Responding to growing discontent with current capital rules, international regulators on Thursday proposed a system that seeks to more closely correlate reserves with risk of loss.
Though less radical than some industry leaders had advocated, the proposal by the Basel Committee for Banking Supervision would for the first time base regulatory capital on the creditworthiness of a bank's borrowers as determined by rating agencies such as Standard & Poor's Corp.
Under the Basel accord, adopted in 1988, capital is determined by loan type. For example, banks must reserve 8% of all corporate loans and 4% of all home mortgages. This approach has come under increasing fire because the same amount of reserves are required for loans to borrowers with excellent repayment records as for those who have defaulted.
In a surprising move, international supervisors also said large banks may be able to use internal models to customize their capital requirements- an option they dismissed as premature just last month.
"The new framework is designed to better align regulatory capital requirements to underlying risks, and to recognize the improvements in risk measurement and control," said Claes Norgren, Sweden's top bank regulator and chairman of the Basel task force that crafted the proposal.
"This is trying to bring market forces to bear to reinforce the goals of supervisors," said Susan F. Krause, senior deputy comptroller for international affairs in the Office of the Comptroller of the Currency. "It proposes to use more market information and it contemplates using more bank risk management information and greater disclosure to allow the market itself to directly regulate capital adequacy."
Comments on the proposal are due at regulatory agencies by March 31, 2000, and a final rule could be adopted in 2001.
Bankers reacted cautiously, and few would speak on the record. But a predominant concern among those interviewed was that the new proposal would force banks to hold more capital.
"This is a step in the wrong direction," said a New York banker. "Regulatory capital will just get bigger."
"Our concern is, this could result in just more capital being required rather than in better capital requirements," said Richard M. Whiting, executive director of the Financial Services Roundtable.
But Ms. Krause said few U.S. banks would be hurt by the proposal. "By and large U.S. banks are so well capitalized right now that if we were to apply this new approach it probably would not require many banks to hold more capital," she said.
Another industry official said bankers are split on using the rating agencies to assess borrower risk. "There is some concern about ... giving implicit regulatory authority to the rating agencies," he said. "But on the pro side, they are in theory independent, third-party sources that have incentives to get it right in determining the correct amount of credit risk."
Still other sources said the Basel Committee should have attempted a more comprehensive overhaul rather than just tweaking existing standards.
"This system is still overly elaborate," said Karen Shaw Petrou, president of the consulting firm ISD/Shaw Inc. "But since there is no commitment to a wholesale new approach, it is vitally important that the current system be fixed now when banks have lots of capital and the system is healthy."
The proposal would be an improvement, she said, because the current approach does not distinguish between loans to healthy and struggling borrowers. As a result, banks are discouraged from holding quality credits on their books because the capital charge is disproportionately high, she said.
The Basel Committee intends to retain the current requirement that banks hold reserves equal to 8% of a loan's value, but the new proposal would alter how banks determine whether a credit qualifies for a so-called discount, which means the lender is allowed to hold less than the standard amount of capital in reserve.
Currently, discounts of 50%, 80%, and 100% are available, which translates into capital charges of 4%, 1.6%, and zero. For instance, loans to sovereign governments do not require any capital reserves, but reserves totaling 4% of a home mortgage must be held.
Under the proposal, banks would rely on scores from credit-rating firms such as Standard & Poor's and from export insurance agencies such as the U.S. Export-Import Bank to determine which borrowers qualify for discounted capital treatment.
The proposal would have some of its greatest impact on corporate loans, which currently are all subject to an 8% reserve requirement.
Loans to top-rated companies-AAA to AA-minus-would require just 1.6% capital, and those with ratings below B-minus would be penalized with a 12% requirement. All other corporate loans would continue to require 8% capital.
Loans to sovereign governments with credit ratings of AAA to AA-minus would not require any capital backing, as under current rules. However, credits to governments with A-plus to A-minus ratings would require 1.6% capital; countries without a rating or with a BBB-plus to BBB-minus grade would require 4% capital; and those with BB-plus to B-minus, 8%.
The Basel Committee also proposed to penalize loans to countries with ratings below B minus by imposing a 12% capital charge.
For loans to other banks, the capital required would be one level above the reserve requirement for the borrower's home country government. For instance, in a country with a 1.6% capital charge, a lender would have to hold 4% of a loan to one of its banks as capital.
As an alternative, the Basel Committee proposed using credit rating agencies to set required capital for loans to banks.
The proposal would also crack down on asset securitizations, a tool some banks use to lower their capital requirements.
Securitized assets would be subject to capital requirements based on the credit rating assigned to the instrument by Standard & Poor's or some similar agency.
For instance, securitized assets with an A plus to A minus rating would be subject to a 4% reserve requirement. Investments in asset securitizations rated B plus or worse would be deducted dollar-for-dollar from a bank's capital.
Currently, most securitized assets are subject to an 8% capital requirement. Regulators have argued for several years that this requirement has little bearing on the actual risk posed by the securities. For instance a bank may purchase the "first loss" portion of a securitization, which means it is liable for losses equal to value of its investment. This is a very risky asset and deserves a higher capital requirement, regulators have argued.
Conversely, banks may purchase the "senior" position in a securitization, which means it only incurs losses if all the other banks have lost their investment. This is a very safe security and an 8% capital requirement is too high.
Regulators would impose these capital requirements on holding companies and affiliated banks. The U.S. already does this, but some foreign countries have exempted holding companies from the capital accords.
Regulators rejected calls to require less capital for loans with short maturities, saying such a system would be too complicated to implement.
But they are considering further changes to the capital accord, such as requiring reserves for operational and interest rate risk, and providing lower capital charges for collateralized loans. Separate proposals would be issued on those topics before changes were made.
The proposal also calls for regulators to examine the capital adequacy of banks engaged in excessively risky activities and it directs banks to disclose more data to investors on their capital structures and risk exposures.
"Taken together, these three elements are the essential pillars of an effective capital framework," said William J. McDonough, president of the Federal Reserve Bank of New York and chairman of the Basel Committee.
Regulators opened the door to letting banks use internal models to set required reserves. Basel said it may be possible to create a system based on credit risk ratings-which are scores assigned by a bank to a loan that reflect the risk of loss.
"Conceptually it is absolutely the right thing to do," agreed James B. Wolf, senior vice president at First Union Corp. "The difficulty will be for regulators to implement this across numerous banks because there is no standardization in credit risk rating systems."
The Basel Committee was originally set to unveil this proposal in early April, but last-minute objections from Germany over commercial real estate lending delayed the release.
German regulators were worried that the proposal would require the full 8% capital reserves on all commercial real estate loans, even if some loans were less risky and did not deserve such a high capital charge. Regulators finessed the point, writing that commercial real estate loans "do not in principle" justify less than an 8% capital charge. But they did not rule out offering a discount in the final version of the rule.
The proposal comes a decade after international regulators adopted a capital accord that for the first time subjected all banks in developed countries to a single reserve requirement.