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Regulators Defend Narrow Applicability of Basel II

APRIL 11, 2003


Regulators Defend Narrow Applicability of Basel II

U.S. regulators are defending their decision to apply the Basel II risk-based capital accord to only the most complex U.S. banks-likely the 10 to 20 largest institutions. Community banks and so-called second tier banks would continue to apply the current Basel I framework to determine capital adequacy. European regulators are reportedly not happy with this decision; they want all banks to comply with the new accord.

Bank regulators around the world continue to work on developing the Basel II accord. They expect to release the third version of Basel II for industry comment in late May. U.S. regulators will follow that with an advanced notice of proposed rulemaking in late June to seek industry comment on how the rule will be applied in the U.S. Final implementation of the new accord is expected in late 2006 or early 2007.

Basel II is a highly complex scheme for assessing capital adequacy. It includes three options for computing credit risk, and three options for computing operational risk, depending on the bank's complexity and the sophistication of its risk management techniques. U.S. regulators plan to require the largest U.S. banks (probably the top ten) to apply only the most sophisticated options-the "Advanced Internal Ratings Based" approach (credit risk) and the Advanced Measurement approach (operational risk), where the bank provides most of the inputs. Another ten or so large banks are expected to opt-in to this more risk sensitive approach for prestige or competitive reasons.

The OCC, the Federal Reserve, and the FDIC have all cited the U.S. "prompt corrective action" scheme, which includes both a leverage ratio and the "well-capitalized" thresholds, as reasons not to apply Basel II to U.S. banks other than the large, complex, internationally active banks. "Given the high capital position these [smaller] banks continue to retain as well as their virtual lack of direct competition with banks in other countries that will be adopting Basel II, it does not seem reasonable to impose the cost of changing systems on most of these banks," Federal Reserve Vice Chairman Roger Ferguson said in a speech this week.

Last month in two speeches, Comptroller of the Currency Jerry Hawke expressed serious concern about the new accord's complexity, as well as its potential to place U.S. banks or small banks at a competitive disadvantage, and banks in general at a competitive disadvantage to other financial services providers.

The Federal Reserve is also mindful of these issues. "We are also aware of concerns that the current competitive balance between Basel I banks and Basel II banks might be upset in certain loan markets. The specific worry of the Basel I banks is that the advance approaches will yield lower capital charges for residential mortgage, retail and small business loans," Gov. Mark Olson said in a speech this week. But loan pricing and profitability are influenced more by factors such as local market competition, cost of funds, and secondary market pricing than by regulatory capital levels, Olson said.

In any event, the U.S. regulators will seek comment on all these issues. "The OCC, which has been vested by Congress with the sole authority to fix capital requirements for national banks, will not give its final agreement to Basel II until we have fully and objectively considered all the comments we receive," Hawke said.