New Basel Standards Spark Discord

Storm clouds are gathering over proposed new international standards governing how bank risk capital is regulated and their on impact the U.S. market. This summer, the Basel Committee on Banking Supervision is set to wrap up its work on the so-called New Capital Accord, better known as Basel II. The committee’s efforts have gotten generally positive reviews elsewhere; here in the States the assessment has been tepid, at best. “The dominant point of view that comes across is that nobody likes it,” says Benton Gup, a banking professor at the University of Alabama and author of a new book on Basel II.

That might be an exaggeration, but not by much. The new standards would permit the nation’s largest “internationally active” banksu00e2u20ac”those with at least $10 billion in cross-border exposure or $250 billion in total assetsu00e2u20ac”to, in essence, determine their own appropriate capital levels via complex computerized models. “Market discipline,” in the form of scrutiny by investors, ratings agencies, and other outsiders, would help ensure capital levels are adequate; regulators, meanwhile, would focus their energies on reviewing the processes by which those levels are determined, not on the numbers themselves. Bank boards could find themselves on the hot seat.

Debate over Basel II has been raging quietly for five years. The proposal has endured three comment periods and a series of “impact studies” analyzing how the rules would affect more than 350 banks globally. With each round of feedback, says Bert Ely, an Arlington, Virginia, regulatory consultant, the proposal has gotten “more complex and convoluted.” As those efforts approach fruition, supporters and opponents are gearing up for their final salvos. Leaders from the three major U.S. bank regulatory agenciesu00e2u20ac”the FDIC, OTS, and OCCu00e2u20ac”have all voiced misgivings. Even the U.S. point man in the negotiations, Federal Reserve Vice Chairman Roger Ferguson Jr., is said to be hedging.

Congressional hearings on the proposal have been heated. “There’s deep skepticism,” Ely says.

Critics say the big banks would almost certainly use this newfound latitude to reduce the capital on their books. Gup reckons a bank could actually wind up with capital levels below what’s required under Prompt Corrective Action statutes. “Any time you let banks write their own tickets, you know there will be huge internal pressures to make that number as low as possible and game the system,” says Michael Roster, executive vice president and general counsel for Golden West Financial Corp., who as a partner with Morrison & Foerster in the 1980s worked extensively on Basel I.

That would raise the risks to the entire system, he argues, setting the table for a crisis that could make the S&L bailout of the late-1980s seem minor. “All it would take is one massive terrorist attack or some other unexpected event, and all those models would break down.” Roster’s conclusion: Leave well enough alone. “If it ain’t broke, don’t fix it.”

Many small and mid-sized banks, meanwhile, fret they could lose business to larger rivals that would gain an implicit pricing advantage from the new standards. Ferguson indicated in a December speech that the other 9,000-plus banks theoretically would be permitted to “opt in” to the accord. “Banks should be free to choose to bear the costs of implementation for the benefits of greater capital risk sensitivity,” he said. As a practical matter, that seems unlikely:

The systems required to implement the advanced internal risk-based approach U.S. regulators envision start at $15 million, Gup says; some large institutions reportedly anticipate spending upward of $200 million. The accord “does not seem to have a favorable cost-benefit ratio for most American banks,” Ferguson conceded. Instead, regulators anticipate a two-tiered, “bifurcated” system where the majority of banks will continue using the old standards. “We’d have to hold more capital than the larger institutions, and not be able to deploy it as efficiently as they could,” says Kathleen Marinangel, chairman and CEO of McHenry (Illinois) Savings Bank. “It would put us at a competitive disadvantage.”

Larger banks have complaints of their own. In a recent comment letter, for instance, William Longbrake, vice chairman and chief risk officer for Washington Mutual, one of the “core” institutions that would be required to adopt Basel II, lauded the committee’s efforts to improve sensitivity and best practices in risk management. But he also noted its impact could be muted by tougher U.S. leveraged-capital and “well-capitalized” standards. “As a practical matter, no publicly traded bank in the U.S. can afford to be deemed less than well capitalized by the regulators,” he wrote. “Simple fairness requires that the ‘well-capitalized’ standards be applied globally,” he added. Ely says resistance from other countries means that will never happen.

Basel I was adopted in 1988, with a simple, one-size-fits-all requirement that banks maintain capital equal to at least 8% of risk assets. While it (along with leveraged-capital ratios implemented as part of FIRREA) has served the U.S. industry wellu00e2u20ac”there hasn’t been a major crisis since Basel I was adoptedu00e2u20ac”capital-conscious large banks, as well as many smaller institutions, have never been big fans. Under present rules, institutions are required to allocate assets into several different risk-weighted “baskets.” Advocates of change say those categories aren’t refined enough to accurately reflect lending risks. U.S. banks, for instance, must hold the same amount of capital against a AAA-rated commercial loan as they do against a BBB-rated loan. They also must treat all mortgage loans the same, regardless of loan-to-value ratios and other factors that can make some loans much less risky than others.

The industry has changed, too. Securitization has allowed banks to categorize mortgages, credit card receivables, and other assets as off balance sheet, while derivatives, sophisticated hedging techniques, and new product offerings have fed the growth of giant megabanksu00e2u20ac””large, complex financial organizations” in committee parlanceu00e2u20ac”that are beyond the ability of regulators to monitor. Citigroup, for example, has more than 100 operating units and competes in more than 60 markets. Add it up, and Basel I “no longer provides these banksu00e2u20ac”and their supervisorsu00e2u20ac”with reliable measures of the actual risks they face,” explained Jaime Caruana, governor of the Bank of Spain and chairman of the Basel Committee, in a November speech.

If adopted, Basel II would present some distinct challenges to bank boards. Smaller institutions would have to decide if they want to pay the hefty price tag for Basel II technologies they might not understandu00e2u20ac”or use. According to Ferguson, 95% of all U.S. banks presently maintain capital ratios of more than 10%. “The industry is pretty overcapitalized,” Gup says. Marinangel, who claims to be frustrated by present capital rules, expects that outside vendors will come up with less-pricey solutions if the new rules go into effect. If permitted, she says her bank would try to opt in.

Beyond costs, the models underlying Basel II calculations are so complicated that only a handful of techiesu00e2u20ac”not most senior managers, and certainly not directorsu00e2u20ac”will ever know exactly how they’re constructed. Those figures, in theory, could even be manipulated by executives whose bonuses are tied to returns (a lower capital number in the return-on-equity denominator would yield a higher final result). Yet Sarbanes-Oxley makes board members, especially those on the audit committee, more responsible for risk management. If something were to go wrong, “How will you demonstrate that you had sufficient knowledge and understanding about how those models work?” Roster asks. Short of hiring a separate auditor to build a parallel model, he’s not sure. “Some fancy material in your board book that shows you’re within acceptable deviations won’t be enough.”

With time, Basel II could spark yet another round of industry consolidation. Big banks would be able to pay higher premiums for smaller, non-Basel II rivals, sucking out the excess capital of acquirees to make up the difference. But first the proposal has to be adopted. Ely questions the need for global capital standards at all, and many industry officials argue it makes more sense to tweak Basel I, creating a sort of “Basel I(a)” that would change some of the risk weightings but retain most of the present system’s features. While Congress technically need not approve Basel II, it has the power to kill it. Given the swirl of lobbying and emotions surrounding the proposal, that wouldn’t be a surprise.