The new capital standards being developed by international financial institution regulators will have a big impact on bank efficiency and the competitiveness. Some banks have estimated that the rules will lead to changes in capital requirements of more than 15%.

Such changes could create a huge edge for banks that are to receive favorable treatment under the new rules. The new Basel Capital Accord will not be implemented until 2004, but comments are due by May 31, finalization is expected by yearend, and, as explained below, it’s a good idea to start some data collection immediately.

A BRIEF COMPARISON

The old capital regulations have been widely criticized as simplistic, lacking in risk-recognition accuracy, and too broad. These criticisms have some merit, though people might argue that the rules can be quite involved in areas such as multiuse credit facilities, syndications, and risk participations. Conversely, the new capital rules are complex and lack uniformity.

Complexity. The old rules were easier to learn, easier to regulate, and had a “one-size-fits-all” framework. The new one are complicated, designed to be more accurate, and will present many regulatory challenges (for example, examiners will be required to get substantial continuing training).

Uniformity. Currently, all banks are bound by the same rules. Under the new regulations, a bank that qualifies under the more advanced provisions will have a competitive advantage over nonqualifying banks. This is because capital requirements will be lower under the accord’s more advanced approaches than under the accord’s default rules. The more capital a bank is required to hold, the more costly its activities will be. In addition, signals will be sent to the market. To the extent that a bank cannot qualify for the accord’s complex approaches, the market will conclude that the bank will be unable to get a good gauge of its portfolio risks.

Some might view the accord as unfair and burdensome. It might appear that its forces banks down yet another tortuous compliance path. A closer look, however, reveals that it will encourage banks to create more accurate models of risk recognition and required capital determination. They also allow for more effective capital determination and product pricing. This will encourage more efficient credit allocation industrywide, and produce a healthier banking system.

CAPITAL DETERMINATION

The Basel accord contemplates giving banks a choice in capital determination: the standard “default” approach or one based on a bank’s own internal ratings. The latter requires validation of the bank’s internal models and procedures by bank regulators.

Standardized approach. The standardized “default” approach, for example, imposes a 20% credit conversion factor on loan commitments of less than a year’s duration. The current rules have no such provision.

While the current rules purport to level the international playing field, they tilt the field against U.S. banks by applying to parent holding companies as well as banks. The U.S. regulators would continue that tradition by denying to U.S. banks the accord’s lower risk-weighting for certain commercial real estate loans with historically low default and loss rates.

Risk weightings also would change. Instead of Organization for Economic Cooperation and Development sovereign exposure carrying a 0% risk weight, agency ratings would be considered. An AAA rating would carry a 0% risk weighting, but a B-minus rating would carry a 150% risk weighting.

This complexity is magnified further in the treatment of bank counterparty risk. Each nation’s bank regulators may select either of two options. Either all banks in a given country would get a risk weighting one category lower than the country’s sovereign rating or each bank could get a risk weighting based on its own credit rating. In theory this rating could be higher than the sovereign rating of the country in which it is located, but the bank’s risk weighting could not be lower than 20%.

Similarly, corporate counterparty risk would be driven by credit ratings. Instead of 100% risk weighting as under the current rules, claims on corporations and other business entities would be 20%, 50%, 100%, or 150%, depending on the entities’ credit rating. Unrated entities would carry a 100% risk weighting, though regulators would have the right to increase the weighting in the case of default or credit quality concerns.

Internal ratings-based approach and data collection. Banks that wish to qualify under the most favorable capital treatment possible, the Advanced Internal Ratings-Based Approach, have much to consider. Though the rules are not to take effect until 2004, banks should prepare now.

There are four main risk components under the new system: Probability of Default, Loss Given Default, Exposure at Default, and Maturity. Regulators will require reliable data to support internally generated estimates for these components, and since a key factor of reliability is the amount of time over which the data are collected, bank systems should begin capturing such information sooner rather than later.

Mr. Gonzalez is associate counsel and Mr. Loeser deputy general counsel of Comerica Bank, Detroit.

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