Latest developments in the progress of the Basel II Capital Accord have raised concerns by both US and European parties that its complexity will lead to unequal treatment.
A collective sigh of relief issued from global bank regulators after their mid-July meeting in the sleepy Swiss town of Basel. They had succeeded in hammering out an agreement on a string of thorny, politically charged issues that had been threatening to derail five years of toil to produce elaborate and far-reaching new rules for the world's larger banks.
Regulators believe that they can at last see light at the end of the tunnel. The painstakingly negotiated Basel II Capital Accord, as the proposed rules are known, is on track for implementation in late 2006 - two years later than originally planned.
Yet, despite the new, upbeat mood, final agreement on the new accord remains far from being a foregone conclusion. And the potential deal-breaker is the US.
Despite the conviction among many regulators in Europe that the new rules must be implemented to reduce the risk of disruption to the international financial system, there is a far more wary mood in Washington. "Having discussed the proposals with heads of several [US bank regulatory] agencies, I don't believe there is anybody that thinks [an agreed Accord] is a 100% knockdown certainty," says Jerry Hawke, Comptroller of the Currency, one of the country's most powerful regulators, and the most vocal critic of the accord's complexity.
Mr Hawke's concern, spelt out in an interview with The Banker, is that those US banks subject to the proposed Basel II rules will be put at a competitive disadvantage - a fear also expressed by banks and regulators elsewhere.
Complexity concerns
Although US unhappiness with the new accord could prove to be potentially the most lethal factor against implementation, there are also influential academic dissidents who are increasingly alarmed about the complexity of the proposals emerging from the various Basel working groups, and the danger that this will lead to unintended consequences. Some fear that the proposed rules will exacerbate the business cycle, intensifying booms and busts.
The Basel II Accord is intended to replace the Basel I rules introduced in 1988. It is designed to be a much more efficient and risk-sensitive way of ensuring that banks keep adequate capital rather than the one-size-fits-all minimum capital-asset ratio employed under the first accord, which has been adopted by more than 100 countries. The successor accord is being tortuously crafted under the auspices of the Basel Committee on Banking and Supervision. This comprises 30 regulators (including four from the US) from some 13 developed countries, under the chairmanship of William McDonough, president of the New York Federal Reserve Bank.
Work on the new accord has certainly been boosted by the July breakthroughs on vexed issues that have kept lights burning late for months in the Basel offices of the banking committee secretariat. These issues include the treatment of loans to small and medium-sized enterprises, something that particularly exercises the German authorities; the precise extent of risk attaching to credit card lending, which particularly concerns US banks; and the risk weights that should be applied to specialised lending, such as project finance and loans to finance revenue-generating real estate.
Compromise boosts confidence
These issues, which turn on how much regulatory capital banks must set aside when they undertake such activities, are mostly proving susceptible to (often, political) compromise. Progress on such issues is boosting confidence that the banking committee can stick to its latest timetable. This involves undertaking a quantitative impact study (QIS) in October, enabling banks to run their risk models on the basis of the deals agreed so far, and feeding the results back to the committee. That will be followed by a third consultative document next spring, and a definitive set of rules towards the end of 2003. After a three-year implementation period, the Basel II accord is scheduled to take effect in late 2006 or early 2007.
Even the most optimistic banking committee members accept that further delay will damage their credibility. "If there is further delay, the whole basis of the process will be called into question. We might as well pack our bags and go home," says one secretariat official.
The problem is that many of the criticisms of the proposed Basel II accord do not concern particular types of lending or mathematical risk-weight formulas that are susceptible to negotiation and compromise. Rather, they challenge the very basis of what the committee is trying to achieve.
In particular, critics despair at the mind-numbing complexity that results from the regulators' attempts to grade risks and calibrate the level of capital that banks must set aside for different types of business and different quality of borrowers. The laudable aim of both making capital requirements more risk sensitive and rewarding those banks that demonstrate the best risk management, is producing something that threatens to be unweildy and unworkable.
This complexity is leading to marked differences between US regulatory agencies. Mr Hawke, who is reported to have described the Basel II accord as "nearly unimplementable," says: "I feel strongly that the more complex and prescriptive this thing gets, the more US banks are going to be disadvantaged and the harder it will be for them to accept the new rules." One of the four US regulators on the Basel banking committee, Mr Hawke argues that the US has the "most intrusive, most hands-on supervisory process in the world," with as many as 40 or 50 regulators resident in large banks, such as Bank of America and Citibank.
As a result, the rules are likely to be much more vigorously enforced in the US than in countries where there may be just an occasional outside audit, he says. The unspoken suggestion is that banks in some jurisdictions will have scope to bend the rules when it suits them.
Difference of opinion?
Although Mr Hawke claims that he and NY Fed chief Mr McDonough agree about many aspects of Basel II, some close observers discern considerable differences of tone in their comments on the subject. Mr Hawke raised eyebrows in June, when he concluded a speech with the words: "Whether we ultimately get a new Accord or not..." This appeared to acknowledge a possibility of failure, something few other regulators would accept.
Hinting at inter-agency differences, Mr Hawke says in his interview with The Banker: "Some people at the Fed respond to criticisms of complexity by saying that 'we live in a complex world.' But I do not think that is a sufficient answer. You can't say we live in a complex world, therefore we have to have 700 pages of capital rules."
In the end, whether the US signs up to Basel II will depend on its acceptability to the banks. So far the "political process in the US has not been activated," on this subject. If the banks are unhappy and decide to lobby Congress "I cannot say what the consequences would be," Mr Hawke says, ominously.
US regulators have already indicated that, in any case, the Basel II rules will only be applied to the country's "internationally active banks," unlike Basel I, which made few distinctions between types of credit risk, and was simple enough to apply to all US banks. Estimates vary over how many banks would fall into this "internationally active" category. It would amount to around 25 out of the total 2200 banks supervised by the Office of the Comptroller of the Currency (OCC). In total, the US has around 8300 deposit taking banks, many of them small community banks, and 1600 thrift institutions.
Mr Hawke reckons that even among the 25 internationally active banks supervised by the OCC, perhaps only half a dozen are capable of the kind of sophisticated credit modelling necessary to qualify under the most advanced Basel II approach to credit risk assessment. It is this so-called Internal Ratings Based (IRB) approach that offers the more sophisticated banks the possibility of demonstrating that they can safely operate at a lower level of capital - and, therefore, more profitably - than regulators will otherwise demand. On some estimates, banks with advanced credit risk models may be able to operate with 20% less capital than presently required.
Europe uneasy
However, alarm over the complexity of the proposed Basel II accord is also being expressed in Europe, where one group of academics and risk managers are considering submitting proposals for a slimmed-down, much simpler Basel II. This has been dubbed the Basel Lite version by Alistair Milne, a senior lecturer at the City University Business School, in London, and an erstwhile economic adviser to the Bank of England, who says the Basel banking committee should admit that it has got it wrong and start again.
One reason for the complexity of the proposals is that they include not only credit and market risks, but also operational risks, such as fraud, computer system failures and trade settlement screw ups, which were not explicitly covered in Basel I. Each of these three types of risk - credit, market and operational - are then dealt with under three pillars. The first pillar sets minimum capital requirements, the second involves a supervisory review process, and the third sets a framework to bolster market discipline through increased information disclosure by banks, allowing investors and customers to see their risk profiles.
On top of this, the measurement for capital adequacy under pillar one allows two or three different approaches for each class of risk. In the case of credit risk, for example, banks are presented with three options, ranging from the standardised, or most basic approach, to the advanced Internal Ratings Based approach.
"It's a complete mess," says Andrew Hilton, director of the Centre for the Study of Financial Innovation (CSFI), a London think-tank, which has become the focus for Basel II dissidents. However, he is doubtful about his group's chances of persuading regulators to slim down the accord into a Basel Lite version. Most regulators, and their support staff, "have fallen in love" with the new accord, he says. "Basel II is the product of a thousand political compromises. If you try and take bits out, the whole thing will unravel."
Boom and bust cycle
One of the strongest intellectual challenges to the Basel II accord is that it could make business cycles more violent, by giving an additional boost to credit expansion in boom times and causing sharper lending contractions in times of recession, thereby exacerbating any credit crunch. This issue has been raised by a number of economists within the financial markets group at the London School of Economics, including professor Charles Goodhart, who is also a part-time adviser to the governor of the Bank of England, on financial stability matters.
It is an issue with which regulators have some sympathy. In a progress report following their June meeting, they announced technical changes aimed at lessening any tendency of the Basel II accord to encourage "pro-cyclical" bank lending.
In addition, banks will be required to maintain a capital "buffer" under pillar two - the supervisory review pillar - that should be built up during good times and run down during bad times, thus offsetting the pro-cyclical character of pillar one. But some academic critics remain concerned that this will not really address the pro-cyclical dangers, in practice.
More of the same
Yet another worry is that the IRB approach to credit risk measurement will result in much greater homogeneity among the more sophisticated banks' risk models.
The current diversity of models will be lost, says Brandon Davies, another prominent critic of the Basel II accord, and head of retail market risk at Barclays Bank, in London. The regulators' prescriptions and suggestions for "best practice" will have the effect of drawing the models closer together, he says.
This will actually create new systemic risks. The convergence of the models will "lead to everybody pricing risk the same way. If this view of risk turns out to be wrong, and some adverse event occurs, we will all go down together," says Mr Davies. "Systemic risk is likely to be more extreme if people have the same view of risk than if you allow them to make decisions for themselves," he adds.
Regulators think such fears are exaggerated. There may be an element of prescription over the framework in which a bank presents its credit risk assessments to its regulator, they say, but there is no intention to tell banks how they should make their risk assessments, in the first place.
Unfair conditions
In the end, however, the issue on which the Basel II accord would be most likely to founder is the way it is perceived to tilt the playing field for different groups of banks. The playing field may not be level today, as many banks complain, but the proposed new rules could put a lot more bumps in it, not least because of the complexity of the new accord, and the inevitably subjective quality of the supervisory review process under pillar two.
The irony is that part of the motive for establishing Basel I was to reduce the differences that then existed in the way that banks were regulated in different jurisdictions. The danger now is that, in interpreting the rules, and deciding how they should be applied, and to whom, the regulators may once again have too much discretion.
The complexity of the accord "means that differences will emerge in the implementing legislation on both sides of the Atlantic, and be magnified," says the CSFI's Mr Hilton. Whereas US regulators are planning to subject only a relatively few of their banks to the new Basel rules, the EU Commission in Brussels intends to impose it, through a directive, on a range of financial institutions in Europe, including non-credit institutions such as investment banks, securities brokers, and fund managers - as well as all banks. For non-credit institutions, it is the need to maintain regulatory capital against operational risks that is the biggest headache.
All this could put many European financial institutions at a disadvantage when competing in the US or internationally, say some critics, because they will be obliged to set aside more regulatory capital than their US rivals.
Operational risk worries
In the US, meanwhile, some specialised banks are also alarmed at the possibility of facing operational risk regulatory capital requirements. For example, Boston-based State Street, specialising in custody business - which accounts for a very high proportion of its activities - is fiercely opposing the Basel II operational risk rules.
State Street - together with Pittsburgh-based Mellon Bank and several others, specialising in businesses such as custody, asset management and payments systems - have formed the Financial Guardian Group (FGG) to lobby on their behalf. These banks, which are likely to be at a competitive disadvantage compared with non-banks undertaking similar types of business in the US, are seeking to have operational risk removed from pillar one and centred in pillar two, instead. This would mean that banks and regulators cease to try and measure such risks numerically - an exercise greatly hindered by the paucity of data - and leave the assessment of a bank's operational risk controls entirely to the judgement of supervisors. It is a counter-proposal strongly backed by Mr Hawke, but would increase regulatory discretion still further.
Although Basel regulators made some technical concessions in their July progress report, the operational risk formula still amounts to a regulatory capital charge "based on a variety of arbitrary factors to which my clients remain opposed," says Karen Shaw Petrou, executive director of FGG. If the operational risk rules are not changed and the banks remain unhappy about the regulatory capital charge, they have the option of "de-banking", she says.
These specialised institutions "do not have to do business as a bank. In the US there are many charter options, and most are not covered by Basel II rules. For example, Goldman Sachs and Merrill Lynch are not registered as banks," she adds.
But if many institutions in the US elect to change their charters in this way, and de-bank, this will increase the pressure on European rivals who do not have this choice. And, it is not just banks in Europe and the US that are fearful. Those in many developing countries are also worried that they are going to be disadvantaged by the Basel II accord. Local banks in developing countries, which are able to apply only the simplest credit risk measurement approach - and, therefore, obliged to hold relatively high levels of regulatory capital - could have a difficult job competing domestically with global banks that employ the most sophisticated techniques, and lower levels of capital.
"Global banks using the IRB approaches will be able to price local banks out of the market," says Mr Hilton. This means that the local regulator will be under intense pressure to sanction their local banks' IRB credit risk models, no matter how bad the models and the banks may be, he argues. "Regulators will start to 'game' the system quite quickly."
Research results
Just how significant the Basel II accord may be for the banking industry was illustrated by research published last September by Schroder Salomon Smith Barney, a subsidiary of the giant Citigroup. It concluded that the winners, under the new rules - the mostly large, sophisticated banks - would ultimately save 20%-30% of regulatory capital, leaving them with large surpluses, to distribute to shareholders or re-deploy in their businesses. Many other banks would find their regulatory capital requirements sharply increased.
This is a predictable, and largely intended result of Basel II. But the consequences could be very undesirable. It will mean, say the researchers, that some businesses become the preserve of a few industry leaders, that barriers to entry will be raised for newcomers, and that M&A activity will surge, as the winners use their surplus capital to acquire the losers. Consolidation in the global banking industry and a big fillip to the emergence of super banks, may be among the more certain consequences of a Basel II agreement.
