WASHINGTON - In the early stages of the ongoing revision of international capital rules, regulators on the Basel Committee on Banking Supervision insisted that whatever changes were made would not substantially alter the overall amount of capital in the banking system.
The pledge puzzled some observers. If the system's exposure to bad loans were reduced by the new accord, why would the same amount of capital be necessary, or even desirable? More specifically, how could a new capital accord featuring improved risk management requirements, increased market discipline, and more supervisory review fail to lower overall capital? 
It may be that international regulators are unwilling to take the political risk inherent in lowering bank capital. In the event of a major string of bank failures, whether related to the accord's provisions or not, fingers would immediately point to the supervisors who had advocated reducing capital requirements.
In June 2000 bankers began to get a hint of how the committee was planning to reconcile improved risk management with static levels of capital. In a speech in Chicago, Christine M. Cumming, then an executive vice president at the Federal Reserve Bank of New York, hinted that an additional capital charge to cover operational risk was being contemplated. Few bankers took note, because the debate over how to define and account for operational risk seemed more academic than practical at the time, and other elements of the accord, such as the proposal to use ratings agencies to assess credit risk, siphoned much of the industry's attention.
But those who did contact regulators to discuss informally the possibility of an operational risk charge learned that many supervisors saw the additional capital requirement as a trade-off: more capital in exchange for more freedom.
PADDING THE CUSHION
The proposed new accord is based on three pillars: capital adequacy, supervisory review, and market discipline, and is expected to allow some banks to use their internal risk rating systems to set regulatory capital. The perception among many regulators - then and now - was that this creates an additional level of risk; if they are going to let banks set their own capital, then the possibility of flaws or outright fraud in banks' internal systems must be considered.
A tough operational risk-based capital requirement, many argue, is their best defense.
In a draft proposal released in January, the committee defined operational risk as "the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems, or from external events."
The committee proposed a three-tiered system for determining how much operational capital a bank would need.
At the most basic level, regulators would determine an institution's operational risk capital charge by applying an undetermined formula to a single indicator, such as gross income. A more sophisticated approach would allow banks to be assessed business line by business line, with the aggregate sum representing the institution's operational risk charge.
Regulators also suggested a possible "internal measurement" approach that would let sophisticated institutions do self-assessments of business lines' risk, and set their capital by applying those analyses to formulas developed by regulators.
Bankers disputed the logic behind the plan, asking in comment letters why institutions currently considered well capitalized should be required to carry more if nothing in their business had changed.
"The proposal will result in a material increase in the amount of regulatory capital required across the banking industry without a commensurate increase in risk," wrote Bank One Corp. chief financial officer Charles W. Scharf. "This is inconsistent with the committee's stated objective of maintaining the current capital levels and creates additional competitive disadvantages for the banking industry."
Even regulators questioned the need for a charge to cover operating risk.
"The proposal of the Basel Committee presupposes that it is necessary to impose an operational risk capital charge at this time," wrote Chicago Fed staff in a comment letter. "In part this appears to be due to concerns not about operational risk per se but that making market and credit risk more risk-sensitive will permit some banks to hold 'too little' capital."
HOW MUCH IS TOO MUCH?
While bankers are skeptical about how regulators want to define operating risk and worried about the three proposed measurement mechanisms, the element of January's proposal drawing the most heat is the committee's position that banks should hold roughly 20% of total risk-based capital to cover operating risks.
In a comment letter, First Union Corp. called 20% "excessive." Such a formula, the Charlotte, N.C., banking company said, would require it to hold $3.2 billion in operational risk-based capital - four to five times what it currently sets aside for these risks.
First Union questioned whether the committee's estimate had resulted from confusion about what banks actually measure when they assess operational risks. It suggested that banks responding to a request for information from the committee had inadvertently combined their assessment of "business risk," which measures the possibility of losses associated with bad business models and changing business conditions, with their assessment of "event" risk, which First Union defined similarly to the committee's definition of operational risk.
"We theorize that many U.S. banks lumped these risks together in their reporting of 'operating risk' to the committee, as the combination of these two approximates the 20% calibration mentioned in the proposal," the bank wrote.
A letter from the accounting firm Arthur Andersen said that bankers have for years observed the capital rules of the original 1988 Basel Accord "merely by obligation, while ignoring the regulatory output in economic decision making" and warned that a similar fate may await the operational risk element of the new proposal if the committee does not "ensure that an artificial and expensive distinction between regulatory and economic capital ceases to exist."
JUDGMENT VS. RULES
Others questioned the feasibility of even measuring something as vague as operational risk, and urged the committee to account for it on a more subjective basis by putting it under Pillar 2 of the proposal, the supervisory arena. Such a move would give regulators the latitude to assess operational risk charges on a bank-by-bank basis.
A group of large banking companies, including State Street Corp. and Mellon Financial Corp., formed a coalition, called the Financial Guardian Group, just to fight the operational risk elements of the proposed accord. Its executive director, Karen Shaw Petrou, complained on the group's behalf that operational risk-based capital "is not quantified in any standard model, and there are no industry-accepted definitions for it."
Because supervisors already deal with more easily quantifiable exposures, such as interest rate risk, she continued, "We believe that the Pillar 2 supervisory approach is a far more appropriate framework for addressing any concern the committee may have about operational risk."
On a more technical level, Ms. Petrou and others objected that the committee had not made it possible to lower operational risk charges with risk mitigation techniques. The proposal would allow banks to reduce their credit-risk-related capital by collateralizing loans or buying credit insurance, they said, but no such mitigating opportunities are offered for the operational risk charge.
A number of insurers are developing products that would protect financial institutions against operational losses, and many industry representatives have argued that banks that outsource particularly risky operations should also get a capital break. But the committee, while recognizing such options exist, stops short of allowing banks to use them to reduce their capital.
"It is important that the broad-brush methodology that the committee has devised is given an increased element of risk sensitivity by acknowledging the effect" of risk mitigation "in changing the operational risk profile of a firm," wrote Charles Ilako, a partner with the accounting firm PriceWaterhouseCoopers. "Insurance and, on the whole, outsourcing, do reduce operational risk, and this should be reflected in the capital charge."
COMING CHANGES
In the face of intense criticism of both the operational risk element and other aspects of the proposal, the Basel Committee on June 25 pushed back implementation of the rule by a year, to 2005, and announced that specific changes would be made.
On the question of operational risk, the committee said that "the target proportion of regulatory capital related to operational risk (i.e., 20%) will be reduced in line with the view that this reflects too large an allocation of regulatory capital to this risk as the committee has defined it."
The two-page release noted more generally that the committee "is considering numerous other comments and suggestions related to operational risk."
But bankers hoping to see the quantitative operational risk formulas replaced altogether by supervisory oversight appear to be out of luck. In a June 20 interview, Mr. McDonough said that both he and the committee maintain "a strong belief" that operational risk should be accounted for under Pillar 1 of the accord, the capital rules.
The third story in this series will appear Monday, July 16.
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