WASHINGTON — As problems in the subprime mortgage market continue to unfold, the already complicated process of implementing the proposed Basel II capital rule could grow more so.
Key features of Basel II, including a reliance on credit rating agencies and models developed by the banks, are being called into question as regulators admit the scope of the subprime crisis has expanded beyond their expectations. The uncertainty could compel regulators to clamp down on capital requirements and subject banks to more scrutiny.
"The net result of this experience with subprime ought to be that the bank regulatory agencies go back and back-test all those models that the banks have been running to see how they held up in the last month," said Daniel Tarullo, a professor at Georgetown University Law School and a former adviser to President Clinton. "What we've seen here is there was a systemic underappreciation of the riskiness of at least some of the securitized mortgage assets."
Unlike the current Basel I capital regime, which puts the onus entirely on regulators to set capital requirements, Basel II requires large banks following its advanced approach to develop their own models. The theory is that banks understand the risk they face better than regulators and can create more effective tools.
But for a regulation that has already hit several snags during its long development process, concerns posed by the mortgage fallout have now convinced some that the models used in the current version of the rule may underestimate capital requirements.
"Recent events have clearly demonstrated that it is essential that institutions maintain strong capital levels during the implementation of Basel II," Federal Deposit Insurance Corp. Chairman Sheila Bair told lawmakers at a House Financial Services Committee hearing Wednesday.
"A purely historic look at mortgage loan data would have suggested much lower capital levels under the advanced approaches of Basel II," Ms. Bair said. "Capital requirements generated under these assumptions would likely have been insufficient given the poor performance experienced in many of the nontraditional mortgage products in the marketplace."
The defectiveness of some mortgage assets has also called other products' capital requirements into question, Ms. Bair said.
"More broadly, it will be no less difficult to fully understand the risks in more complex and dynamic products, such as collateralized debt obligations, credit derivatives, and leveraged lending," she said.
Even if the market turmoil does not bring about changes to the rule itself, observers said the crisis will likely cause regulators to look more closely at banks' compliance with the rule.
"With each individual bank, especially those with subprime mortgages, you'll see a more conservative approach," said Karen Shaw Petrou, the managing partner of Federal Financial Analytics Inc.
Before the crisis, examinations of Basel banks "would have been more of a process of negotiation," Ms. Petrou said. "I think the discussions will now be one-way."
But others were much less concerned, stressing that the models are only part of the Basel equation.
"The limits of models have been widely understood by banks and regulators for some time now," said Jeff Brown, a managing director at Promontory Financial Group LLC and a former regulator at the Office of the Comptroller of the Currency.
Furthermore, the rule allows the federal regulators to offer their own input and require more capital than that called for by the models. Industry representatives said concerns about weaknesses highlighted during the mortgage crisis underscore the value of Basel II's Pillar 2, a section of the rule that would hand discretion to examiners to adjust capital levels at individual banks as needed.
"Capital models are just that. They're models," said Rob Strand, the senior economist at the American Bankers Association. "They try to simulate reality, but they never replace judgment. That's what Pillar 2 is all about."
But models are not the only concern raised by the subprime crisis. Under Basel II's standardized approach, which will be available to smaller banks, capital requirements would be determined to a great extent by a bank's rating from the credit agencies. But those agencies have been criticized for giving high ratings — sometimes triple-A — to securities that were much more sensitive to a subprime downturn than the ratings would have suggested.
"It underscores for me the fact that with Basel II … we really are leaping into the dark," Mr. Tarullo said. "My concern is that we're also jumping off a cliff."
Observers acknowledge the reliance on rating agencies could be problematic, but with Basel II slated for implementation in January, they say there is no better solution.
"It's always been a troublesome issue, like so many other Basel provisions," Ms. Petrou said. "But it was always the least-worst decision, because absent the ratings agencies, what else would one do?"
The subprime crisis is just the latest in a series of events that have threatened regulators' goal of implementing Basel II in January. A review by the Office of Management and Budget last fall delayed the release of a notice of proposed rulemaking last year and regulators — disagreeing on several aspects of the regulation — missed an informal July deadline for publishing a final rule.
The situation looked dire until the regulators broke the logjam by agreeing to an outline of a final version in July that is on track for release later this year.
Even though the subprime crisis is renewing focus on Basel II, some observers doubt regulators will suddenly employ particularly harsh tactics. After all, bankers have spent years deriding the proposal even before problems in the subprime mortgage market came to light.
"I don't think you can be much more conservative than the U.S. regulators have decided to be, and it's because regulators are aware from history that things like this can happen," Mr. Brown said.
Moreover, even though regulators are under persistent pressure on Capitol Hill to crack down on abusive lending, industry representatives say tinkering with Basel II may not solve anything, since most of the loans that precipitated the crisis were made outside the banking industry.
"In a sense, the Basel accord gets to the heart of the problem in that it would require more capital," said Pam Martin, the regulatory affairs director at the Risk Management Association. "But there are a lot of players that were involved in the subprime situation that would not have been subject to Basel even if it had been in place.
"No one's ever said the models were perfect or that Basel II was perfect, but I think it's certainly better than what we have."
