a little history.
The original Basel Accord was finished in 1988, tying the amount of capital backing an asset to its level of risk. Corporate loans required 8% set aside as a cushion, while only $4 of capital was needed for every $100 of a residential mortgage. This risk-based capital idea was a breakthrough, and regulators worldwide adopted it and applied it to all their banks.
But over time bankers figured out how to push more capital-intensive assets off their books, a practice the regulators disparage as capital arbitrage.
So five years ago the Basel Committee on Banking Supervision set out to overhaul the rule. Since then two major proposals have been vetted, numerous papers addressing particular issues have been written, and three full-fledged tests - known as "quantitative impact surveys" in the jargon of Basel II - have been conducted.
The regulators are at last ready for prime time: A final proposal, Consultative Paper 3, will be issued next month; a final rule will be issued by yearend. Along with this global effort, U.S. regulators promise to issue an "advanced notice of proposed rulemaking," or ANPR, in June. Most bankers have low hopes for CP3, but they are crossing their fingers that the U.S. plan will resolve some particular concerns and generally give them more leeway to use their own systems to calculate credit and operational risk.
How far the U.S. regulators will be willing or able to deviate from CP3 is uncertain.
"That's the $64,000 question," Jack Wixted, the chief regulatory officer at PNC Financial Services Group Inc. in Pittsburgh, said in an interview Friday. "I don't know how much flexibility they are going to have."
Regulators clearly want a global standard that allows true comparisons of banks' capital strength. They are trying to strike a balance between this comparability and banks' having the flexibility to design their own risk-management systems.
For now regulators are making accommodating sounds. Mr. Ferguson noted that U.S. regulators "will ask questions in the ANPR that will be intended to elicit comments on credible alternatives to some of the decisions made" by the Basel Committee.
Howard Davies, the chairman of the United Kingdom's Financial Services Authority, signaled a willingness to compromise in a speech to the Bond Market Association on Friday.
"What is important as we move forward is not absolute uniformity, but broad consistency," Mr. Davies said. "We must all work for arrangements which promote prudence and fair international competition."
U.S. regulators upset their European counterparts by deciding to apply Basel II only to the 10 largest, most internationally active banks, and to limit the implementation to the most sophisticated of Basel II's three options. Mr. Ferguson said he expects another 10 banks to voluntarily comply, which would bring to roughly two thirds the amount of U.S. banking assets covered by the rule.
Some banks are less than thrilled by the expensive prospect of jumping on board. As one industry representative put it last week: "Some banks think the direction is wrong, and the details are worse."
But others, like KeyCorp in Cleveland, can't wait.
"Without a doubt, we're going to do it," Kevin Blakely, a senior executive vice president, said last week. "That decision took less than 24 hours to make."
Basel II will help the bank price its products smarter, he said. "It's a fantastic competitive advantage."
Mr. Wixted, another fan, cited the "tremendous convergence" between PNC's own systems and the one contemplated in Basel II. But, like most bankers, he is pushing for changes. For instance, he wants regulators to count reserves held against unexpected losses as capital.
According to Mr. Ferguson, no U.S. bank is completely ready for Basel II. Bankers bristled when former Fed Gov. Laurence Meyer said the same thing two years ago. But now everyone is more realistic about the expense and effort it will take to build sophisticated systems that measure and monitor credit and operational risk.
In fact, First Manhattan Consulting Group, working with RMA-the Risk Management Association, recently surveyed 30 international banks and found that 40% had "just started" to implement a companywide risk-management system.
Finally, bankers want to know whether Basel II will evolve as best practices advance - especially between late this year, when the final rule will be adopted, and early 2007, when it is implemented.
Mr. Ferguson said amendments would still be possible if a consensus emerged that they were necessary. Regulators would not do this lightly, though, recognizing bankers' need for certainty during the transition.
After 2007, Mr. Ferguson said, pieces that do not work will be discarded and replaced by better ones, making it an "evergreen Basel that quickly catches up with the best practices and encourages others to catch up as well."
