NEW YORK International regulators on Tuesday proposed revisions to the Basel Capital Accord that would let banks reduce capital charges for individual loans by as much as 85% through credit risk mitigation techniques such as holding collateral or obtaining loan guarantees.
But the reduction could be offset at least partially by a new charge based on an institutions operational risk. Regulators estimate that such a charge could account for as much as 20% of bank capital requirements when the rule takes effect in 2004.
As expected, the proposal also offered several ways that banks could use their internal risk rating systems to set or to help set their regulatory capital requirements.
Additionally, the Basel Committee on Banking Supervision proposed extending the capital regime to include the consolidated holding companies of firms that are predominantly banking groups.
Federal Reserve Bank of New York president William J. McDonough said the 500-page plan, which is divided into 11 sections, would give many sophisticated banks unprecedented leeway.
A good banker is going to find that this capital accord is a dream that he could not have thought of, because it is so flexible, he said. The new accord has become a larger and more complex framework. The depth and breadth of the package is a reflection of the changes that have occurred in the banking industry and the economy.
Mr. McDonough released the proposal at a news conference here. He was accompanied by Daniele Nouy, Secretary General of the Basel Committee, and Claes Norgren, director general of Swedens Financial Supervisory Authority and chairman of the Committees Task Force on the Future of Capital Regulation.
Initial industry reaction to the proposal appeared to bear out these officials enthusiasm.
We appreciate the integrated approach to risk review, said Richard M. Whiting, executive director of the Financial Services Roundtable. Internal models and other initiatives could prove favorable as institutions coordinate risk management techniques with supervisory requirements.
The document expands on a June 1999 paper that attempted to revise the original Basel Accord, which was adopted in 1988. The original accord, under which banks still operate, has been criticized as too crude to be useful. It sorts bank assets into broad categories of riskiness, resulting, for example, in identical capital requirements for loans to Fortune 500 firms and to Internet start-ups.
The June 1999 proposal offered more finely drawn distinctions between assets but was still criticized as being too simplistic to reflect the average banks true risk exposure.
The latest proposal offers banks the choice of three ways of calculating minimum capital requirements: a standardized method and two internal ratings-based methods.
Under the standardized approach, which regulators expect will be used primarily by small institutions, banks would use the borrowers creditworthiness to set the capital for a particular loan. That creditworthiness would be determined by the borrowers rating with an independent organization such as Moodys or Standard & Poors.
The internal ratings-based methods use two elements to determine the necessary capital charge for a given loan: the borrowers probability of default and the amount the bank is likely to lose in the event of default.
One internal ratings-based method, the so-called foundation approach, would be available to banks that are able to calculate a borrowers probability of default but are unable to calculate their own loss in event of default. For such institutions, regulators would supply the second figure.
Under the so-called Advanced internal ratings-based approach, banks able to calculate both elements to regulators satisfaction would be allowed to establish the necessary capital level using internal data.
Many critics of the June 1999 paper noted that the Basel Committee had made almost no allowance for banks ability to reduce their credit risk by holding collateral, obtaining loan guarantees, and other credit risk hedging techniques.
The latest proposal recognizes the value of such techniques in reducing bank risk, and would let banks reduce the capital they must hold by as much as 85% for some collateralized transactions and as much as 100% for loans guaranteed by other banks or sovereign countries.
One likely subject of debate during the comment period is the committees decision to add a capital charge for operational risk, which it defines as the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems, or from external events.
The committee proposes a three-tiered system, much like that suggested for capital requirements tied to credit risk:
Under the Basic Indicator approach, regulators would determine an institutions operational risk capital charge by applying an as-yet undetermined formula to a single indicator, such as its gross income. What the indicator would be has not been determined, either.
Under the Standardized approach, regulators would treat each of a banks self-defined lines of business separately, calculating the operational risk of each and adding them to arrive at a total for the entire institution.
Under the Internal Measurement approach, sophisticated institutions could apply self-generated risk analyses of their separate business lines to a formula generated by regulators to come up with operational risk capital requirements.
An element likely to raise industry hackles is the application of the accord to banks consolidated holding companies. The move is necessary, the committee said, to preserve the integrity of capital in banks with subsidiaries because it eliminates double-counting of capital.
The proposal will be open for comment until May 31 and a final rule is expected well before the end of this year, Mr. McDonough said. U.S. bank regulators said Tuesday that as soon as this week they will release a summary of the new capital accord along with a list of questions bankers may want to consider while preparing comments.
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