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Banks Worry as US Stalls Over Basel II (January 23, 2006)

Location: Washington, DC
Author: Ellen J. Silverman
Date: Monday, January 23, 2006

The implementation of Basel II in the US continues to progress slowly and frustrate financial institutions. The Basel II accord is intended to help improve risk management globally through better alignment with capital requirements. It is hoped that Basel II will improve capital allocation and efficiency in the international financial markets.

In a report to the Basel committee last month the Institute of International Finance, said: "We believe that adoption of inconsistent versions of the accord in different jurisdictions not only would generate additional costly efforts for banks, but also could ultimately disrupt the successful implementation of Basel II, undermine its basic fabric and create serious level playing field issues."

Daniel Bouton, chairman and chief executive of Societe Generale and chair of the IIF's steering committee on Basel II, said, "Our members, many of whom operate in many countries, are concerned that different implementation schedules have been set for various jurisdictions. This is in our view regrettable. In addition to the increased risk that competitive inequities could develop, it would also generate costly inefficiencies in the implementation of the accord."

Although the US banking regulators were involved in negotiating Basel II and continue to express support for it, they have been slow to introduce final rules to implement the accord. This has been due in part to concerns expressed by financial institutions and politicians who say that the two-tier version of the accord the regulators plan to use would put smaller US banks at a competitive disadvantage. Questions have also been raised over the treatment of credit derivatives and securitization products.

The EU will separate its banking system into three tiers--standard, foundation and advanced--with increasing levels of adherence to the full Basel II accord. The US regulators, however, have essentially foregone the middle tier. Under their current plans only the very largest and most international banks will be able to adopt Basel II, while the remaining smaller institutions will apply a watered-down version, known as Basel IA. The intention of having multiple tiers is to enable smaller banks to avoid the costs associated with implementing the highly complex risk assessment processes required to meet Basel II standards.

However a study known as QIS-4, released earlier this year, indicated that applying Basel II would also enable banks to cut their capital costs significantly. The smaller banks fear they will be put out of business if they cannot take advantage of these savings and are lobbying for the regulators to change their plans. Many mid-size and larger banks that do not qualify to use the Basel II rules say that they should be allowed to do so, and that Basel IA does not recognize their risk management systems.

In response to these criticisms, banking agencies The Federal Reserve, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation and the Office of Thrift Supervision issued an advanced notice of proposed rulemaking (ANPR) in October detailing the Basel IA requirements. The ANPR seeks to allay the fears of smaller banks. This measure would reduce, though not completely remove, the risk-weighting advantage that so-called Basel II banks would enjoy. It also suggests measures such as a wider use of credit ratings to help set risk weights.

At around the same time, the four agencies also announced that they would delay implementation of Basel II. Under the new timetable, US banks will be able to conduct parallel runs where they comply with the existing and Basel II rules from January 2008, a year behind the EU, and full implementation will not take place until 2012. This discrepancy between the US and EU schedule will mean that US banks subject to Basel II will have to balance two sets of rules where they have foreign-based subsidiaries and operations. They will also be at a competitive disadvantage to European banks that are able to make use of the lower capital requirements possible under the accord.

The US agencies were due to release a notice of proposed rulemaking (NPR) detailing how Basel II will apply to larger US banks earlier in 2005 but have continued to postpone its release in the face of political and industry scrutiny and rumors of disagreements among the agencies over how to proceed. Last month representatives of the agencies were called to give testimony to the US Senate committee on banking, housing and urban affairs on the implementation of Basel II and revisions to the original Basel I.

Comptroller of the currency John Duggan defended the rulemaking process and the twin-track Basel II and Basel IA approach. "I believe that, once the Basel II framework is implemented completely and rigorously supervised in the controlled environment of the transition period, and once we have had the opportunity to make necessary changes to the framework based on the knowledge we gain during that period, the concerns raised by QIS-4 will be addressed," he said.

Lawyers who advise financial institutions are also left in limbo by the delays. At this stage, they say, there is little they can do to help clients. Most of the larger and more sophisticated institutions have put in place systems and processes to calculate their cap ital requirements tinder the Basel II proposals and are simply waiting to be given the permission to start operating.

Delaying implementation of Basel II in the US presents its own problems, but one lawyer warns that this disconnect with the rest of the world might become permanent. Despite this, Basel IA still leaves a few remaining issues that could be difficult to resolve. While as a compromise it might not satisfy everyone, banks and the regulators could decide that making the final few steps towards Basel II is not worth the effort. Instead, all US banks could adopt Basel IA and drop the Basel II proposals. That would not be the outcome many would wish for, and if it leaves the larger US banks at a competitive disadvantage against their European and Asian rivals, they can be expected to take serious action. But after many years of negotiations, and with enthusiasm for the project said to be waning at some of the agencies, it could potentially happen.

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