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Basel II, US Banks Have Until January 2008 to Comply Plus 3 Year Transition Period (September 29, 2006)

Location: Basel
Author: Ellen J. Silverman
Date: Friday, September 29, 2006

U.S. banking agencies announced in late 2005 that U.S. banks will be granted an extension to the January 2007 deadline for Basel II compliance by the Bank for International Settlements. In May, the Basel Committee announced plans to maintain the most recently proposed capital-adequacy guidelines, which will decrease reserve levels for internationally active, diversified institutions based on the adopted approach to credit and operational risk. U.S. banks now have until January 2008 to adhere to the new cross-border capital adequacy mandates, plus an additional three-year transition period, while other global institutions will be required to comply by early 2007.

Basel II brings a much greater level of granularity in the assessment of creditworthiness among obligors. The goal is to align global capitalization standards with current banking practices. This will help minimize the potential for regulatory arbitrage-including known instances in which banks have leveraged certain assets to exploit weaknesses in Basel I's risk weighting system. Basel II promotes three mutually reinforcing standards: minimum risk-based capital set-asides; supervisory review of an institution's capital adequacy and internal risk measurement methodologies; and market discipline through disclosure in order to promote sound practices. In the U.S., guidelines will be mandatory for financial institutions with $250 billion or more in assets or $10 billion or more in foreign exposure.

As background, when Basel II was first proposed, it was presumed that the world's largest banks would have a leg up given their vast resources, including historical risk databases. In fact, the biggest banks faced the greatest challenge because of the difficulty aggregating enterprise data like default rates and loss-given-default statistics. Global banks have spent millions of dollars scaling the Basel II implementation curve and compliance costs will undoubtedly rise as Basel II applies new methods for measuring and managing risk across a firm's varied business lines. In late 2005, the Basel committee issued an updated and final Basel II framework, as well as a modified version of the amendment to the capital accord. The revised guidelines will rely on banks' internal risk systems as well as data supplemented and verified by regulators and credible third parties.

Regulators are still addressing competitive concerns raised by smaller banks with fewer resources to implement Basel II's more complex risk-based methodologies. Many of the same smaller U.S. institutions contend they will be placed at a competitive disadvantage due to lower capital requirements of the large institutions adopting Basel II. U.S. banking authorities have indicated they will closely monitor any reduction in regulatory capital arising from Basel II for the larger banks.

As firms begin the necessary legwork to implement systems and processes in keeping with the new accord, one major factor contributing to the revised U.S. plan was the most recent in a series of authentic impact studies sponsored by the Basel committee on banking supervision. The initial studies found that most banks would require more capital to cover credit, operational and market risk. Some banks protested the results, which implied less cash that could be put to work in the markets. Quantitative impact study four, sponsored by the committee, recalibrated the risk-weighting curves. Based on the revised calculations, the majority of international banking supervisors found the need for regulatory capital wasn't as high as projected.

Some market participants say that in trying to satisfy banks that will be required to participate in the accord, Basel committee members may have overreached their mark. The lowered capital-adequacy threshold appears low against S&P's default experience based on the weighting and credit quality of assets. Some U.S. regulators agree. Speaking before the U.S. Senate Banking Committee in mid-November, U.S. Federal Reserve Board governor Susan Schmidt Bies says QIS4 was fundamentally flawed because data was collected at a particularly favorable point in the business cycle, and reflected asset portfolio, risk-management information and models during one of the best periods of credit quality in recent years.

U.S. regulators further contend that Basel II fails to leverage appropriate risk-measurement methodologies, including distinct risk weights for diversified assets. This point is key, given the complex nature of global banking. In addition to lowered capital reserve levels, QIS4 found a much greater-than-expected dispersion of risk across banks with similar portfolios. This counterintuitive result called into question the efficacy of Basel II for calculating and weighting risk. U.S. broker-dealers that fall within the aegis of the new banking law will be required to adopt Basel-compliant capitalization standards under the purview of the SEC. Brokerage reserve levels were initially set at 99 percent or more of 10-day value-at-risk.

With the lines between the banking and trading book increasingly blurred, one challenge will be assessing risk that straddles multiple risk categories in the Basel regime, such as credit, market and operational risk. Regulators are working to resolve Basel's diversification and risk-allocation issues. As Basel members continue to collaborate in refining Basel's risk-measurement and risk-management methodologies, some complain that the emerging standards are so arcane; it will be exceedingly difficult to implement them. Countering these concerns, regulators say Basel II must reflect the technologically advanced and sophisticated quantitative solutions used in many of today's global banks.

U.S. compliance rules are set to be finalized by the third quarter. Supervised testing of the Basel II guidelines is scheduled to begin in the U.S . in January 2008. In the meantime, banks continue to lack clarity on what will be expected of them. Even regulators concede that making the necessary enhancements to risk-measurement and risk-management systems, including developing robust historical databases, is all the more challenging in the absence of final supervisory guidance. Notwithstanding the challenges, the outcome for firms that implement the new banking standards will be an improved risk-management profile and potentially better bottom-line results.

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