Risk-Based Capital
Bank Regulators Need to Improve Transparency and Overcome Impediments to Finalizing the Proposed Basel II Framework Gao ID: GAO-07-253 February 15, 2007Concerned about the potential impacts of the proposed risk-based capital rules, known as Basel II, Congress mandated that GAO study U.S. implementation efforts. This report examines (1) the transition to Basel II and the proposed changes in the United States, (2) the potential impact on the banking system and regulatory required capital, and (3) how banks and regulators are preparing for Basel II and the challenges they face. To meet these objectives, GAO analyzed documents related to Basel II and interviewed various regulators and officials from banks that will be required to follow the new rules.
Rapid innovation in financial markets and advances in risk management have revealed limitations in the existing Basel I risk-based capital framework, especially for large, complex banks. U.S. banking regulators have proposed a revised regulatory capital framework that differs from the international Basel II accord in several ways, including (1) requiring adoption of the most advanced Basel II approaches and by only the largest and most internationally active banks; (2) proposing Basel IA, a simpler revision of Basel I, and retaining Basel I as options for all other banks; and (3) retaining the leverage requirement and prompt corrective action measures that exist under the current regulatory capital framework. While the new capital framework could improve banks' risk management and make regulatory capital more sensitive to underlying risks, its impact on minimum capital requirements and the actual amount of capital held by banks is uncertain. The approaches allowed under Basel II are not without risks, and realizing the benefits of these approaches while managing the related risks will depend on the adequacy of both internal and supervisory reviews. The move to Basel II has also raised competitiveness concerns between large and small U.S. banks domestically and large U.S. and foreign banks internationally. The impact of Basel II on the level of required capital is uncertain, but in response to quantitative impact study results showing large reductions in minimum required capital, U.S. regulators have proposed safeguards, such as transitional floors, that along with the existing leverage ratio would limit regulatory capital reductions during a multiyear transition period. Finally, the impact on actual capital held by banks is uncertain because banks hold capital above required minimums for both internal risk management purposes as well as to address the expectations of the market. Banks and regulators are preparing for Basel II without a final rule, but both face challenges. Bank officials said they were refining their risk management practices, but uncertainty about final requirements has made it difficult for them to proceed further. Banks also face challenges in aligning their existing systems and processes with some of the proposed requirements. While regulators plan to integrate Basel II into their current supervisory process, they face impediments. The banking regulators have differing regulatory perspectives, which has made reaching consensus on the proposed rule difficult. Banks and other stakeholders continue to face uncertainty. Among the issues that regulators have yet to resolve are how the rule will treat bank portfolios that do not meet data requirements, how they will calculate reductions in aggregate minimum regulatory capital and what they will do if the reduction exceeds a proposed 10 percent trigger, and what criteria they will use to determine the appropriate average level of required capital and cyclical variation. Increased transparency going forward could reduce ambiguity and respond to questions and concerns among banks and industry stakeholders about how the rules will be applied, their ultimate impact on capital, and the regulators' ability to oversee their implementation.
RecommendationsOur recommendations from this work are listed below with a Contact for more information. Status will change from "In process" to "Open," "Closed - implemented," or "Closed - not implemented" based on our follow up work.
Director: Team: Phone:GAO-07-253, Risk-Based Capital: Bank Regulators Need to Improve Transparency and Overcome Impediments to Finalizing the Proposed Basel II Framework
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Report to Congressional Committees:
United States Government Accountability Office:
GAO:
February 2007:
Risk-Based Capital:
Bank Regulators Need to Improve Transparency and Overcome Impediments
to Finalizing the Proposed Basel II Framework:
GAO-07-253:
GAO Highlights:
Highlights of GAO-07-253, a report to Congressional Committees
Why GAO Did This Study:
Concerned about the potential impacts of the proposed risk-based
capital rules, known as Basel II, Congress mandated that GAO study U.S.
implementation efforts. This report examines (1) the transition to
Basel II and the proposed changes in the United States, (2) the
potential impact on the banking system and regulatory required capital,
and (3) how banks and regulators are preparing for Basel II and the
challenges they face. To meet these objectives, GAO analyzed documents
related to Basel II and interviewed various regulators and officials
from banks that will be required to follow the new rules.
What GAO Found:
Rapid innovation in financial markets and advances in risk management
have revealed limitations in the existing Basel I risk-based capital
framework, especially for large, complex banks. U.S. banking regulators
have proposed a revised regulatory capital framework that differs from
the international Basel II accord in several ways, including (1)
requiring adoption of the most advanced Basel II approaches and by only
the largest and most internationally active banks; (2) proposing Basel
IA, a simpler revision of Basel I, and retaining Basel I as options for
all other banks; and (3) retaining the leverage requirement and prompt
corrective action measures that exist under the current regulatory
capital framework.
While the new capital framework could improve banks‘ risk management
and make regulatory capital more sensitive to underlying risks, its
impact on minimum capital requirements and the actual amount of capital
held by banks is uncertain. The approaches allowed under Basel II are
not without risks, and realizing the benefits of these approaches while
managing the related risks will depend on the adequacy of both internal
and supervisory reviews. The move to Basel II has also raised
competitiveness concerns between large and small U.S. banks
domestically and large U.S. and foreign banks internationally. The
impact of Basel II on the level of required capital is uncertain, but
in response to quantitative impact study results showing large
reductions in minimum required capital, U.S. regulators have proposed
safeguards, such as transitional floors, that along with the existing
leverage ratio would limit regulatory capital reductions during a
multiyear transition period. Finally, the impact on actual capital held
by banks is uncertain because banks hold capital above required
minimums for both internal risk management purposes as well as to
address the expectations of the market.
Banks and regulators are preparing for Basel II without a final rule,
but both face challenges. Bank officials said they were refining their
risk management practices, but uncertainty about final requirements has
made it difficult for them to proceed further. Banks also face
challenges in aligning their existing systems and processes with some
of the proposed requirements. While regulators plan to integrate Basel
II into their current supervisory process, they face impediments. The
banking regulators have differing regulatory perspectives, which has
made reaching consensus on the proposed rule difficult. Banks and other
stakeholders continue to face uncertainty. Among the issues that
regulators have yet to resolve are how the rule will treat bank
portfolios that do not meet data requirements, how they will calculate
reductions in aggregate minimum regulatory capital and what they will
do if the reduction exceeds a proposed 10 percent trigger, and what
criteria they will use to determine the appropriate average level of
required capital and cyclical variation. Increased transparency going
forward could reduce ambiguity and respond to questions and concerns
among banks and industry stakeholders about how the rules will be
applied, their ultimate impact on capital, and the regulators‘ ability
to oversee their implementation.
What GAO Recommends:
With safeguards, it is appropriate for U.S. banking regulators to
proceed with finalizing Basel II and begin the transition period. GAO
recommends that they (1) clarify some aspects of the Notice of Proposed
Rulemaking (NPR); (2) issue a new NPR if material differences from the
current NPR, or a U.S. standardized approach option, are planned for
the final rule; (3) issue periodic public reports on progress, results,
and any needed adjustments; and (4) at the end of the transition
period, reevaluate the appropriateness of Basel II as a long-term
framework for setting regulatory capital. The Federal Reserve said it
agreed with our recommendations and the other banking agencies said
they will consider them as part of the rule-making process.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-07-253].
To view the full product, including the scope and methodology, click on
the link above. For more information, contact Orice Williams at
williamso@gao.gov or Tom McCool at mccoolt@gao.gov.
[End of section]
Contents:
Letter:
Results in Brief:
Background:
The Transition to Basel II Has Been Driven by Limitations of Basel I
and Advances in Risk Management at Large Banking Organizations:
Federal Regulators Are Proposing a Regulatory Capital Framework that
Differs from the International Basel II Accord in Several Respects:
Basel II Is Expected to Improve Risk Management and Enhance Capital
Allocation, While Proposed Safeguards Would Help to Prevent Large
Capital Reductions during a Temporary Transition Period:
Core Banks Are Incorporating Basel II into Ongoing Efforts to Improve
Risk Management, but Challenges Remain:
U.S. Regulators Are Integrating Preparations for Basel II into Their
Current Supervisory Process but Face a Number of Impediments:
Conclusions:
Recommendations:
Agency Comments and Our Evaluation:
Appendix I: Scope and Methodology:
Appendix II: U.S. and International Transition to Basel II:
Appendix III: Basel II Descriptive Overview:
Appendix IV: Comments from the Board of Governors of the Federal
Reserve System:
Appendix V: Comments from the Office of the Comptroller of the
Currency:
Appendix VI: Comments from the Federal Deposit Insurance Corporation
and the Office of Thrift Supervision:
Appendix VII: Comments from the Department of the Treasury:
Appendix VIII: GAO Contacts and Staff Acknowledgments:
Related GAO Products:
Tables:
Table 1: Major Types of Banking Risks:
Table 2: U.S. Basel I Credit Risk Categories:
Table 3: Differences in U.S.-Proposed Implementation of Basel II and
International Accord:
Figures:
Figure 1: The Three Pillars of Basel II:
Figure 2: Banks that Meet U.S.-Proposed Criteria for Mandatory Adoption
of Basel II:
Figure 3: Sensitivity to Credit Risk for Mortgages under Basel I and
Basel IA:
Figure 4: U.S. Regulatory Capital Requirements:
Figure 5: Leverage Ratio vs. Basel II Credit Risk Required Capital for
Externally Rated Corporate Exposures, by Rating:
Figure 6: Leverage Ratio vs. Basel II Credit Risk Required Capital for
Mortgages, by Probability of Default:
Figure 7: Computation of Capital Requirements for Wholesale and Retail
Credit Risk under Basel II:
Abbreviations:
A-IRB: Advanced Internal Ratings-Based Approach:
AMA: Advanced Measurement Approaches:
ANPR: advance notice of proposed rulemaking:
EAD: exposure at default:
FDIC: Federal Deposit Insurance Corporation:
LDA: loss distribution approach:
LGD: loss given default:
LTV: loan-to-value:
MRA: Market Risk Amendment:
NPR: Notice of Proposed Rulemaking:
OCC: Office of the Comptroller of the Currency:
OTS: Office of Thrift Supervision:
PCA: prompt corrective action:
PD: probability of default:
QIS-4: Fourth Quantitative Impact Study:
SEC: Securities and Exchange Commission:
VAR: value-at-risk:
United States Government Accountability Office:
Washington, DC 20548:
February 15, 2007:
The Honorable Christopher Dodd:
Chairman:
The Honorable Richard Shelby:
Ranking Member:
Committee on Banking, Housing, and Urban Affairs:
United States Senate:
The Honorable Barney Frank:
Chairman:
The Honorable Spencer Bachus:
Ranking Member:
Committee on Financial Services:
House of Representatives:
For nearly a decade, federal banking regulators have been considering
revisions to risk-based capital rules that could have far-reaching
consequences for the safety, soundness, and efficiency of the U.S.
banking system.[Footnote 1] The original risk-based capital rules,
known as Basel I, were adopted by the Basel Committee on Banking
Supervision in 1988 and implemented in the United States in
1989.[Footnote 2] The proposed changes, known as Basel II, are based on
an internationally adopted framework developed by the Basel Committee.
Basel II aims to align minimum capital requirements with enhanced risk
measurement techniques and to encourage banks to develop a more
disciplined approach to risk management. In the United States, Basel II
rules are intended to apply primarily to the largest and most
internationally active banking organizations. U.S. regulators expect
about 11 banking organizations (core banks), which account for close to
half of U.S. banking assets, to be required to implement Basel II. As
such, regulators must take care to ensure that Basel II functions as
intended to help preserve the safety and soundness of the banking
system and mitigate the risk of losses to the federal deposit insurance
fund.
However, in moving toward the proposed Basel II framework, a number of
serious concerns have been raised by regulatory officials, banks,
academics, and congressional and industry stakeholders. First,
considerable uncertainty remains about the appropriate level of minimum
required capital and the potential impact of the proposed rules on
minimum required risk-based capital levels. Second, the proposed rules
depend in part on the reliability of banks' internal models, and some
observers have expressed concerns about using banks' internal models
for establishing regulatory capital requirements. Third, the increased
complexity of regulatory capital calculations undertaken by banks
heightens the challenge of effective oversight by banking regulators.
Fourth, the U.S. proposed rules differ in some respects from those of
other countries, raising concerns about possible competitive effects of
different rules between domestic and foreign banking organizations.
Concerns have also been raised about domestic competitive inequities
between banks that adopt Basel II and those that do not.
In light of these concerns, Congress has held several oversight
hearings that have provided valuable information on regulatory
objectives, actions, and potential pitfalls throughout the ongoing rule-
making process. As part of this effort, Congress mandated that we
review the implementation of Basel II in the United States.[Footnote 3]
To date, federal regulators have requested public comment on a Basel II
Advance Notice of Proposed Rulemaking (ANPR) and Notice of Proposed
Rulemaking (NPR). They also have proposed additional changes, known as
Basel IA, to establish simpler revisions to the regulatory capital
framework for banks not subject to Basel II.[Footnote 4] However,
regulators do not expect to issue final rules until later in 2007.
Because the rule-making process is not complete, this report can
address only certain aspects of the implementation process to date.
Specifically, this report examines the following:
1. developments leading to the transition to Basel II,
2. the proposed changes to the U.S. regulatory capital framework,
3. the potential implications of Basel II's quantitative approaches and
their potential impact on required capital,
4. banks' preparations and related challenges, and:
5. U.S. regulators' preparations and related challenges.
To meet our objectives, we reviewed the Basel II international accord,
the U.S. proposed rules for Basel II and Basel IA, draft supervisory
guidance, and related materials. We interviewed officials at the
federal bank regulatory agencies to obtain their views. We also
interviewed officials at each of the banks that, under the proposed
rule, would be required to adopt Basel II; a sample of banks that may
opt into Basel II (based in part on size and primary regulator); a
state bank regulator and an association of state bank supervisors; two
bank trade associations; and two credit rating agencies. To understand
how regulators oversee risk management processes at core banks and how
the regulators are planning to incorporate Basel II into their
examinations, we interviewed bank examiners and reviewed examination
reports. We also compared the proposed capital requirements for
different assets to demonstrate how related capital requirements may
change, depending on the business cycle and the estimated level of risk
of holding certain assets. We conducted our work from April 2006 to
January 2007 in accordance with generally accepted government auditing
standards. More information on our scope and methodology appears in
appendix I.
Results in Brief:
The motivation to revise risk-based capital requirements in the United
States and internationally has been driven by the limitations of Basel
I, especially for large, complex banking organizations, and by advances
in risk management at these organizations. Regulatory officials
generally agree that while Basel I continues to be an adequate capital
framework for most banks, several limitations have rendered it
increasingly inadequate for supervising the capital adequacy of the
nation's largest, most complex banks. For example, Basel I's simple
risk weighting approach does not adequately differentiate between
assets that have different risk levels, offers only a limited
recognition of credit risk mitigation techniques, and does not
explicitly address all risks faced by banking organizations. In
addition, significant financial innovations have occurred since Basel I
was established in 1988 to the point where a bank's regulatory capital
ratios may not always be useful indicators of its risk profile. Many
large banks have also developed advanced risk measurement techniques--
including economic capital models--which regulators have sought to
encourage both as an element of strong risk management and because such
techniques may provide useful input to the supervisory process. By more
closely aligning regulatory capital methodologies with banks' internal
economic capital methodologies, Basel II aims to encourage large banks
to develop and maintain a more disciplined approach to risk management.
While Basel II is an international accord based on shared regulatory
objectives, U.S. regulators are proposing a regulatory capital
framework that differs from the international accord in several ways.
As recognized in the international accord, the United States and other
adopting countries have used different degrees of national discretion
in developing their own national rules to implement Basel II. The U.S.-
proposed changes would result in three risk-based capital regimes--
Basel II, Basel IA, and Basel I--largely based on a banking
organization's size and complexity. While the Basel II international
accord allows for the option of choosing from among several risk
measurement approaches, U.S. regulators have proposed to limit the
scope of Basel II to the advanced approaches and to require it only for
the largest and/or most internationally active banks. These advanced
approaches depend in part on a bank's own internal models. However,
regulators have requested public comments on simpler approaches for
determining minimum required capital--such as the "standardized
approach" in the international accord and the U.S. Basel IA rule--as
possible options for Basel II banks.[Footnote 5] U.S. regulators also
have delayed implementation of the changes to the regulatory capital
framework in response to concerns raised by a quantitative impact study
about the potential adverse impact of Basel II on regulatory capital.
They also have proposed prudential safeguards beyond those in the
international accord, such as more conservative limits on permissible
reductions in required capital during the transition period for Basel
II banks. For banks not subject to Basel II, U.S. regulators have
proposed Basel IA, which consists of simpler revisions to Basel I, to
address potential domestic competitive inequities among banks. U.S.
regulators also plan to retain Basel I as an option for banks not
required to adopt Basel II. Finally, regulators plan to retain the
existing leverage ratio and prompt corrective action requirements for
all banks.[Footnote 6]
The new capital framework could improve bank risk management and make
the allocation of capital more risk sensitive, but the impact of Basel
II on minimum capital requirements and the actual amount of capital
held by banks is uncertain. The advanced Basel II risk-modeling
approaches have the potential to better align capital with risk, such
that banks would face minimum capital requirements more sensitive to
their underlying risks. However, the advanced approaches themselves are
not without risks, and realizing the benefits of these approaches will
depend on (1) the adequacy of bank quality assurance processes and
supervisory review surrounding the development and maintenance of
models, (2) the sufficiency of credit default and operational loss
event data used as inputs to the regulatory and bank models that
determine capital requirements, and (3) regulators' attention to the
appropriate level of risk-based capital. Possible differences in
regulatory capital requirements across banks subject to different risk-
based capital regimes have raised some banks' concerns about
competition between large and small banks domestically, and between
large banks headquartered in the United States and foreign banking
organizations. While initial estimates of the potential impact of Basel
II showed large drops in minimum required risk-based capital, a
considerable amount of uncertainty remains about the potential impact
of Basel II on the level of regulatory capital requirements and the
degree of variability in these requirements over the business cycle.
The banking regulators have committed to broadly maintaining the
current level of risk-based regulatory capital and have proposed
safeguards that would limit regulatory capital reductions during a
transition period. Regulators have also stated that banks under Basel
II would continue to be subject to the leverage ratio, which while
making required capital somewhat less risk sensitive, would also
prevent significant reductions in capital. Basel II's impact on the
total amount of capital held by banks, which would include capital held
above the regulatory minimum, is also uncertain, given banks' internal
assessments of capital needs and the amount of actual capital the
market and rating agencies expect them to hold. In light of the
uncertainty concerning the potential impact of Basel II, these issues
will require further and ongoing examination as the banking regulators
continue to finalize the Basel II rule and proceed with the parallel
run and transition period.
Officials from most core banks with whom we spoke reported that they
are making significant progress in further enhancing their risk
management practices but said that they faced several challenges,
including uncertainty about what the final rule would require. Most
officials at core banks stated that the banks had been working to
improve the way they assessed and managed credit, market, and other
types of risks, including the allocation of capital for these risks,
for some years and were largely integrating their preparations for
Basel II into their current efforts. Some officials saw Basel II as a
continuation of the banking industry's evolving risk management
practices and risk-based capital allocation that regulators had
encouraged. Many officials reported that their banks were investing in
information technology and establishing processes to manage and
quantify credit and operational risk, including collecting data on
credit defaults and operational losses, in order to meet the regulatory
requirements proposed for the advanced approaches. To varying extents,
many core banks are training staff and have hired additional staff to
implement Basel II. Furthermore, officials at most core banks said that
they had or would incur significant monetary costs and were allocating
many resources to implement Basel II. However, many officials reported
that their banks faced several challenges in implementing Basel II,
including the lack of a final rule, difficulty obtaining data that met
the minimum requirements for the advanced approaches for all asset
portfolios and data on operational losses, and difficulty aligning
their existing systems and processes with the proposed rule. Overall,
core bank officials with whom we spoke viewed Basel II as an
improvement over Basel I, and officials from noncore banks that were
considering adopting Basel II stated that they believed the new
regulatory capital framework would further improve their risk
management practices.
Likewise, U.S. regulators are integrating preparations for Basel II
into their current supervisory process, but a number of issues remain
to be resolved as regulators finalize the rule. In preparation for
Basel II implementation, bank regulatory officials said they had been
integrating plans for Basel II's additional supervisory requirements
into their existing oversight processes and supervisory reviews of
banks' risk management. Regulators are also preparing for the process
of qualifying banks to move to Basel II; coordinating with other U.S.
and international regulators; hiring additional staff with needed
quantitative skills; and training current supervisory staff, including
examiners. However, regulators face a number of impediments in their
efforts to agree on a final rule for the transition to Basel II. The
uncertainty about Basel II's potential impact and different regulatory
perspectives made reaching agreement on the NPR difficult, as is likely
to be the case for the final rule. Regulators have yet to resolve some
of the uncertainty and increase the transparency of their thinking by
providing more specific information about certain outstanding issues,
such as the following:
* how they will treat portfolios that may lack adequate data to meet
regulatory requirements for the advanced approaches,
* how they will calculate reductions in aggregate minimum regulatory
capital and what would happen if a reduction exceeds a proposed 10-
percent trigger, and:
* what criteria they will use to determine the appropriate average
level of required capital and appropriate cyclical variation in minimum
regulatory capital.
Moreover, the process could benefit from greater transparency going
forward--for example, by the regulators providing additional
information to facilitate understanding how they will assess the Basel
II results during the transition years and how they will report on any
modifications to the rule during that period. If these issues are not
addressed, the ongoing ambiguity and lack of transparency could result
in continued uncertainty about the appropriateness of Basel II as a
regulatory capital framework.
With the use of safeguards during the transition period, it is
appropriate for U.S. banking regulators to proceed with finalizing
Basel II and proceed with the parallel run and transition period. To
help reduce the uncertainty about the potential impact of Basel II,
improve transparency, and address impediments that regulators face in
transitioning to Basel II, we are making several recommendations to the
heads of the Federal Reserve System (Federal Reserve), Federal Deposit
Insurance Corporation (FDIC), the Office of the Comptroller of the
Currency (OCC), and the Office of Thrift Supervision (OTS):
* As part of the process leading to the proposed parallel run and
transition period, regulators need to clarify certain issues in the
proposed final rule, including how they will treat portfolios that may
lack adequate data to meet regulatory standards for the advanced
approaches, how they will calculate the 10-percent reduction in
aggregate minimum regulatory capital and respond if this reduction is
triggered, and the criteria regulators will use to determine the
appropriate average level of required capital and the appropriate level
of cyclical variation in minimum required capital.
* Regulators should issue a new NPR before finalizing the Basel II
rule, if the final rule differs materially from the NPR or if a U.S.
standardized approach is an option in the final rule.
* Regulators should also periodically publicly report on the progress
and results of the proposed parallel run and transition period along
with any needed regulatory alignments.
* Finally, regulators need to reevaluate, at the end of the last
transition period, whether the advanced approaches of Basel II can and
should be relied on to set appropriate regulatory required capital in
the long term. Based on the information obtained during the transition,
this reevaluation should include a range of options, including
consideration of additional minor modifications to U.S. Basel II as
well as whether more fundamental changes are warranted to set
appropriate required regulatory capital levels.
We received written comments on a draft of this report from the Federal
Reserve, OCC, FDIC and OTS in a joint letter, and the Department of the
Treasury. These letters are reprinted in appendixes IV through VII. The
banking agencies and Securities and Exchange Commission (SEC) also
provided technical comments, which we incorporated in the report where
appropriate. The Federal Reserve and OCC concurred with our recognition
of Basel I's limitations for large and/or internationally active banks
and agreed with our conclusion that the regulators should finalize the
Basel II rule and proceed with the parallel run and transition period.
OCC said its position has been to move forward with strong safeguards
in place and assess the need for adjustment during the transition
period before removing any temporary safeguards. OCC, and FDIC and OTS
in their joint letter, noted that the U.S. proposals leave two
safeguards that are not temporary in place--the leverage ratio and
prompt corrective action framework--and that these underscore the
agencies' commitment to maintaining a safe and sound banking industry.
The Federal Reserve commented that it and the other regulators had
attempted to be as transparent as possible in the rule-making process
consistent with the letter and spirit of the Administrative Procedure
Act, and OCC commented that it will ensure that the rule-making process
remains compliant with the act. FDIC and OTS said they believe serious
consideration of a U.S. version of the Basel II standardized approach
should be considered as an option for all U.S. banks.
The Federal Reserve said it concurred with our recommendations and
would seek to implement them. OCC, FDIC, and OTS said they will
consider our recommendations as part of their overall review of the
comments received on the NPR. Treasury expressed concern with our
recommendation on the possible issuance of a new NPR, saying that the
overlapping comment periods for Basel II and IA should give commenters
the ability to opine on implementation issues and options. We realize
that an additional NPR would further delay the Basel II process;
however, under certain circumstances an additional NPR would be a
necessary step to provide more transparency to the process and to
ensure that the full implications of the final rule are fully
considered. In response to comments on this recommendation from the
Federal Reserve, OCC, and Treasury, we have clarified the wording of
our recommendation to more clearly state the need for a new NPR if the
regulators intend to issue a final rule that is materially different
from the NPR or if they intend to provide a U.S. standardized approach.
Background:
The business of banking involves taking and managing a variety of
risks. Major risks facing banking institutions include those listed in
table 1.
Table 1: Major Types of Banking Risks:
Risk: Credit risk;
Definition: The potential for loss resulting from the failure of a
borrower or counterparty to perform on an obligation.
Risk: Market risk;
Definition: The potential for loss resulting from movements in market
prices, including interest rates, commodity prices, stock prices, and
foreign exchange rates.
Risk: Interest rate risk;
Definition: A type of market risk that involves the potential for loss
due to adverse movements in interest rates.[A].
Risk: Operational risk;
Definition: The risk of loss resulting from inadequate or failed
internal processes, people, and systems or from external events.
Risk: Liquidity risk;
Definition: The risk that a bank will be unable to meet its obligations
when they come due, because of an inability to liquidate assets or
obtain adequate funding.
Risk: Concentration risk;
Definition: The risk arising from any single exposure or group of
exposures with the potential to produce losses large enough to threaten
a bank's health or ability to maintain its core operations.
Risk: Reputational risk;
Definition: The potential for loss arising from negative publicity
regarding an institution's business practices.
Risk: Compliance risk;
Definition: The potential for loss arising from violations of laws or
regulations or nonconformance with internal policies or ethical
standards.
Risk: Strategic risk;
Definition: The potential for loss arising from adverse business
decisions or improper implementation of decisions.
Source: GAO.
[A] As discussed later in this report, current and proposed risk-based
capital rules require banks with significant trading activity to hold
capital for market risk from their trading activities. However, the
current and proposed rules do not explicitly require capital for
interest rate risk arising from nontrading activities.
[End of table]
Changes in the banking industry and financial markets have increased
the complexity of banking risks. Banking assets have become more
concentrated among a small number of very large, complex banking
organizations that operate across a wide range of financial products
and geographic markets. Due to these organizations' scale and roles in
payment and settlement systems and in derivatives markets, a
significant weakness in any one of these entities could have severe
consequences for the safety and soundness of the banking system and
broader economy. As a result, federal banking regulators have adopted a
risk-focused approach to supervision that emphasizes continuous
monitoring and assessment of how banking organizations manage and
control risks. Faced with such risks, banks must take protective
measures to ensure that they remain solvent. For example, banks are
required to maintain an allowance for loan and lease losses to absorb
estimated credit losses. Banks must also hold capital to absorb
unexpected losses. Capital is generally defined as a firm's long-term
source of funding, contributed largely by a firm's equity stockholders
and its own returns in the form of retained earnings. In addition to
absorbing losses, capital performs several other important functions:
it promotes public confidence, helps restrict excessive asset growth,
and provides protection to depositors and the federal deposit insurance
fund.
Capital adequacy is fundamental to the safety and soundness of the
banking system, and a bank's capital position can affect its
competitiveness in several ways. Strong capital enhances a bank's
access to liquidity on favorable terms and ensures that it has the
financial flexibility to respond to market opportunities. However,
holding capital imposes costs on banks, because equity is a more costly
form of financing than debt. Capital adequacy regulation seeks to
offset banks' disincentives to hold capital, which result in part from
access to federal deposit insurance. In addition, capital adequacy
requirements for large banks are especially important because of the
systemic risks these banks can pose to the banking system. Regulators
require banks to maintain certain minimum capital requirements and
generally expect banks to hold capital above these minimums,
commensurate with their risk exposure. However, requiring banks to hold
more capital may reduce the availability of bank credit and reduce
returns on equity to shareholders. In addition, capital requirements
that are too high relative to a bank's risk profile may create an
incentive for a bank to hold more high-risk assets, in order to earn a
market-determined return on capital. Banking regulators attempt to
balance safety and soundness concerns with the costs of holding higher
capital.
U.S. Regulators Responsible for Implementing Basel II:
Four federal banking regulators supervise the nation's banks and
thrifts, and each serves as primary federal regulator over certain
types of institutions:
* OCC supervises national (i.e., federally chartered) banks. Many of
the nation's largest banks are federally chartered.
* The Federal Reserve supervises bank holding companies, including
financial holding companies, as well as state chartered banks that are
members of the Federal Reserve System (state member banks). Many of the
largest banking organizations are part of holding company structures--
companies that hold stock in one or more subsidiaries--and the Federal
Reserve supervises bank holding company activities.
* FDIC serves as the deposit insurer for all banks and thrifts and has
backup supervisory authority for all banks it insures. It is also the
primary federal regulator of state chartered banks that are not members
of the Federal Reserve System (state nonmember banks).
* OTS regulates all federally insured thrifts, regardless of charter
type, and their holding companies.[Footnote 7]
Under the dual federal and state banking system, state chartered banks
are supervised by state regulatory agencies in addition to a primary
federal regulator. In addition to these banking regulators, SEC
supervises broker-dealers. In 2004, SEC established a voluntary,
alternative net capital rule for broker-dealers whose ultimate holding
company consents to groupwide supervision as a consolidated supervised
entity. The rule requires consolidated supervised entities to compute
and report capital adequacy measures consistent with Basel standards.
Existing Regulatory Capital Framework:
The U.S. regulatory capital framework includes both risk-based and
leverage minimum capital requirements. Both banks and bank holding
companies are subject to minimum leverage standards, measured as a
ratio of tier 1 capital to total assets.[Footnote 8] The minimum
leverage requirement is between 3 and 4 percent, depending on the type
of institution and a regulatory assessment of the strength of its
management and controls.[Footnote 9] Leverage ratios are a commonly
used financial measure of risk. Greater financial leverage, as measured
by higher proportions of debt relative to equity (or lower proportions
of capital relative to assets), increases the riskiness of a firm.
During the 1980s, regulators became concerned that simple capital-to-
assets leverage measures required too much capital for less risky
assets and not enough for riskier assets. Another concern was that such
measures did not require capital for growing portfolios of off-balance
sheet items. In response to these concerns, regulators from the United
States and other countries adopted Basel I, an international framework
for risk-based capital that required minimum risk-based capital ratios
of 4 percent for tier 1 capital to risk-weighted assets and 8 percent
for total capital to risk-weighted assets. By 1992, U.S. regulators had
fully implemented Basel I; and in 1996, they and supervisors from other
Basel Committee member countries amended the framework to include
explicit capital requirements for market risk from trading activity.
The use of a leverage requirement was continued after the introduction
of risk-based capital requirements as a cushion against risks not
explicitly covered in the risk-based capital requirements. The greater
level of capital required by the risk-based or leverage capital
calculation is the binding overall minimum requirement on an
institution.
Furthermore, the Federal Deposit Insurance Corporation Improvement Act
of 1991 created a new supervisory framework known as prompt corrective
action (PCA) that links supervisory actions closely to a bank's capital
ratios. PCA, which applies only to banks, not bank holding companies,
has become a primary regulatory influence over bank capital levels. PCA
requires regulators to take increasingly stringent forms of corrective
action against banks as their leverage and risk-based capital ratios
decline. The purpose is to ensure that timely regulatory action is
taken to address problems at financially troubled banks in order to
prevent bank failure or minimize resulting losses.[Footnote 10] There
is a strong incentive for banks to qualify as "well-capitalized," which
is the highest capital category and exceeds the minimum capital
requirements, because banks deemed less than well-capitalized have
restrictions or conditions on certain activities and may also be
subject to mandatory or discretionary supervisory actions. Regulatory
officials noted that the PCA well-capitalized standards are the de
facto minimum regulatory capital requirements for banks and that
virtually all banks maintain capital levels that meet the well-
capitalized criteria. As shown later in this report in figure 4, the
required capital ratios for the well-capitalized category are: (1) a
total risk-based capital ratio of 10 percent or greater, (2) a tier 1
risk-based capital ratio of 6 percent or greater, and (3) a leverage
ratio of 5 percent or greater.[Footnote 11]
The Transition to Basel II Has Been Driven by Limitations of Basel I
and Advances in Risk Management at Large Banking Organizations:
Regulatory officials generally agree that while Basel I continues to be
an adequate capital framework for most banks, it has become
increasingly inadequate for supervising the capital adequacy of the
nation's largest, most complex banking organizations. Many of these
banks have developed advanced risk measurement techniques that have
created a growing gap between the regulatory capital framework and
banks' internal economic capital allocation methods. Regulators have
sought to encourage the use of such methods as an element of strong
risk management and because such methods may provide useful input to
the supervisory process. Basel II is intended to address the
shortcomings of Basel I and further encourage banks to develop and
maintain a disciplined approach to risk management.
Basel I Is a Simple Framework with Broad Risk Categories That Is
Inadequate for Large Banking Organizations:
When established internationally in 1988, Basel I represented a major
step forward in linking capital to risks taken by banking
organizations, strengthening banks' capital positions, and reducing
competitive inequality among international banks. Regulatory officials
have noted that Basel I continues to be an adequate capital framework
for most banks, but its limitations make it increasingly inadequate for
the largest and most internationally active banks. As implemented in
the United States, Basel I consists of five broad credit risk
categories, or risk weights (table 2).[Footnote 12] Banks must hold
total capital equal to at least 8 percent of the total value of their
risk-weighted assets and tier 1 capital of at least 4 percent. All
assets are assigned a risk weight according to the credit risk of the
obligor and the nature of any qualifying collateral or guarantee, where
relevant. Off-balance sheet items, such as credit derivatives and loan
commitments, are converted into credit equivalent amounts and also
assigned risk weights. The risk categories are broadly intended to
assign higher risk weights to--and require banks to hold more capital
for--higher risk assets.
Table 2: U.S. Basel I Credit Risk Categories:
Risk weight: 0%;
Major assets: Cash; claims on or guaranteed by central banks of
Organization for Economic Cooperation and Development countries; claims
on or guaranteed by Organization for Economic Cooperation and
Development central governments and U.S. government agencies. The zero
weight reflects the lack of credit risk associated with such positions.
Risk weight: 20%;
Major assets: Claims on banks in Organization for Economic Cooperation
and Development countries, obligations of government-sponsored
enterprises, or cash items in the process of collection.
Risk weight: 50%;
Major assets: Most one-to-four family residential mortgages; certain
privately issued mortgage-backed securities and municipal revenue
bonds.
Risk weight: 100%;
Major assets: Represents the presumed bulk of the assets of commercial
banks. It includes commercial loans, claims on non-Organization for
Economic Cooperation and Development central governments, real assets,
certain one-to-four family residential mortgages not meeting prudent
underwriting standards, and some multifamily residential mortgages.
Risk weight: 200%;
Major assets: Asset-backed and mortgage-backed securities and other on-
balance sheet positions in asset securitizations that are rated one
category below investment grade.
Source: GAO analysis of federal regulations. See, e.g., 12 C.F.R. Part
3, App. A (OCC).
[End of table]
However, Basel I's risk-weighting approach does not measure an asset's
level of risk with a high degree of accuracy, and the few broad
categories available do not adequately distinguish among assets within
a category that have varying levels of risk. For example, although
commercial loans can vary widely in their levels of credit risk, Basel
I assigns the same 100 percent risk weight to all these loans. Such
limitations create incentives for banks to engage in regulatory capital
arbitrage--behavior in which banks structure their activities to take
advantage of limitations in the regulatory capital framework. By doing
so, banks may be able to increase their risk exposure without making a
commensurate increase in their capital requirements. For example,
because Basel I does not recognize differences in credit quality among
assets in the same category, banks may have incentives to take on high-
risk, low-quality assets within each broad risk category. As a result,
the Basel I regulatory capital measures may not accurately reflect
banks' risk profiles, which erodes the principle of risk-based capital
adequacy that the Basel Accord was designed to promote.
In addition, Basel I recognizes the important role of credit risk
mitigation activities only to a limited extent. By reducing the credit
risk of banks' exposures, techniques such as the use of collateral,
guarantees, and credit derivatives play a significant role in sound
risk management. However, many of these techniques are not recognized
for regulatory capital purposes. For example, the U.S. Basel I
framework recognizes collateral and guarantees in only a limited range
of cases.[Footnote 13] It does not recognize many other forms of
collateral and guarantees, such as investment grade corporate debt
securities as collateral or guarantees by externally rated corporate
entities. In addition, the Basel Committee acknowledged that Basel I
may have discouraged the development of specific forms of credit risk
mitigation by placing restrictions on both the type of hedges
acceptable for achieving capital reduction and the amount of capital
relief. As a result, regulators have indicated that Basel II should
provide for a better recognition of credit risk mitigation techniques
than Basel I.
Furthermore, Basel I does not address all major risks faced by banking
organizations, resulting in required capital that may not fully address
the entirety of banks' risk profiles. Basel I originally focused on
credit risk, a major source of risk for most banks, and was amended in
1996 to include market risk from trading activity. However, banks face
many other significant risks--including interest rate, operational,
liquidity, reputational, and strategic risks--which could cause
unexpected losses for which banks should hold capital. For example,
many banks have assumed increased operational risk profiles in recent
years, and at some banks operational risk is the dominant
risk.[Footnote 14] Because minimum required capital under Basel I does
not depend directly on these other types of risks, U.S. regulators use
the supervisory review process to ensure that each bank holds capital
above these minimums, at a level that is commensurate with its entire
risk profile. In recognition of Basel I's limited risk focus, Basel II
aims for a more comprehensive approach by adding an explicit capital
charge for operational risk and by using supervisory review (already a
part of U.S. regulators' practices) to address all other risks.
Basel I Does Not Reflect Financial Innovations and Risk Management
Practices at Large Banking Organizations:
The rapid rate of innovation in financial markets and the growing
complexity of financial transactions have reduced the relevance of the
Basel I risk framework, especially for large banking organizations.
Banks are developing new types of financial transactions that do not
fit well into the risk weights and credit conversion factors in the
current standards. For example, there has been significant growth in
securitization activity, which banks engaged in partly as regulatory
arbitrage opportunities.[Footnote 15] In order to respond to emerging
risks associated with the growth in derivatives, securitization, and
other off-balance sheet transactions, federal regulators have amended
the risk-based capital framework numerous times since implementing
Basel I in 1992. Some of these revisions have been international
efforts, while others are specific to the United States. For example,
in 1996, the United States and other Basel Committee members adopted
the Market Risk Amendment, which requires capital for market risk
exposures arising from banks' trading activities.[Footnote 16] By
contrast, federal regulators amended the U.S. framework in 2001 to
better address risk for asset securitizations.[Footnote 17] These
changes, while consistent with early proposals of Basel II, were not
adopted by other countries at the time. The finalized international
Basel II accord, which other countries are now adopting, incorporates
many of these changes.
Despite these amendments to the current framework, the simple risk-
weighting approach of Basel I has not kept pace with more advanced risk
measurement approaches at large banking organizations. By the late
1990s, some large banking organizations had begun developing economic
capital models, which use quantitative methods to estimate the amount
of capital required to support various elements of an organization's
risks. Banks use economic capital models as tools to inform their
management activities, including measuring risk-adjusted performance,
setting pricing and limits on loans and other products, and allocating
capital among various business lines and risks. Economic capital models
measure risks by estimating the probability of potential losses over a
specified period and up to a defined confidence level using historical
loss data. This method has the potential for more meaningful risk
measurement than the current regulatory framework, which differentiates
risk only to a limited extent, mostly based on asset type rather than
on an asset's underlying risk characteristics. Recognizing the
potential of such advanced risk measurement techniques to inform the
regulatory capital framework, Basel II introduces "advanced approaches"
that share a conceptual framework that is similar to banks' economic
capital models. With these advanced approaches, regulators aim not only
to increase the risk sensitivity of regulatory measures of risk but
also to encourage the advancement of banks' internal risk management
practices.
Although the advanced approaches of Basel II aim to more closely align
regulatory and economic capital, the two differ in significant ways,
including in their fundamental purpose, scope, and consideration of
certain assumptions. Given these differences, regulatory and economic
capital are not intended to be equivalent. Instead, regulators expect
that the systems and processes that a bank uses for regulatory capital
purposes should be consistent with those used for internal risk
management purposes. Regulatory and economic capital approaches both
share a similar objective: to relate potential losses to a bank's
capital in order to ensure it can continue to operate. However,
economic capital is defined by bank management for internal business
purposes, without regard for the external risks the bank's performance
poses on the banking system or broader economy. By contrast, regulatory
capital requirements must set standards for solvency that support the
safety and soundness of the overall banking system. In addition, while
the precise definition and measurement of economic capital can differ
across banks, regulatory capital is designed to apply consistent
standards and definitions to all banks. Economic capital also typically
includes a benefit from portfolio diversification, while the
calculation of credit risk in Basel II fails to reflect differences in
diversification benefits across banks and over time. Also, certain key
assumptions may differ, such as the time horizon, confidence level or
solvency standard, and data definitions. For example, the probability
of default can be measured at a point in time (for economic capital) or
as a long-run average measured through the economic cycle (for Basel
II). Moreover, economic capital models may explicitly measure a broader
range of risks, while regulatory capital as proposed in Basel II will
explicitly measure only credit, operational, and where relevant, market
risks.
Federal Regulators Are Proposing a Regulatory Capital Framework that
Differs from the International Basel II Accord in Several Respects:
While Basel II is an international framework based on shared regulatory
objectives, it is subject to national implementation. In the United
States, federal regulators have proposed a series of changes that would
result in multiple risk-based capital regimes--Basel II, Basel IA, and
Basel I--largely based on the banking organization's size and
complexity.[Footnote 18] U.S. regulators proposed requiring only the
Basel II advanced approaches for credit and operational risk for a
small number of large and/or internationally active banking
organizations, but regulators are currently seeking comment on allowing
simpler risk measurement approaches for these organizations. The U.S.-
proposed changes to implement Basel II differ from the international
Basel II accord in several ways: the U.S. proposal has a more limited
scope, contains additional prudential safeguards, retains key aspects
of the existing regulatory capital framework, and contains certain
technical differences.
Basel II Is an International Framework Based on Shared Regulatory
Objectives but Subject to National Implementation:
The Basel II international accord seeks to establish a more risk-
sensitive regulatory capital framework that is sufficiently consistent
internationally but that also takes into account individual countries'
existing regulatory and accounting systems. The international accord
allows for a limited degree of national discretion in the application
of the approaches for calculating minimum capital requirements, in
order to adapt the standards to different conditions of national
markets. Since the international accord was issued in 2004, individual
countries have been implementing national rules based on the principles
and detailed framework that it sets forth, and each country--including
the United States--has used some measure of national discretion within
its jurisdiction. The Basel Committee noted that as a result,
regulators from different countries will need to make substantial
efforts to ensure sufficient consistency in the application of the
framework across jurisdictions. Furthermore, the Basel Committee
emphasized that the international accord sets forth only minimum
requirements, which countries may choose to supplement with added
measures to address such concerns as potential uncertainties about the
accuracy of the capital rule's risk measurement approaches. As detailed
later in this report, the U.S.-proposed rules include such supplemental
measures, including certain requirements that already exist in the
current U.S. regulatory capital framework.
Basel II aims for a more comprehensive approach to addressing risks,
based on three pillars: (1) minimum capital requirements, (2)
supervisory review, and (3) market discipline in the form of increased
public disclosure. As shown in figure 1, Pillar 1 establishes several
approaches (of increasing complexity) to measuring risk. The advanced
approach for credit risk (known as the advanced internal ratings-based
approach, or A-IRB) uses risk parameters determined by a bank's
internal systems for calculating minimum regulatory capital. The A-IRB
will increase both the risk sensitivity and the complexity of such
calculations. Under the advanced approach for operational risk (known
as the advanced measurement approaches or AMA), a bank is to use its
internal operational risk management systems and processes to assess
its need for capital to cover operational risk. This method provides
banks with substantial flexibility and does not prescribe specific
methodologies or assumptions, although it does specify several
qualitative and quantitative standards. Pillar 2 explicitly recognizes
the role of supervisory review, which includes assessment of capital
adequacy relative to a bank's overall risk profile and early
supervisory intervention that are already part of U.S. regulatory
practice. Pillar 3 establishes disclosure requirements that aim to
inform market participants about banks' capital adequacy in a
consistent framework that enhances comparability. Appendix III
describes the Basel II framework in further detail.
Figure 1: The Three Pillars of Basel II:
[See PDF for image]
Source: GAO.
Note: U.S. proposed rules solicit comments generally on permitting core
banks the option of using other credit and operational risk approaches
similar to those provided in the international accord. For credit risk,
the U.S. proposed rules specifically request comments on the
suitability for core banks of the standardized approach under the
international accord or the U.S. Basel IA proposal.
[End of figure]
Federal banking regulators have proposed adopting the international
accord and integrating it into the existing U.S. regulatory capital
framework, but the four agencies have faced a number of impediments to
explicitly defining their objectives and balancing among several often
competing priorities. The international accord identifies several broad
objectives, and reaching agreement on these goals has been an important
part of building consensus among U.S. regulators on how to proceed with
Basel II. The international accord's objectives are:
* Safety and soundness. To further strengthen the soundness and
stability of the international banking system;
* Consistency and competitive equity. To maintain sufficient
consistency that capital adequacy regulation will not be a significant
source of competitive inequality among internationally active banks;
* Focus on risk management. To promote the adoption of stronger risk
management practices by the banking industry; and:
* Capital levels. To broadly maintain the aggregate level of minimum
capital requirements, while also providing incentives to adopt the more
advanced risk-sensitive approaches of the revised framework.
However, in satisfying these goals, federal regulators have struggled
to balance incentives (in the form of permissible capital reductions)
for banks that adopt the advanced risk measurement approaches with the
objective of broadly maintaining the aggregate level of minimum
required capital. At the same time, regulators seek to ensure that any
incentives for these banks do not adversely affect the ability of other
banks to compete domestically. In addition, regulators have sought to
balance efforts to protect safety and soundness under Basel II with
efforts to maintain sufficient consistency with the international
framework. In particular, regulators must ensure that the revised U.S.
regulatory capital framework does not create excessive international
competitive inequities for U.S. banking organizations. Unless these
issues are resolved, they are likely to generate ongoing questions
about the appropriateness of Basel II as a regulatory capital
framework.
U.S. Regulators Propose to Apply Basel II Only to Large and/or
Internationally Active Banks and Are Considering Which Risk Measurement
Approaches to Make Available:
As currently proposed in the United States, Basel II would be required
only for the nation's largest and/or most internationally active
banking organizations. In addition, while banks in other countries may
choose from options that include both standardized and advanced
approaches available in the international accord, the current U.S.
proposal permits only the advanced approaches for credit risk (A-IRB)
and operational risk (AMA).[Footnote 19] In the proposed rule, U.S.
regulators stated that they proposed to implement only the advanced
Basel II approaches, which use the most sophisticated and risk-
sensitive measurement techniques, in order to promote further
improvements in the risk measurement and management practices of large
and internationally active banks. Although other countries may offer
banks the choice of using any of the approaches in the international
accord, U.S. regulators noted that most foreign banks comparable in
size and complexity to U.S. core banks are adopting some form of the
advanced approaches.[Footnote 20] Regulators estimate that, according
to currently proposed criteria, 11 organizations would be required to
comply with Basel II.[Footnote 21] Together, these banks (known as core
banks) hold about $4.9 trillion in assets, or about 42 percent of total
banking assets in the United States (fig. 2). Other banks that are not
required to adopt the Basel II rule may opt into it with the approval
of their primary federal regulator, and regulators estimate that about
10 additional banks are considering doing so.
Figure 2: Banks that Meet U.S.-Proposed Criteria for Mandatory Adoption
of Basel II:
[See PDF for image]
Source: GAO analysis of public regulatory filings; FDIC.
Note: Banks were identified based on regulatory filings as of December
31, 2005. Assets data shown as of September 30, 2006 for the lead bank
(i.e., depository institution) in each respective core banking
organization.
[A] Refers only to the lead U.S. bank subsidiary of a foreign-owned
banking organization.
[End of figure]
Beginning in mid-2006, several core banks and industry groups have
called for the U.S.-proposed rules to offer all banks the option of
adopting alternative risk measurement approaches, including a
standardized approach for credit risk such as the one available in the
international accord. A standardized approach for credit risk, which is
simpler and less costly to implement than the Basel II advanced
approach (A-IRB), increases risk sensitivity compared to Basel I by
expanding the number of risk weight categories and more fully
recognizing credit risk mitigation. However, it is not as risk
sensitive as the Basel II A-IRB approach, which relies in part on
banks' internal models to estimate inputs into capital calculations.
Bank officials stated that the A-IRB approach, as proposed in the
United States, would yield little opportunity for banks to realize the
benefits of a more risk-sensitive capital framework. Officials from a
few core banks acknowledged that a standardized approach for credit
risk might not adequately address the risks facing large, complex
banks. However, other bank officials said that they would prefer having
the option of using a standardized approach for credit risk, especially
if the U.S.-proposed rule for the advanced approach continued to
exhibit certain differences from the international accord.
Some federal and state regulators have also noted the potential
advantages of allowing a standardized approach for credit risk. For
example, FDIC officials have noted that because the standardized
approach establishes a floor for each risk exposure, it does not
provide the same potential for dramatic reductions in capital
requirements and would not pose the same competitive inequity concerns
as the advanced approach. But FDIC officials also recognized that
others have argued that only the advanced approaches would provide an
adequate incentive for strengthening risk measurement systems at the
largest banks. An association of state bank regulators also called for
consideration of the standardized approach in the international accord,
stating that it would be more risk sensitive than the current framework
and simpler to implement and supervise than the advanced approach. An
academic familiar with bank regulation also expressed support for a
standardized approach as an interim solution to allow the regulators
time to further assess the feasibility of the internal ratings based
approach.
In response to these developments, regulators have requested public
comments on whether U.S. banks subject to the advanced approaches
should be permitted to use other credit and operational risk approaches
similar to those provided in the international accord. However,
regulators have not specified how, if at all, they might propose to
apply such approaches, citing the need first to review comments
received during the comment period of the rule-making process, which
has been extended to March 26, 2007. Regulators have also noted that to
date, banks have not sufficiently clarified their views on what form a
standardized approach for credit risk should take. Given that the Basel
II NPR only asks a question about a standardized approach and offers no
specifics, the banking regulators indicated that pursuant to the rule-
making requirements of the Administrative Procedure Act they would
likely issue a new, targeted NPR if they were to include the approach
as an option for credit risk.[Footnote 22] This new proposal would
require a definition of the standardized approach in the United States,
its application criteria, and how long banks could opt to use it.
Failure to provide a subsequent NPR if this option were included in the
final rule could result in new questions, issues, and potential
unintended consequences that the regulators may not have considered.
U.S. Regulators Have Revised Time Frames for Implementation and
Proposed Prudential Safeguards:
Concerns in the U.S. about the potential adverse impact of Basel II on
regulatory capital requirements have led federal regulators to revise
the time frame for implementation and propose additional prudential
safeguards. Appendix II shows key events in the transition to Basel II
and proposed implementation time frames in the United States and
abroad. In April 2005, U.S. federal regulators announced that a
quantitative impact study (QIS-4) had estimated that Basel II could
cause material reductions in aggregate minimum required risk-based
capital and significant variations in results across institutions and
portfolio types. As a result, they delayed the time frame for issuing
the Basel II NPR in order to further analyze the results of the study.
In February 2006, regulators announced that QIS-4 had estimated
reductions in minimum total risk-based capital requirements of 15.5
percent (mean) and 26.3 percent (median), as well as reductions in
minimum tier 1 risk-based capital requirements of 22 percent (mean) and
31 percent (median), relative to the current Basel I-based framework.
The study also estimated significant reductions in minimum required
capital for almost every portfolio category.[Footnote 23] In addition,
the study showed that similar loan products at different banks may have
resulted in very different risk-based capital requirements. However, as
discussed later in this report, regulators were unable to conclude
whether the study's estimates were an understatement or overstatement
of the overall level of minimum risk-based capital that would be
required in a fully implemented Basel II. Nevertheless, the regulators
stated that the results observed in QIS-4 would be unacceptable in an
actual capital regime.
While regulators decided to proceed with issuing a proposed rule,
delays in both the rule-making process and the implementation time
frame have created challenges. Regulators stated that a final rule,
supplemented with certain prudential safeguards, would allow them to
more reliably observe the impact of Basel II. Such a controlled
environment would prevent unintended capital reductions and would allow
banks to submit compliant data based on a final rule that would provide
greater certainty than data submitted under a preliminary impact study.
For example, regulators delayed the start of the first available
"parallel run" until January 2008, a year later than the international
accord, creating challenges for banks that operate in multiple
countries.[Footnote 24] Regulators also added a third transition period
to the original two transition periods and established floors on
capital reductions for individual institutions during the transition
period that are more conservative than those proposed in the
international accord.[Footnote 25]
Regulators must resolve a number of open questions before issuing the
final rule for Basel II. They have expressed a goal of doing so by June
30, 2007, at least 6 months prior to the start of the first available
parallel run. The regulators have defined more specific objectives in
the U.S.-proposed rule that include the following:
* Viewing a 10 percent decline in aggregate risk-based capital
requirements compared to risk-based capital requirements under the
existing rules as a material reduction warranting modifications to the
Basel II-based framework;
* Establishing comparable capital requirements for similar portfolios;
* Domestically, working to mitigate differences in risk-based capital
requirements between institutions that participate in Basel II and
those that do not; and:
* Retaining the leverage ratio and prompt corrective action
requirements.
Table 3 summarizes some of the key differences between the U.S.-
proposed rules for Basel II and the international accord.
Table 3: Differences in U.S.-Proposed Implementation of Basel II and
International Accord:
Scope of application;
United States:
* Proposes only the advanced approaches for credit and operational risk
for largest banks;
* Proposes Basel IA and retains Basel I for all other banks;
* First available parallel run in 2008;
International Accord:
* Provides all banks with a choice of multiple approaches for assessing
risks;
* Replaces Basel I;
* First available parallel run for A-IRB and/or AMA in 2007.
Prudential safeguards;
United States:
* Transitional floors in which required risk-based capital cannot go
below 95 percent, 90 percent, and 85 percent of Basel I requirements in
three transition years, respectively;
* Regulators intend to view a 10 percent or greater decline in
aggregate risk-based capital requirements (compared to Basel I) as a
material reduction warranting modifications to the U.S. Basel II
framework;
* Leverage ratio and prompt corrective action are retained;
International Accord:
* Transitional floors in which required risk-based capital cannot go
below 90 percent and 80 percent of Basel I requirements in the first
and second transition years, respectively;
* Supplementary measures are not required under the international
accord, but national authorities are free to adopt them as they see
fit.
Significant technical differences.
Wholesale definition of default;
United States: Based on whether:
* the bank places any exposure to the obligor on nonaccrual status,;
* the bank incurs full or partial charge-offs on any exposure to the
obligor, or;
* the bank incurs a credit-related loss of 5 percent or more on the
sale of any exposure to the obligor or transfer of any exposure to the
obligor to the held-for-sale, available-for-sale, trading account, or
other reporting category;
International Accord: Based on whether:
* the bank considers an obligor unlikely to pay in full without
recourse to bank actions, or;
* an obligor's payment on principal or interest is more than 90 days
past due;
* Includes nonaccrual status and material credit-related loss on sale
as elements indicating unlikeliness to pay. However, the accord does
not specify the threshold of 5 percent for credit-related losses upon
sale or transfer, and other countries' definitions do not generally
include nonaccrual status.
Retail definition of default;
United States: Occurs when an exposure reaches 120 or 180 days past
due, depending on exposure type, or when the bank incurs a full or
partial charge-off or write-down on principal for credit-related
reasons;
International Accord: Occurs when an exposure reaches a past due
threshold between 90 and 180 days, set by the national supervisor, or
when the bank considers an obligor unlikely to pay in full without
recourse to bank actions.
Small-and medium-sized business lending;
United States: Does not include an adjustment that would result in a
lower capital requirement for loans to small and medium-sized
enterprises compared to other business loans under the framework;
International Accord: Includes such an adjustment.
Loss given default (LGD);
United States:
* A bank may use its own LGD estimates upon obtaining supervisory
approval, which is based in part on whether the estimates are reliable
and sufficiently reflective of economic downturn conditions;
* A bank that does not qualify to use its own internal LGD estimates
must instead compute LGD using a supervisory formula that some bank
officials have described as overly conservative;
International Accord:
* Requires banks to estimate losses from default that would occur
during economic downturn conditions, which may result in higher
regulatory required capital for some exposures under the framework;
* Does not identify an explicit supervisory formula for estimating LGD
when a bank's internal LGD estimates do not meet minimum requirements;
* Instead, if a bank is unable to estimate LGD for any material
portfolio, it would not qualify for the A-IRB approach.
Source: GAO analysis.
[End of table]
U.S. Regulators Proposed Basel IA and Plan to Retain Basel I for All
Other Banks:
Regulators have proposed revising and retaining key aspects of Basel I,
which would result in multiple risk-based capital regimes--Basel II,
Basel IA, and Basel I. The regime that each bank uses will be largely
based on its size and complexity. Federal regulators had initially
limited the scope of Basel II to a small number of large and/or
internationally active institutions and had planned to retain Basel I
unchanged for all other institutions, in order to reduce the regulatory
burden for these banks. In response to concerns voiced by small banks
about potential competitive inequities between them and banks adopting
Basel II, regulators proposed Basel IA.[Footnote 26] Regulatory and
bank officials acknowledge that Basel IA may help mitigate potential
competitive inequities, although the extent of this impact is still to
be seen. Basel IA is a risk-weighting approach that provides greater
risk sensitivity than the current Basel I framework and is less risk
sensitive and less complex than the Basel II advanced approaches. The
Basel IA proposal discusses various modifications that would increase
the number of risk-weight categories relative to Basel I; permit
greater use of external credit ratings, if available, as an indicator
of credit risk; expand the range of eligible collateral and guarantors
used to mitigate credit risk; and use loan-to-value (LTV) ratios to
determine risk weights for most residential mortgages.[Footnote 27]
Specifically, Basel IA proposes six risk-weight categories based on LTV
ratios that would replace Basel I's single risk category for most
mortgages.[Footnote 28] As a result, minimum capital requirements for
mortgages under Basel IA would be more sensitive to risk than they
would be under Basel I. As shown in figure 3, Basel I would generally
require the same amount of capital regardless of the risk level (LTV
ratio) of the mortgage, but Basel IA would generally increase required
capital for higher risk loans and decrease required capital for lower
risk loans. Nevertheless, Basel IA would not be as sensitive to credit
risk as the Basel II A-IRB approach, nor would it rely on banks'
internal models to determine minimum capital requirements. Under the
Basel II A-IRB approach, risk parameter estimates take into account a
wider variety of information, such as probability of default, loss
given default, and exposure at default.
Figure 3: Sensitivity to Credit Risk for Mortgages under Basel I and
Basel IA:
[See PDF for image]
Source: GAO analysis of information from the Basel IA Draft NPR and
Congressional Research Service.
[End of figure]
Federal regulators have recently requested comment on whether Basel IA
might be an appropriate option for banks subject to Basel II as an
alternative to the advanced approaches. As discussed earlier, in the
September 2006 Basel II NPR regulators requested comment on whether,
and for what length of time, a standardized approach for credit risk
similar to the approach in the international accord should be provided
as an option for core banks. Subsequently, in the Basel IA NPR released
in December 2006, the regulators requested comment on whether the Basel
IA proposal or the standardized approach in the international Basel II
accord would be an appropriate credit risk measurement approach for
Basel II banking organizations and whether operational risk should be
addressed using one of the three Basel II approaches.[Footnote 29] In
many respects, the Basel IA proposal is similar to the Basel II
standardized approach for credit risk. Both approaches create several
additional risk categories and for the most part do not rely on banks'
internal models for calculating risk-based capital. Unlike Basel IA,
the standardized approach has only a single risk-weight category for
most mortgage loans. Compared with the advanced approach, the
standardized approach offers less risk sensitivity but also less
complexity, and it does not provide capital incentives for large banks
to further improve their risk management practices. Regulators also
asked in the Basel IA proposal how, if Basel IA is an option for Basel
II banking organizations, they can be encouraged to enhance their risk
management practices or financial disclosures if provided options other
than the advanced approaches. Lack of sufficient resolution on these
significant questions may lead to continued uncertainty about the
proposed changes to the U.S. regulatory capital framework.
Given the large number of U.S. banks of different sizes, including
thousands of small banks, regulators also plan to retain Basel I. Any
bank not required to adopt Basel II would have the option of either
adopting Basel IA, upon notifying its primary regulator, or remaining
under Basel I. Regulatory officials have noted that Basel I would still
be an adequate capital regime for most banks but that it is becoming
increasingly inadequate for the largest and most complex banks.
Regulators have stated that some small banks tend to hold capital well
in excess of current regulatory minimums. Regulators indicated, based
on comment letters received, that due to the compliance burden
associated with moving to Basel IA, some small banks that are highly
capitalized may choose to remain under Basel I.
U.S. Regulators Plan to Retain the Leverage Requirement and Apply
Existing Prompt Corrective Action Measures:
While the U.S.-proposed Basel II and Basel IA rules address revisions
to risk-based regulatory capital, regulators also plan to retain the
existing leverage requirements and prompt corrective action (PCA)
measures. Federal regulators have committed to retaining a minimum
leverage requirement for all banks, regardless of whether they use
Basel II, IA, or I to calculate their risk-based required
capital.[Footnote 30] The leverage requirement, a simple ratio of tier
1 capital to on-balance sheet assets, is a U.S.-specific measure, while
risk-based requirements are generally defined based on the
international Basel accords. U.S. regulators stated that risk-based and
leverage requirements generally serve complementary functions, in which
the leverage ratio can be viewed as offsetting potential weaknesses of
the risk-based ratios, while the risk-based ratios offset weaknesses of
the leverage ratio. Risk-based requirements are intended to be more
sensitive to assets of varying levels of risk and to address risks of
off-balance sheet activities. However, the complexity of risk-based
capital calculations will increase significantly under the advanced
approaches of Basel II as these calculations depend on banks' estimates
of risks and supervisory formulas that are based on certain
assumptions. By contrast, a leverage ratio is easy to calculate and
verify. Regulatory officials also noted that the leverage requirement
can be considered to cover areas that risk-based requirements do not
currently address, such as interest rate risk, concentration risk, and
"model risk" (i.e., risk that the model assumptions or underlying data
could be unreliable). While U.S. regulators support the use of a
leverage requirement, some have noted that the leverage ratio, as
currently formulated, may impede the risk sensitivity of the proposed
changes to risk-based requirements.[Footnote 31]
In addition, under the PCA framework in the United States, banks tend
to hold both risk-based and leverage capital at significantly higher
levels than the international regulatory minimums. As figure 4 shows,
the PCA thresholds for "well-capitalized" status exceed the
international Basel minimums, which are considered under PCA as
"adequately capitalized." According to banking regulators, failure to
maintain well-capitalized status can have significant consequences,
such as higher deposit insurance premiums. As a result, most U.S. banks
maintain regulatory capital at levels that achieve well-capitalized
status. In connection with the U.S.-proposed Basel II framework, PCA
will play a significant role in ensuring that Basel II banks maintain
sufficient capital.
Figure 4: U.S. Regulatory Capital Requirements:
[See PDF for image]
Source: GAO.
[A] Selected capital categories as defined in PCA, which applies to
banks (i.e., insured depository institutions), but not bank holding
companies.
[B] The well-capitalized designation for bank holding companies under
Regulation Y has equivalent risk-based minimums as those under the well-
capitalized PCA designation for banks, but it does not have a minimum
leverage requirement.
[C] For the risk-based capital ratios, the adequately capitalized
minimums are equivalent to the internationally adopted Basel minimums
and apply to both banks and bank holding companies.
[D] A minimum leverage requirement of 3 percent applies to (1) banks
that receive the highest supervisory rating and (2) bank holding
companies that have adopted the Market Risk Amendment or that hold the
highest supervisory rating. All other banks and bank holding companies
are subject to a 4 percent minimum leverage requirement.
[End of figure]
The U.S. Proposal Differs in Other Ways from the International Accord:
The Basel II NPR contains several other deviations from the
international accord that have resulted in uncertainty and concerns
about international consistency. For example, the proposed definitions
of default for wholesale and retail exposures in the United States
differ from those used in other jurisdictions. Differences in such
fundamental definitions could have significant effects on the
implementation costs of banks operating in multiple jurisdictions,
possibly requiring banks to develop multiple data systems and
processes. Furthermore, in contrast to the international accord, the
U.S. proposal does not include an adjustment that would result in
required capital for loans to small-and medium-sized businesses being
lower than would be required for other business loans under the
framework. Regulators noted that some misunderstanding may exist among
banks on aspects of the proposed rule, such as the estimation of loss
given default (LGD), a key risk input, under economic downturn
conditions. The regulators proposed a supervisory formula for banks
that do not qualify for use of their own LGD estimates, but it was not
intended as a requirement for those banks that do qualify for use of
their own LGD estimates. A number of other differences exist, and
regulatory officials noted the need to take a comprehensive view of
these differences, that in some areas the proposed U.S. requirements
are less conservative than the international accord, and in other areas
the requirements are more conservative. Notwithstanding these
differences, other international differences in regulatory and
accounting standards also have significant consequences for the
comparability of capital ratios and the associated costs of
implementing Basel II.
In addition, SEC has established a holding company supervision regime
for certain securities firms that requires computation of groupwide
capital adequacy measures and is separate from the federal banking
regulators' proposed Basel II rule, raising some concerns about
competitiveness between large commercial and investment banks subject
to different capital rules. SEC's voluntary, alternative net capital
rule, approved in 2004, allows certain broker-dealers to use internally
developed mathematical models to calculate market and derivatives-
related credit risk.[Footnote 32] In order for a broker-dealer to apply
the rule, its ultimate holding company (collectively, the "consolidated
supervised entity") must calculate and report capital adequacy measures
that are broadly consistent with Basel standards and consent to
groupwide supervision by SEC.[Footnote 33] SEC issued the rule in part
as a response to a requirement by the European Union that non-European
Union financial institutions be subject to consolidated supervision at
the groupwide level in order to conduct business in Europe without
establishing a separate European holding company. Five investment bank
holding companies have elected to be treated as consolidated supervised
entities. While the rule does not prescribe the use of the Basel II
advanced approach for credit risk, consolidated supervised entities
have with one exception elected to apply this approach.[Footnote 34]
According to SEC officials, because the timetable imposed by the
European requirements necessitated the adoption of holding company
capital requirements by consolidated supervised entities prior to
issuance by U.S. banking regulators of guidance on Basel II, SEC has
used the 2004 international Basel II accord as its guide for Basel II
implementation. SEC officials stated that they would review the changes
in the banking regulators' final rule and that they planned to
implement Basel II for investment banks in a way that was generally
consistent with the Federal Reserve's interpretation of Basel II as
applied to financial holding companies.
Basel II Is Expected to Improve Risk Management and Enhance Capital
Allocation, While Proposed Safeguards Would Help to Prevent Large
Capital Reductions during a Temporary Transition Period:
The longer-term impact of Basel II on minimum regulatory capital
requirements and the safety and soundness of the banking system is
largely unknown, but its implementation could have a variety of
consequences for the banking system. First, bank and regulatory
officials generally agree that the movement toward Basel II has
prompted the largest U.S. banking organizations to make improvements in
their risk measurement and risk management systems. Second, the
advanced Basel II risk modeling approaches have the potential to better
align capital with risk, such that banks would face minimum capital
requirements more sensitive to their underlying risks. However, the
advanced approaches are not themselves without risks and realizing the
benefits of these approaches will depend in part on the sufficiency of
credit default and operational loss event data used as inputs to the
regulatory and bank models that determine required capital. Third,
while initial estimates of the potential impact of Basel II showed
large drops in minimum required capital, the impact of Basel II on
minimum required capital is uncertain, and U.S. regulators have
proposed safeguards to prevent the large reductions in required capital
during a transition. Fourth, possible changes in regulatory capital
requirements have also raised some banks' concerns about competition
between large and small banks domestically, and between large banks
headquartered in the United States and foreign banking organizations.
Finally, Basel II's impact on the amount of capital banks' actually
hold is also uncertain because regulatory requirements are just one of
several factors that banks weigh in deciding how much capital to hold.
In light of the uncertainty concerning the potential impact of Basel
II, these issues will require further and ongoing examination as the
banking regulators continue to finalize the Basel II rule and proceed
with the parallel run and transition period.
Basel II Preparations Have Contributed to Improved Risk Management at
Participating Banks:
Bank and regulatory officials generally agree that, due to the systems
required for the use of the advanced approaches, Basel II has already
prompted some large banks to improve their risk measurement and
management systems. For example, officials at one bank said that the
more detailed categorizing of risks under the advanced approaches would
offer information about a portfolio that banks could use to identify
and plan for potential problems. Other officials said that Basel II
would improve their collection and use of data so that they could
aggregate and better understand information about their risk profile
across all their portfolios. Some officials noted that Basel II would
help to formalize processes for identifying and addressing operational
risk. In preparation for Basel II implementation, many banks have
improved data collection and invested resources in quantifying and
modeling operational risk. Although they felt it still had many gaps,
officials from several core banks said that Basel II also brought
regulatory requirements closer to the ways in which they have been
addressing economic risk internally. Many of these officials believe
that the transition to Basel II should help the banks continue to more
quickly improve their risk management practices.
Officials from some banks that were considering adopting Basel II cited
several factors that made the new framework attractive. Officials from
some banks acknowledged that over the long run Basel II would make the
regulatory capital framework more risk sensitive and improve bank's
risk management and internal controls, resulting in stronger banks.
Officials from one bank stated that over the long term, Basel II would
equip them with the tools to better differentiate and price risks and
allocate capital, placing the bank in a stronger position to compete
with larger banks. Officials from a few banks said that as a result of
acquisitions or business growth, their institutions would grow and
become more complex, requiring more sophisticated risk measurement and
management tools. These officials also shared the view that Basel II
would further improve their collection and use of data and other
information. Officials from one bank believed that such information
would allow banks to make better decisions during emergency situations.
Finally, officials at some banks said that their foreign parent
companies were required to implement the new framework, facilitating
their adoption of Basel II in the United States.
Regulatory officials also believed that the systems required for the
advanced approaches would allow banks to better understand and measure
risk, and they suggested that the improvements in risk management at
these banks was one of the primary benefits of Basel II. For example,
Federal Reserve officials noted that the proposed rule mandates that
the largest U.S. banks adopt the advanced approaches of Basel II
because these approaches would strongly encourage improved risk
measurement and management practices. Regulatory officials stated that
the requirement to model operational risk has created significant
interest in the discipline and has motivated some banks to collect
operational loss data. Another positive risk management effect of Basel
II preparation, according to some regulatory officials, is improved
data collection that will be useful for internal economic capital
purposes as well as for calculating regulatory capital.
Basel II Models Could Improve the Risk Sensitivity of Capital
Requirements but Also Have Limitations:
The bank and regulatory models associated with the Basel II advanced
approaches have the advantage of making capital requirements more
sensitive to some underlying risks, but also have a number of
limitations. This improved risk sensitivity could improve the safety
and soundness of the banking system. However, the use of bank models
that influence capital requirements requires increased reliance on risk
assessments provided by bank officials, though these assessments are
subject to both internal and supervisory review. The A-IRB approach
incorporates historical estimates of credit losses to determine
required capital but is based on simplifying assumptions provided by
regulators about the sources of credit risk. Its effectiveness will
depend on the quality and sufficiency of data on credit losses. With
sufficient controls on the modeling process, and relevant historical
data, the A-IRB approach should generate capital requirements more
reflective of actual credit risk than the broader risk categories of
Basel I. The AMA approach offers a number of channels for risk
sensitivity, though the operational risk capital requirements are
sensitive to the potentially varied statistical assumptions and data
banks would use to estimate the magnitude of severe operational loss
events. Finally, while banks' models have been used for internal
purposes, they are relatively unproven for regulatory capital purposes.
The use of these models also raises concerns about their ability to
estimate losses from low-frequency catastrophic events, which also
increases the importance of supervisory review as well as regulators'
attention to the appropriate level of risk-based capital.
More Risk-Sensitive Capital Requirements Could Improve Safety and
Soundness:
For a given amount of capital, more risk-sensitive capital requirements
could improve the safety and soundness of the banking system through a
number of channels--each of which more closely aligns required capital
with associated risks--and provide a required level of capital more
likely to absorb unexpected losses. First, holding assets with higher
risk under Basel II would require banks to hold more capital relative
to lower risk assets. For example, while Basel I requires the same
amount of capital for many high-risk and low-risk mortgages, those
mortgage loans on average expected to have greater credit losses under
Basel II would require more capital than would be required for other
mortgage loans. Second, banks with higher risk credit portfolios or
greater exposure to operational risk would be required to hold
relatively more capital than banks with lower risk profiles. For
example, a bank with a speculative bond portfolio, or one with a
business line more susceptible to fraud, could face relatively higher
capital requirements in those areas. Third, because credit quality
varies over the business cycle, banks could be required to hold more
capital for some assets as economic conditions are expected to
deteriorate. As a result, banks would have a relatively larger capital
requirement when credit losses from default are more likely. Finally,
although more risk-sensitive capital requirements can help enhance
safety and soundness, the level of regulatory capital must also be
sufficient to account for broader risks to the economy and safety and
soundness of the banking system, which will require ongoing regulatory
scrutiny.
A-IRB Approach for Credit Risk Has Strengths and Weaknesses:
Assuming sufficient controls on the quantification and modeling
process, and relevant historical data, the A-IRB approach should
generate capital requirements more reflective of actual credit risk
than the broad Basel I risk categories; however, the formulas provided
by regulators for calculating capital requirements for credit risk have
both strengths and weaknesses. The A-IRB formulas generate a capital
requirement that depends on risk characteristics of the asset,
estimated by the bank, such as the probability of default (PD) and LGD,
thus making required capital more sensitive to the underlying risk of
the asset. This improved risk sensitivity would help ensure that banks
are required to hold relatively more capital against riskier assets
more likely to generate unanticipated credit losses and hold less
required capital against less risky assets. However, the
appropriateness of the capital requirements generated by the A-IRB
approach depends on the accuracy of parameter estimates, such as PD and
LGD, which depend in part on the quality and comprehensiveness of the
historical data that underlie the estimates. For portfolios with data
that cover short time horizons or incomplete economic cycles, the
capital required under the A-IRB approach will not necessarily
accurately reflect the risk of credit losses from the asset because the
more limited history may not be representative. However, for portfolios
with data covering longer time horizons that include adverse economic
conditions, the A-IRB approach is anticipated to generate a capital
requirement better aligned with the underlying risk of the asset than
the broad risk categories of Basel I.
The authors of a Basel Committee working paper have noted significant
challenges related to estimation of loss severity and exposure at
default in particular, and highlight the importance of building
consistent data sets at banks.[Footnote 35] For new or innovative
financial products, bank officials described a number of strategies for
estimating risk parameters, including simulating how the borrower would
behave under a variety of economic conditions, comparing the product to
similar products for which the banks already had data, using expert
judgment, and making conservative adjustments to estimates. Officials
at several banks told us these sorts of products were typically not
material portions of their credit portfolio, and therefore would not
materially affect their capital requirements under Basel II. None of
the bank officials with whom we spoke had received formal feedback or
guidance from regulators clarifying the treatment of portfolios that
did not have a historical track record, though one official explained
that similar strategies to those described above had already been
endorsed by regulators for market risk calculations.
For large corporate borrowers, bonds or loans with lower external
ratings would generally be assigned a higher probability of default,
resulting in relatively higher required capital. In addition, estimates
of LGD for small business loans, for example, will be sensitive to
collateral that the borrower provides, with greater collateral reducing
the losses to the lender if the borrower defaults, and hence required
capital. However, the A-IRB formulas are based on certain simplifying
assumptions that provide only limited recognition of diversification
and concentration in credit risk, among other limitations. Other
criticisms include inappropriate values for the regulator-provided
asset correlations with the overall economy, and the assumption that
credit risk at a given bank is driven by a single, economy-wide risk-
factor with simplified statistical properties. More generally, some
researchers believe that the A-IRB approach does not reflect best
practices in banking but instead reflects a negotiated compromise that
attempts to balance competing goals, including improved risk
sensitivity and simplicity.[Footnote 36] In essence, the A-IRB approach
is an attempt to convert historical data on credit defaults into worst-
case scenario credit losses, assuming that this scenario can be
captured by statistical assumptions about the distribution of losses.
These severe scenarios are inherently difficult to estimate, because of
their rarity, but their magnitude will determine the level of resources
banks will need to weather similar events. Regulators acknowledge the
assumptions of the A-IRB approach represent simplifications of very
complex real-world phenomena, meant to approximate such severe
scenarios.
AMA for Operational Risk Also Has Strengths and Weaknesses:
The Basel II NPR is less prescriptive on the calculation of capital
requirements for operational risk, the AMA. Nevertheless, banks must
incorporate a number of elements, and regulators have prescribed a
level of confidence for bank models that is equivalent to requiring a
capital level for operational risk that would have a one in one
thousand chance of being exceeded by operational losses in a given
year, provided the underlying assumptions were correct. The elements
that banks must incorporate are internal operational loss event data,
external operational loss event data, results of scenario analyses, and
assessments of the bank's business environment and internal
controls.[Footnote 37] One rationale for the flexibility afforded under
the AMA approach is that operational risk modeling is a new and
evolving discipline.
According to some regulatory officials, Basel II banks are all
currently exploring the loss distribution approach (LDA) to estimating
their exposure to operational risk. Under one possible way to implement
a LDA, a bank would use internal and external operational loss data to
separately estimate the range of possible frequencies and magnitudes of
operational losses. The bank would then combine this information with
expert-designed scenarios to better anticipate very infrequent, yet
very severe operational loss events. Finally, the bank is required to
incorporate information regarding the strength of its internal
controls, and risks of its particular business environment into its
estimates of potential losses. Banks may also be able to use insurance
or other risk mitigants aimed at covering operational losses to reduce
their operational risk required capital by up to 20 percent. This
approach offers a number of channels for risk sensitivity and also
provides incentives to mitigate operational risk. First, internal
operational loss data are by nature specific to individual banks, so
they are expected to reflect the types of losses that have historically
affected the bank. Second, because the AMA requires that banks
incorporate an assessment of the strength of internal controls, expert-
designed scenarios could reflect where internal controls, or lack of
them, are likely to mitigate or exacerbate potential operational
losses. Third, because banks would, to a limited extent, be able to
reduce their capital requirements by insuring against some operational
losses, the AMA could provide additional incentives for banks to
purchase such insurance or other risk mitigants.
There are several methodological challenges with respect to quantifying
operational risk. For example, the operational risk capital charge will
be strongly influenced by infrequent but very large operational losses.
Because of their rarity, the magnitude and likelihood of these losses
is difficult to estimate. Some banks have joined industry groups to
share data or have purchased data from external sources to supplement
internal data. Nevertheless, the estimated operational risk exposure
will be sensitive to the potentially varied statistical assumptions and
data sources chosen by the bank. The lack of data on severe operational
losses also increases reliance on scenario analysis. While scenario
analysis can be useful in offering a forward-looking perspective not
captured by internal data, the Basel Committee has noted that the rigor
applied to scenario development varies greatly from bank to bank.
Using Bank Models for Regulatory Capital Purposes Increases Importance
of Validation and Supervisory Review of Bank Models:
Required capital levels under Basel II will depend in part on a bank's
own assessment of the risks to which it is exposed, and these
assessments are to be subject to both independent internal scrutiny and
supervisory review. The use of these assessments has the advantage of
making regulatory capital more sensitive to risks but also requires
bank supervisors to increase their reliance on the risk assessments of
bank officials. As discussed previously, models similar in some ways to
the ones that would be used for Basel II have been used by banks for
internal risk management purposes but, with the exception of market
risk, have not been used to calculate minimum regulatory capital
requirements. To address this issue, regulators have put several
safeguards in place to provide greater confidence in bank estimates,
especially the requirement that the models that the bank would use to
implement Basel II must be validated on an ongoing basis. That is,
these models must have an independent internal evaluation for
conceptual soundness and real-world performance, among other areas. The
model validations can also be reviewed by bank examiners and
quantitative specialists at the discretion of the regulators, and the
integrity of the process surrounding model validation is also subject
to regulatory review. The adequacy of the supervisory review process
will be particularly important to ensure prudent estimates of risk, and
hence, required capital.
Changes in Capital Requirements Could Affect Competition among Banks:
Possible changes in regulatory capital requirements have raised
concerns about competition between large and small banks domestically;
between large banks headquartered in the United States and foreign
banks; and commercial and investment banks in the United States, though
the effect of Basel II on bank competition remains uncertain. The
competitive landscape for banks headquartered in the United States will
change in 2007 as some foreign banks implement Basel II, which has
raised concerns among core banks. For example, some core banks are
concerned that the leverage ratio, to which foreign banks based in
industrialized countries are generally not subject, may impose higher
capital requirements than Basel II for banks with relatively low-risk
credit portfolios. U.S. banks competing in foreign jurisdictions would
be subject to foreign regulatory requirements, as well as a 3 percent
leverage ratio at the holding company level. U.S. banks have also
expressed concern about other aspects of the U.S. Basel II rules that
could impose higher costs than foreign Basel II rules.[Footnote 38]
Controversial initial estimates of the capital levels that would be
required under the A-IRB approach suggested that credit risk capital
required for many broad asset classes could fall relative to Basel I.
In particular, OCC has noted that because of the low credit risk
associated with collateralized mortgage lending, that Basel II may lead
to substantial reductions in credit-risk capital for residential
mortgages. Because mortgage lending is an area where the largest U.S.
banks compete with smaller banks, some regulators and smaller banks
were concerned that those banks not subject to Basel II would be at a
disadvantage. Regulators proposed Basel IA in part to mitigate
potential competitive disparities between large and small banks, and
the proposal features some additional risk sensitivity for mortgages
and lower capital requirements than Basel I for some lower risk
mortgages. OCC has noted that another potential avenue for competitive
effects between smaller banks and Basel II banks is small business
lending. One study of lending to small and medium enterprises found
only relatively minor competitive effects between community banks and
Basel II banks, because community banks and large banks make different
kinds of small business loans. However, there were potentially
significant adverse competitive effects on large banks that do not
adopt Basel II in the United States.[Footnote 39] While this study is a
comparison of the A-IRB approach and Basel I, regulators state in the
Basel IA NPR that they are exploring options for an additional, lower
risk-category for certain small business loans (the equivalent to a 25
percent reduction in capital requirements for those loans). Even with
Basel IA as an option, FDIC officials have highlighted concerns about
potential competitive disadvantages for banks that do not adopt Basel
II based on lower estimated capital requirements in the QIS-4 as
compared with the Basel IA ANPR. Retaining the leverage ratio for all
U.S. banks will likely be important to addressing some of these
competitiveness concerns.
Finally, banking organization officials have also raised the concern
that they will face disadvantages relative to domestic competitors that
will not be subject to the U.S. version of Basel II, such as some large
investment banks regulated by SEC at the holding company level
(consolidated supervised entities), which are permitted to use the
international Basel II framework. SEC officials with whom we spoke
generally did not believe that the differences between the NPR and
SEC's rule would raise material competitiveness issues, mostly because
investment banks did not currently engage in significant middle market
and retail lending. The officials said they would review the changes to
the banking regulators' final rule and planned to implement Basel II
for investment banks in a way that was generally consistent with the
Federal Reserve's interpretation of Basel II, as applied to financial
holding companies, and would consider changes that went beyond the
Basel agreement. SEC officials stated they did not anticipate the need
to propose another rule to incorporate any such changes.
The Impact of Basel II on the Level of Bank Capital Is Uncertain, but
Proposed Safeguards Would Limit Capital Reductions during a Transition
Period:
While initial estimates of the impact of Basel II showed large drops in
minimum required capital, a considerable amount of uncertainty remains
about the potential impact of Basel II on the level of regulatory
capital requirements and the degree of variability in these
requirements over the business cycle in the long term. The banking
regulators have committed to broadly maintain the level of risk-based
capital requirements and proposed safeguards that would limit capital
reductions during a transition period.
Quantitative Impact Study Raised Concerns about Large Drops in Required
Capital:
The QIS-4 showed, on average, large drops in minimum required risk-
based capital for participating banks, and there are a number of
factors affecting capital requirements that could make the potential
impact of Basel II, as currently proposed, vary in either direction
from the QIS-4 results. First, the Basel Committee has instituted a
"scaling factor" that was not included in the QIS-4 results, currently
1.06, equivalent to a 6 percent increase, which would raise capital
requirements for credit risk relative to QIS-4.[Footnote 40] The U.S.
regulators, who have included this increase in the NPR, view 1.06 as a
placeholder, and have stated that they will revisit the scaling factor
along with other calibration issues identified during the parallel run
and transitional floor periods. U.S. regulators have also committed to
broadly maintain the overall level of risk-based capital requirements
(i.e., capital neutrality) with some incentives for the advanced
approaches in the NPR, though they have not defined precisely how they
plan to achieve this goal. Large reductions in minimum required capital
could reduce safety and soundness because banks would generally hold
too little capital in the absence of capital regulation. Second, the
regulators have noted a number of factors that could have biased the
QIS-4 estimates in either direction. For example, the limited use of
downturn LGDs, meant to capture economic losses from default in a
stressed or recessionary economic environment, might have caused
required capital to be understated during QIS-4, while the lack of
incorporation of credit risk mitigation may have overstated required
capital. Officials at some banks noted more recently that, based on
their estimates, they did not expect large deviations from their QIS-4
results--with respect to the level of total minimum capital
requirements--given similar economic conditions. Finally, the greater
sensitivity of the A-IRB approach to economic conditions and the good
economic environment during QIS-4 was an important factor in explaining
lower estimates of required capital, and less favorable economic
conditions could produce greater required capital.
The QIS-4 results featured variations in capital requirements across
portfolios and also identical assets. Regulators offered several
possible explanations for this variation, but some regulatory officials
believed that the variation raised questions about the reliability of
bank models for determining regulatory capital. One result of the QIS-
4 was a variation in capital requirements for the same broad class of
assets. However, portfolios for a given type of exposure can vary
significantly from bank to bank. For example, one bank may specialize
in prime credit card borrowers, while another may specialize in less
credit worthy credit card borrowers. The former would therefore be
required to hold less capital for its credit card risks under a risk-
sensitive system such as Basel II. FDIC officials have expressed
particular concern regarding variation in capital requirements for
identical assets across banks based on a test constructed by regulators
as part of the QIS-4. In a functioning capital regime, this variation
would imply different capital treatment across banks for the same
degree of risk, which, if significant, would run counter to both the
goals of capital adequacy and competitive equity. The regulators
emphasized that the QIS-4 was conducted on a "best efforts" basis
without the benefit of either a definitive set of proposals or
meaningful supervisory review of the institutions' systems.[Footnote
41] Nevertheless, QIS-4 raised a number of questions that have
significantly changed the way U.S. regulators are planning to implement
Basel II.
The Parallel Run, Transitional Floors and Leverage Ratio Would Help
Prevent Large Declines in Required Capital during a Transition Period:
As proposed in the United States, Basel II would initially have a less
significant impact on minimum required capital because the parallel run
and transitional floors would prevent large reductions in capital
requirements during a transition. The parallel run would allow
regulators to observe how Basel II would affect minimum capital
requirements; and regulators would see how the banks' models perform,
as banks would calculate required capital under both Basel I and Basel
II, while meeting the Basel I requirement. The NPR notes that
regulators plan to share information related to banks' reported risk-
based capital ratios with each other for calibration and other
analytical purposes. Banks would be qualified to transition to Basel II
only after four consecutive calendar quarters during which the bank
complies with all of the qualification requirements to the satisfaction
of its primary federal supervisor. During at least three transitional
years, permissible risk-based capital reductions at a qualified bank
would rise by 5 percent per year relative to minimum capital
requirements calculated using Basel I. Regulators have also stated that
banks under Basel II would continue to be subject to the leverage
ratio--a capital requirement that is calculated as a percentage of
assets, independent of risk--which could also prevent significant
reductions in required capital.
As mentioned previously, regulatory officials have suggested a number
of advantages to the leverage ratio--a common financial measure of
risk--although as it is currently formulated, it also has some
drawbacks. The advantages of the leverage ratio include that it is easy
to calculate and that it can compensate for the limitations of the risk-
based minimum requirements, including coverage of only market, credit,
and operational risk, and the possibility that risks could be
quantified incorrectly. However, the leverage ratio could be the higher
capital requirement for some banks at some times, especially those with
low risk profiles. This would dampen some of the risk sensitivity of
Basel II for low-risk banks and assets, possibly leading to
disincentives for banks to hold low-risk portfolios. Furthermore, some
banks were concerned that the leverage ratio requirement, along with
certain safeguards, defied the purpose of moving to a conceptually more
risk-sensitive capital allocation framework. These banks believed that
the leverage requirement and some safeguards could prevent banks'
regulatory capital levels from reflecting actual risk levels. As a
result, the banks would not benefit from the capital reductions
associated with taking on less risk, or managing it more effectively.
As seen in figure 5, the leverage capital requirement for the lowest
risk externally rated corporate exposures could exceed the Basel II
credit risk requirement, making the leverage ratio the relevant
requirement. Both figures 5 and 6 compare the minimum leverage ratio
requirement (a tier 1 capital requirement) with the Basel II credit
risk capital requirement (a total capital requirement that must be met
with at least half tier 1 capital, but can also include tier 2
capital). If the figures compared only tier 1 capital, the Basel II
credit risk capital requirements would be half as high, which would
mean that the leverage ratio would exceed the Basel II tier 1 capital
Basel requirement for a broader range of assets, and thus be the
relevant constraint.[Footnote 42]
Figure 5: Leverage Ratio vs. Basel II Credit Risk Required Capital for
Externally Rated Corporate Exposures, by Rating:
[See PDF for image]
Source: GAO analysis of information from the Basel II NPR, Federal
Reserve System, Moody's Investors Service, and QIS-4 Summary.
Note: Estimates in the figure assume a LGD of 31.6 percent (mean LGD
for corporate, bank, and sovereign exposures from QIS-4), a downturn
LGD of 37.07 percent (calculated using the supervisory formula from the
Basel II NPR) and a maturity of 5 years. Default probabilities, from
Moody's, are 0.03 percent for AAA (the lower bound in the Basel II
NPR), 0.08 percent for Aa and A, 0.3 percent for Baa, 1.43 percent for
Ba, 4.48 percent for B, and 19.09 percent for C. The leverage
requirement is measured in tier 1 capital, and the Basel II credit risk
requirement is measured in total capital. The estimates do not include
any increase in the operational risk capital requirement that could
come from holding additional assets.
[End of figure]
OTS has noted that because of the low credit risk associated with
residential mortgage-related assets, relative to other assets held by
banks, the risk-insensitive leverage ratio may be more binding for
mandatory and opt-in thrifts, thus the proposed rule may cause these
institutions to incur much the same implementation costs as banks with
riskier assets, but with reduced benefits. Similar to the lowest risk
externally rated corporate exposures, as seen in figure 6, the leverage
capital requirement for many lower risk mortgages, such as those with a
lower probability of default, could exceed the Basel II credit risk
requirement. Also, the U.S. leverage requirement does not include off-
balance sheet exposures, which include many securitizations and
derivatives, resulting in an incomplete picture of capital
adequacy.[Footnote 43] As a result, the retention of the leverage ratio
under Basel II may still provide a regulatory disincentive to hold low-
risk assets on the balance sheet.[Footnote 44]
Figure 6: Leverage Ratio vs. Basel II Credit Risk Required Capital for
Mortgages, by Probability of Default:
[See PDF for image]
Source: GAO analysis of information from the Basel II NPR, Federal
Reserve System, and QIS-4 summary.
Note: According to one estimate, a borrower with a LTV ratio of 80
percent (equivalent to a 20 percent down payment) and a credit score of
740 has a 0.15 percent annual probability of default. For the same down
payment, credit scores of 700, 660, and 620 are associated with default
probabilities of 0.2, 0.31, and 0.51 percent, respectively. Estimates
in the figure assume a LGD of 17.7 percent (mean LGD for mortgage
exposures, other than home equity lines of credit, from QIS-4) and a
downturn LGD of 24.28 percent (calculated using the supervisory formula
from the Basel II NPR). The leverage requirement is measured in tier 1
capital, and the Basel II credit risk requirement is measured in total
capital. The estimates do not include any increase in the operational
risk capital requirement that could come from holding additional
assets.
[End of figure]
Basel II Required Capital Could Vary over the Business Cycle:
To supplement the results from QIS-4, some banks simulated their
portfolios under alternative economic conditions and estimated that
capital requirements for consumer and business credit exposures could
vary from 20 to 35 percent over the business cycle under Basel II,
because defaults and losses are higher in poor economic times.[Footnote
45] More generally, some bank officials said that Basel II is more
sensitive than Basel I to the risk level of their exposures and the
health of the economy in which they were operating. However, federal
regulatory officials with whom we spoke were uncertain about how much
capital requirements would or should vary over the business cycle. FDIC
officials with whom we spoke said they believed it was undesirable for
bank capital requirements to fall substantially during expansions and
rise substantially during recessions, when bank capital may be most
difficult to obtain. Because capital requirements could vary over the
business cycle, average (i.e., through the cycle) capital could be
higher or lower than Basel I, depending on how Basel II is calibrated.
In particular, if Basel II were calibrated to be capital neutral with
Basel I during good economic conditions, average capital requirements
could actually rise relative to Basel I.
While minimum capital requirements are expected to vary over the
business cycle, actual capital held by banks could be more stable if
banks take into account more stressed economic scenarios through
holding capital above regulatory minimums. Requiring banks to hold more
capital when borrowers are more likely to default could help ensure
that banks have adequate capital when economic conditions begin to
deteriorate. However, some experts have raised concerns that this could
exacerbate already deteriorating economic conditions by discouraging
banks from lending. Regulatory officials were uncertain of whether
minimum required capital would adjust in advance of changes in economic
conditions. However, the Basel II NPR contains a stress-testing
requirement in which banks must simulate their portfolios in order to
understand how economic cycles, especially downturn conditions, affect
risk-based capital requirements. Adequate stress testing, as in
calculating risk parameters, will depend on banks gathering data from
historical recessions that could reflect future economic downturns, or
adjusting existing data to reflect more severe economic conditions. As
part of Pillar 2, according to the NPR, regulators expect that banks
will manage their regulatory capital position so that they remain at
least adequately capitalized during all phases of the economic
cycle.[Footnote 46] OCC has noted that the stress-testing requirements
will help ensure that institutions anticipate cyclicality in capital
requirements, reducing the potential impact of changes in capital
requirements. In other words, bank capital would be relatively stable
over the business cycle, while the buffer between required capital and
actual capital held would fluctuate through the cycle. Several bank
officials have suggested that this scenario is consistent with banks'
desire to avoid raising additional capital during a downturn.
Impact of Basel II on Total Capital Held Is Uncertain Because Banks
Hold Capital for a Variety of Reasons:
Basel II's impact on the capital actually held by banking organizations
is also uncertain, because banks hold capital for a variety of reasons,
including market forces such as meeting the expectations of
counterparties and credit rating agencies. Officials at several banks
told us that they weighed a number of factors when deciding how much
capital to hold, including both minimum and Pillar 2 regulatory
requirements; internal economic capital models; senior management
decisions; and market expectations, which are often exemplified by
assessments from credit rating agencies such as Moody's and Standard
and Poor's.[Footnote 47] The Basel Committee has identified important
obligations for banks as part of Pillar 2 supervision, specifically a
process for assessing their overall capital adequacy in relation to
their risk profile and a strategy for maintaining their capital levels.
This process requires banks to demonstrate that their internal capital
targets are well founded and consistent with their overall risk profile
and current operating environment. Banks are to assess all material
risks, including both those risks covered by Pillar 1 minimum
requirements as well as other risks that are not addressed, such as
concentration, interest rate, and liquidity risks. One rating agency
expected that banks would hold a larger capital cushion than they
currently do over regulatory requirements under Basel II because of the
uncertainty about the new requirements. Further, a foreign bank
supervisor suggested that the effect of Basel II on actual capital
would be less than the change in minimum required capital, due in part
to the expectations of counterparties and rating agencies.
Core Banks Are Incorporating Basel II into Ongoing Efforts to Improve
Risk Management, but Challenges Remain:
Officials at most core banks with whom we spoke reported that their
banks had been working to improve the way they managed and assessed
credit, market, and other types of risks, including the allocation of
capital to cover these risks for some years. According to these
officials, the banks were largely integrating their preparations for
Basel II into their current risk management efforts. Some officials saw
Basel II as a continuation of the banking industry's evolving risk
management practices and risk-based capital allocation practices that
regulators had encouraged. To help meet the regulatory requirements
proposed for Basel II's advanced approaches, many core bank officials
reported that their banks were investing in information technology and
establishing processes to manage and quantify credit and operational
risk. To varying extents, many officials said that the banks had hired
additional staff or were providing different levels of training for
current employees. Most officials said that their banks had incurred or
would incur significant monetary costs and were allocating substantial
resources to implement Basel II. Many officials also reported that
their banks faced challenges in implementing Basel II, including
operating without a final rule, obtaining data that meet the minimum
requirements for the A-IRB for all asset portfolios and data on
operational losses, and difficulty aligning their existing systems and
processes with the proposed rules. Officials at many core banks viewed
Basel II as an improvement over Basel I, and some banks considering
adopting Basel II believed that the new regulatory capital framework
would help improve their risk management practices.
Core Banks Are Working to Integrate Basel II into Existing Efforts to
Improve Risk Management and Capital Allocation Practices:
Officials at many core banks with whom we spoke pointed out that their
banks had been improving the way they managed and assessed credit,
market, and other types of risks for some time, including allocating
capital to cover these risks. Some officials noted that regulators had
encouraged these efforts and added that many of the steps the banks had
taken foreshadowed proposed Basel II requirements, in part because of
regulatory guidance. For example, a number of core banks noted that the
Federal Reserve's Supervisory Letter 99-18 (SR 99-18) emphasized the
need for banking organizations to make greater efforts to ensure that
their capital reflected their underlying risk positions.[Footnote 48]
The guidance also encouraged the use of credit-risk rating systems in
measuring and managing credit risk. One official compared the processes
that the guidance encouraged for determining whether or not banks were
adequately capitalized to the role of supervisory oversight under
Pillar 2 of Basel II. Officials at another bank explained that the bank
had already set up an internal risk rating system that was similar to
what the officials believe will be required under the A-IRB. Officials
at other banks noted that they were complying with OCC's supervisory
guidance in Bulletin 2000-16 for validating computer-based financial
models, a process similar to that which is proposed under Basel
II.[Footnote 49]
Officials at many core banks said that their efforts to comply with the
proposed Basel II rules took place within an existing corporate
structure that allocated risk management, review, and reporting
responsibilities among different divisions and business units. For
example, officials from one bank said that their business units follow
a common set of implementation tools and information regarding these
projects, which is consolidated to facilitate managerial oversight.
Some banks are establishing risk governance policies or processes to
help in developing assessments of their risks and are monitoring and
reporting these risks. Officials from one bank noted that policies and
processes for determining risk parameters were being used to assess
capital needs. Other banks have established or are enhancing internal
controls for systems related to Basel II, including data systems.
Core Banks Are Investing in Information Technology, Such as Data
Collection, to Quantify and Manage Risks:
Officials at many core banks reported that their banks were investing
in information technology and establishing processes to manage and
quantify credit and operational risk, including collecting data on
credit defaults and operational losses, in order to meet the regulatory
requirements proposed for the advanced approaches. To varying extents,
core banks are making efforts to collect, aggregate, and store data and
detailed information associated with credit defaults that can be used
to determine risk parameters. For example, officials at several banks
explained that they were collecting more comprehensive and detailed
information on their credit defaults or were gathering such information
more consistently. Many banks are automating or upgrading their data
collection systems, including building data repositories that aggregate
default information in a centralized database.
In preparation for Basel II, some bank officials also reported that
their banks were creating or refining systems to classify and assign
internal ratings showing the risk levels of their credit exposures.
Many banks are also making efforts, to varying extents, to establish an
ongoing, independent process to track, review, and validate the
accuracy of the risk ratings. Many banks are working on statistical
models that will generate risk parameters that can be used to determine
the level of regulatory capital needed to cover their exposures to
credit risk, according to bank officials. For this effort, some banks
are using existing models that are also used to determine internal
economic capital. Many are establishing processes to review and
validate the accuracy of their regulatory and economic capital model
inputs using quantitative methods and expert judgment.
Similarly, officials at many core banks reported that their banks had
built or were in the process of building systems and databases to
collect and store data on operational losses. Officials at some banks
noted that their banks were compiling key risk indicators for potential
operational losses or said that their banks had engaged in benchmarking
exercises for operational risk with federal regulators. Several
officials also reported that their banks were in the process of
codifying and enhancing their internal controls for operational risk,
including developing and documenting relevant policies. Other banks are
conducting independent reviews of the operational risk-control
processes that their business lines are required to follow. As with
credit risk, many officials said that their banks were building or
further developing their models to assess capital needs for potential
operational losses, including by applying scenario analyses.
Core Banks Reported That They Were Training Employees and Hiring
Additional Staff to Implement Basel II:
To varying extents, officials at many core banks stated that as part of
their preparations for Basel II they had hired or would hire additional
staff and were providing different levels of training for their staff
to implement Basel II. For example, one bank intends to hire more than
100 new staff who would largely be devoted to building systems to
address credit, operational and market risk, including modifying the
bank's capital models for operational risk. Some officials noted that
they were reallocating human resources within their organizations or
drawing on the expertise of existing staff who were already familiar
with the Basel II requirements. Some banks have devoted or plan to
devote more resources to modeling efforts, such as hiring consultants
and validating models.
Bank officials also described training programs and standardized
training procedures that were tailored to projects related to Basel II
or to staff audiences, including (1) providing courses and online
information on the Basel II requirements and (2) educating senior
management about the new systems required under the advanced
approaches. Banks have also invested in or identified the need to focus
training in specific areas, such as how to assign credit-risk ratings
to their borrowers, or validate their rating systems. Other specific
training topics reported by bank officials included calculating capital
for wholesale credit exposures, transferring information from databases
into risk models, and effective regulatory reporting. In addition,
banks have invested in training for operational risk--for example, by
promoting awareness for and treating operational risk in a consistent
manner. Some officials also noted that the training required to
implement Basel II was similar to the training they had developed for
their own risk management or economic capital efforts. Officials from
several banks expect to provide additional training as they continue to
implement Basel II or when they better understand what will be required
in the final rule.
Core Banks Reported Having Incurred Significant Monetary Costs in
Implementing Basel II:
Officials at many core banks said that they had or would incur
significant monetary costs, and were allocating substantial resources
to implement Basel II. Some banks had developed plans or performed
analyses to see what areas of their implementation efforts required
improvement, so that they could determine the skill sets, staffing
levels, systems, and technology needed to comply with the proposed
rules. Many bank officials expected to make significant investments in
building their credit-risk infrastructure, including developing models
to measure risk. Specifically, some officials noted that they were
making greater investments to collect data and build data warehouses.
Officials at several banks added that they expected to incur ongoing
costs as a result of implementing Basel II. For example, one bank
official explained that they had performed a number of analyses to
estimate certain risk parameters and needed to check regularly that the
numbers generated from the analyses were reasonable.
Depending on the final rule, bank officials expect to incur additional
costs. The uncertainty about the final rule has contributed to the
expense of preparing for Basel II, according to the officials, because
some banks have been unable to make timely decisions or have had to
adjust their systems to conform to different stages of the proposed
rules for Basel II specified in the ANPR, and later in the draft NPR.
However, officials at many core banks stated that they might have
incurred some of these costs regardless of Basel II in their efforts to
improve their risk management practices and economic capital systems.
For example, officials at one bank stated that upgrading the bank's
technological infrastructure would also help the bank meet Basel II
requirements. Some officials were concerned that the expenditures and
efforts they had made to prepare for Basel II were far greater than the
improvements they expected Basel II to bring to their risk management
practices. But others noted that separating the direct costs of Basel
II from other expenses was difficult, because the banks had ongoing
risk management needs and laws to comply with, such as the Sarbanes-
Oxley Act of 2002.[Footnote 50] Ultimately, banks' efforts to meet
Basel II requirements have compressed such expenditures into a shorter
time frame.
Core Banks Face Challenges, Including the Lack of a Final Rule and
Difficulties in Obtaining Data and Aligning Existing Systems with the
Proposed Rules:
Officials at many core banks reported that their banks faced challenges
in implementing Basel II. Key among these challenges is the uncertainty
created by the lack of a final rule. Some officials, for example,
stated that they had prepared for the implementation of Basel II
knowing that the requirements of the rule could change, potentially
increasing costs. Officials at a few banks noted that they might be
unable to move forward with certain implementation efforts, such as
hiring or providing specific training for their staff, without a final
rule. If the final rule requires that banks make significant changes to
their current efforts, several officials said that they might be
unprepared for the parallel run that is scheduled to start in January
2008. Other officials stated that without the final rule, regulators
were unable to provide banks with formal regulatory guidance or
definitive evaluations of their readiness to meet Basel II
requirements, thus making it difficult for banks to obtain
clarification on parts of the proposed rules. However, several
officials found the preliminary feedback they had received from
regulators to be helpful.
Further, officials from many core banks said that they were having
difficulty obtaining data that met the minimum requirements of the A-
IRB for all asset portfolios and data on operational losses. For
example, some banks have not historically collected all of the data
required for Basel II. While bank officials generally said they
believed their banks would meet the data requirements by the start of
the parallel run in 2008, many said that they did not have enough
historical data on loan defaults for credit risk. In some cases,
officials said that they did not have enough data on credit defaults
for immaterial portfolios or portfolios with low-risk, high-quality
exposures. In other cases, the officials said that they needed to
collect additional information specified in the regulatory criteria.
For example, officials at a few banks described having to integrate and
reconcile different types of financial and risk data before they could
apply the information to their modeling efforts. Some banks lacked
historical data covering more than one economic cycle and noted that it
was difficult to capture default information reflecting what could
occur during a significantly stressed economic environment. Officials
at a few banks noted that it either took more effort or was a challenge
to collect data from different legacy systems. Similarly, many
officials said that their banks had limited internal data on
operational losses, including instances of severe loss. For both credit
and operational risk, banks are supplementing insufficient internal
data with external data obtained through rating companies or data
consortiums. However, several officials noted that it was difficult to
assess the reliability of external data or to draw analogies from
external information that adequately represented the risks of a bank's
portfolio.
Core bank officials also said that they were having difficulty aligning
their existing models with the proposed specifications for the A-IRB
approach. For example, some bank officials were concerned that the
proposed safeguards, such as certain limits that constrain how banks
could calculate risk parameters used to determine capital for credit
risk, differed from banks' internal practices or would lead to higher
capital requirements. In calculating capital for credit risk, some
banks use probabilities and definitions of default for their internal
economic capital that are different from the regulatory capital
specifications. Officials from several banks noted that they were
collecting separate information for both types of calculations or
maintaining separate models for calculating economic and regulatory
capital. Some officials also noted that because the U.S. requirements
for Basel II differed from those of other countries--for example, the
definitions of default and the implementation time frames--they were
having difficulty using the systems and models used for the U.S.
requirements to meet the capital requirements of other countries.
Others noted that it would be difficult to comply with different Basel
II rules across countries, and some banks were preparing to implement
the standardized approach for credit risk in other countries because of
the delay in finalizing the rules for the advanced approaches in the
United States.
U.S. Regulators Are Integrating Preparations for Basel II into Their
Current Supervisory Process but Face a Number of Impediments:
While U.S. regulators have been integrating preparations for Basel II
into their current supervisory processes and building on their
experience overseeing risk management practices of the banks, a number
of issues remain to be resolved as regulators finalize the rule. All
the regulators have some experience overseeing models-based risk
management at core banks. In addition, they plan to integrate Basel II
supervisory requirements into their existing oversight processes and
reviews and are taking steps to prepare for the process of qualifying
banks to use the advanced approaches by reviewing banks' preliminary
qualification plans. Regulators are also hiring and training staff and
coordinating with U.S. and foreign regulators.[Footnote 51] However,
regulators face a number of impediments in their efforts to agree on a
final rule for the transition to Basel II. Regulators' different
perspectives have made reaching agreement on the NPR difficult, as will
likely be the case for the final rule. Moreover, the process could
benefit from greater transparency going forward, including how
regulators will assess the Basel II results during the transition years
and report on any modifications to the rule during that period. It is
also important for regulators to resolve some of the uncertainty and
increase the transparency of their thinking by including in the final
rule more specific information about certain outstanding issues, such
as how regulators will treat portfolios that lack adequate data to meet
regulatory requirements for the advanced approaches, how regulators
will calculate reductions in aggregate minimum regulatory capital and
what would happen if the reduction exceeds a proposed 10-percent
trigger, and how worthwhile public disclosure will be under Pillar 3.
If these issues are not addressed, the ongoing ambiguity and lack of
transparency could result in continued uncertainty about the
appropriateness of Basel II as a regulatory capital framework.
Regulators Have Been Building on Experience Overseeing Risk Management:
To varying degrees, banking regulators have overseen some aspects of
banking organizations' internal models-based risk management since the
mid-1990s, including economic capital and market risk models similar to
those that will be a part of Basel II. Although this oversight has been
for risk management and--with the exception of certain market risk
models--not for capital-setting purposes, regulators believe this
experience will help them oversee banks in a Basel II environment.
Regulators have also developed regulatory practices that will continue
after the Basel II rule is finalized. These practices include, among
others, creating standards to use in calculating banks' risk-based
capital ratios and reviewing banks' internal controls to determine if
they are sufficient for sound risk management.
In 1996, regulators amended Basel I to incorporate market risks in the
Basel I calculations of required capital.[Footnote 52] The Market Risk
Rule, which is overseen by the Federal Reserve, OCC, and FDIC for a
small number of institutions, requires banks to use their own internal
models to measure risk. Specifically, it requires banks to measure
banks' daily value-at-risk (VAR) for covered positions--that is, banks
must maintain capital to cover the risks associated with potential
fluctuations in future market prices.[Footnote 53] A bank's internal
model may use any generally accepted technique to measure VAR, but the
regulation requires that the model be sophisticated and accurate enough
for the nature and size of the covered positions. To adapt banks'
internal models for regulatory purposes, banking regulators developed
minimum qualitative and quantitative requirements for all banks subject
to the market risk rule. Banks use these standards in calculating their
VAR estimate for determining their risk-based capital ratio.[Footnote
54]
The Federal Reserve, OCC, and FDIC also review banks that are subject
to the market risk capital requirements for evidence of sound risk
management, such as an institution's risk control unit that reports
directly to senior management and is independent of the business
trading units. The Market Risk Rule requires banks to conduct periodic
backtesting--for example, by comparing daily VAR estimates generated by
internal models against actual daily trading results to determine how
effectively the VAR measure has identified the boundaries of
losses.[Footnote 55] Banks must use the backtesting results to adjust
the multiplication factor used to determine the bank required capital.
Federal Reserve officials said that the VAR models have performed well,
and noted that no banks have had model backtest results that have
required multiplication factors higher than the minimum prescribed in
the Market Risk Rule. The officials said that such performance was due,
in large part, to the continual improvement of the banks' VAR
methodologies and other requirements of the Market Risk Amendment,
including the use of stress testing. Federal Reserve officials said
that regulators actively monitor the rigor and adequacy of banks'
internal VAR models in light of new and emerging products.
As part of their risk management reviews, the Federal Reserve and OCC
have also overseen some aspects of core banks' economic capital models
since the 1990s. Although that oversight has focused on risk management
and not setting regulatory capital levels, Federal Reserve and OCC
officials said that the experience had helped prepare them for
oversight of Basel II regulatory capital models, as economic capital
models and Basel II regulatory capital models were similar. For
example, as discussed earlier, both measure risks by estimating the
probability of potential losses over a specified time period and up to
a defined confidence level, using historical loss data. According to
these regulators, banks are generally using existing economic capital
systems as a starting point to create their Basel II regulatory
systems. Federal Reserve officials noted that because Basel II would
establish common system requirements for regulatory capital purposes,
in areas where banks have varying requirements for their internal
modeling systems, such as how they define default, regulators will have
greater comparability across systems. Further, some regulatory
officials noted that overseeing models to set regulatory capital levels
would involve increased regulatory scrutiny for model validation as
well as greater market discipline, because banks would be required to
publicly disclose aggregated information underlying the calculation of
their risk-weighted assets.
The Federal Reserve and OCC also have existing supervisory guidance
that describes the regulatory approaches for some aspects of their
oversight of internal models, oversight that the regulators say has
helped prepare them for oversight of models in a Basel II environment.
Federal Reserve Supervisory Letter 99-18 (SR 99-18), issued on July 1,
1999, directs supervisors and examiners to evaluate banks' internal
capital management processes to judge whether these processes
meaningfully tie the identification, monitoring, and evaluation of risk
to the determination of the institution's capital needs. In addition,
SR 99-18 requires examiners to consider the results of sensitivity
analyses and stress testing conducted by the institution and the way
these results relate to their capital plans. According to the letter,
banks must be able to demonstrate that their capital levels are
adequate to support their risk exposure, and examiners are to review
the banks' analyses. Finally, SR 99-18 directs examiners to assess the
degree to which an institution has in place, or is making progress
toward implementing, a sound internal process to assess capital
adequacy, including any risk modeling techniques used. Federal Reserve
officials noted that, although challenges continue to exist, banks in
general have made considerable strides in evaluating their internal
capital adequacy and enhancing governance and controls around the
process that produces such estimates. In some cases, work on the
internal assessment of capital adequacy has highlighted the need for
institutions to focus on fundamental risk management issues, such as
risk identification, risk measurement, and internal controls.
Likewise, OCC Bulletin 2000-16 (2000-16) (May 30, 2000) articulates
procedures for model validation: independent review of the models'
logical and conceptual soundness, comparisons with other models, and
comparison of model predictions and subsequent real-world events. OCC
officials and examiners for two large U.S. banking organizations said
they used 2000-16 to assess banks' processes for validating their
economic capital models. One examiner, for example, noted that a review
using 2000-16 led to requiring a bank to improve its documentation
surrounding models it had created. According to another official, it
also helped to promote greater understanding and awareness of the need
for model validation to become an integral part of bank risk
measurement and management systems. It further promoted greater
consistency in supervisory assessments of bank model validation
practices.
OTS and FDIC officials said they also have some experience working with
models. OTS, the primary federal regulator of the remaining core Basel
II institution, has policy staff and examination experience in interest
rate risk modeling and validation processes. OTS created and maintains
a Net Portfolio Value model, which allows users to create customized
interest rate risk stress scenarios and incorporate emerging interest
rate exposures and techniques, among other things. OTS officials said
this oversight had helped OTS policy and examiner staff gain experience
in overseeing the use of models and validation processes. OTS officials
also said that they have some recent experience reviewing economic
capital models and validation for risk management purposes, though
OTS's experience in this area has not been as extensive as the Federal
Reserve's or OCC's. Although OTS has not analyzed market risk models,
it will do so should the September 2006 amendments to the Market Risk
Rule be adopted as proposed. FDIC, as noted earlier, will be involved
in the Basel II implementation process as the deposit insurer for all
of the Basel II banks, and FDIC officials said they could be the
primary federal regulator for insured subsidiaries of core Basel II
banks or possible opt-in banks. FDIC officials said that, in addition
to its oversight of banks subject to the Market Risk Amendment, its
examiners also have some experience working with a variety of credit
risk and valuation models.
Regulators Plan to Integrate Basel II into Their Existing Supervisory
Processes:
The regulators plan to incorporate Basel II's additional supervisory
requirements into their existing oversight processes and supervisory
reviews.[Footnote 56] Regulatory officials said that because they
currently oversee risk modeling and capital adequacy activities, Basel
II oversight is largely an evolution of existing supervisory
strategies. The primary federal regulators' current supervisory
processes for core banks were generally similar--risk-focused
approaches that emphasize continuous monitoring and assessment of how
banking organizations manage and control risks. Consistent with their
current approaches, a team of examiners from the relevant primary
regulator will continue to be in charge of the supervision of Basel II
banks (core and opt-in banks), and teams from the Federal Reserve will
continue to oversee all of the Basel II bank holding companies. Bank-
specific examination teams are supported by other regulatory staff on
specific technical issues, such as core credit, credit quantification,
models and methodologies, and operational risk. As part of their
examination process, examiners will continue to assess the banks'
risks, identifying the business activities that pose the greatest risk,
and validate the use and effectiveness of the bank's risk management
practices. Risks may include credit risks, both commercial and retail
(such as a bank's credit rating system), risks involving the bank's
information technology system (such as data warehousing issues), or
corporate governance risks (such as a bank's ability to provide
adequate audit coverage). Officials from two regulators noted that
these risk factors are all part of banks' risk management processes and
would have to be reviewed even in the absence of Basel II.
Based on their risk assessment, examiners develop and execute
supervisory plans that set out the timetable and work schedule for the
examiners for the year. The supervisory plans typically would include
oversight of several aspects of risk management that will continue
under Basel II. For example, examiners from two regulators noted they
assess how banks validate their models, by reviewing how banks verify
their own modeling processes (e.g., independent validation, sound
governance, and internal controls), peer benchmarking studies, and
comparisons to rating agencies. These examiners said they may also
compare some models, test specific assumptions, and assess data and
internal audit systems and procedures such as stress testing, use of
scorecards (devices used to determine an obligor's default probability
by associating it with a risk rating for the obligor) and internal
ratings for loans. Finally, these examiners noted they review banks'
businesses or products, such as equity derivatives, and conduct
targeted exams that assess specific areas--for instance, collateral or
asset management for credit, market and operational risk.
Regulators Are Taking Steps toward Eventual Qualification of Banks to
Use the Advanced Approaches:
Regulatory officials told us that they were taking steps toward
eventual qualification of banks to use the advanced approaches once the
final rule was in place but that this qualification work was
preliminary because the rule was not final. A bank will be qualified
when its primary federal regulator approves it and, after consulting
with other relevant regulators, determines whether the bank's Basel II
systems satisfy the supervisory expectations for these approaches. The
NPR states that regulators will evaluate banks on their advanced
internal ratings based systems for rating risk and estimating risk
exposure; regulators will consider a bank's estimates of key risk
characteristics, such as probability of default and loss given default
(a process called quantification), ongoing model validation, data
management and maintenance, and oversight and control
mechanisms.[Footnote 57] As part of this evaluation, regulators said
the examination teams for each bank would develop a qualification
strategy designed to help the team better understand the design of the
bank's Basel II systems, drawing on existing supervisory tools and
assessing compliance with the forthcoming U.S. rule and supervisory
guidance. Regulatory officials said that the qualification process
would be a series of targeted reviews tailored to each institution and
determined by the results of specialized reviews and the bank's own
independent testing. Regulatory officials also emphasized that
qualification would be an ongoing process and that the final rule would
require banking organizations to meet the qualification requirements on
a continuous basis, subject to supervisory review. In addition,
regulators plan to:
* Continue conducting discovery reviews of banks' Basel II systems and
processes that will cover areas such as data collection and
warehousing, wholesale and retail credit models, and the definition of
default. Like examinations, these reviews assess risks and look at
parts of a bank's risk management programs; but unlike examinations,
they cannot include tests for compliance with Basel II requirements
until a final rule is in place. Federal Reserve and OCC examiners told
us that the goals of discovery reviews conducted before the rule was
finalized are to understand the conceptual underpinnings of a bank's
Basel II systems and evaluate the processes and models from a prudent
risk management standpoint. These examiners said that discovery reviews
could not result in formal evaluations of banks' Basel II progress
because there was no final rule yet. But they noted that they would
speak with banks whose approaches differed from what was currently
proposed in Basel II.[Footnote 58] Similarly, some regulatory officials
and examiners told us that not having a final rule made it difficult to
gauge the progress that banks were making and prevented them from
determining what else banks might need to do to be Basel II compliant.
* Conduct reviews of each bank's Basel II implementation plans and the
progress made in meeting them, called gap analyses, to identify
additional work that the banks need to do. The NPR requires banks'
implementation plans to detail the necessary elements of rolling out
advanced approaches in both credit and operational risk. But without a
final rule, regulators and banks have been working with informal
implementation plans and gap analyses using previous regulatory
guidance. Regulatory officials said the preliminary implementation
plans were an essential feature of the qualification process, as they
linked existing regulatory guidance with specific implementation
activities and provided an initial basis for the development of
supervisory plans related to the qualification process. For example,
one examiner's review of a bank's gap analysis found that the bank
needed to more fully define how it planned to estimate key risk
characteristics. The examiner noted that the bank was proceeding to
update its implementation plans across the other components of its
commercial internal ratings-based portfolio. As a result of these
efforts, regulators have developed gap analysis templates to guide
examiners.
* Communicate with banks about Basel II issues. Regulatory officials
emphasized that they were speaking with bank officials about the
development of the bank's Basel II systems, including methodologies and
processes. These discussions will continue until after the final rule
is issued, and according to regulators, facilitate discovery and
qualification work.
Regulatory officials emphasized that, without a final rule, their work
on qualification was preliminary, although they said it did provide
useful information about the status of banks' implementation efforts.
For example, regulators observed that all core banks had draft
implementation plans and have Basel II project management offices. But
regulatory officials said that core banks varied in their degree of
preparation to date, specifically, in the quality of their data and
risk management systems. OCC officials said that some banks are more
likely than others to make use of the potential 3-year implementation
period between becoming a core bank and the first transitional floor
period to fully develop their data and risk management systems.
Hiring and Training Supervisory Staff Is an Important Part of
Regulators' Basel II Preparations, but Retaining Staff Is a Key
Challenge:
U.S. banking regulators have been preparing for Basel II by hiring
additional supervisory staff, including examiners, with the necessary
quantitative skills and by providing training specific to Basel II.
Officials told us that although the skills needed to oversee Basel II
implementation were similar to the skills needed for all risk
management oversight, additional quantitative skills would be
necessary. Regulatory officials emphasized that, like their supervisory
processes, these hiring and training efforts were part of their
evolving human capital plans and coincided with increased oversight of
banks' models-based risk management approaches. Therefore, officials
said, the specific impact of Basel II on human capital efforts was
difficult to quantify. Regulatory officials stated that they had been
building the skill sets required to oversee economic capital models as
their responsibilities in this area increased and added that many of
these efforts would be under way even in the absence of Basel II. And
while several regulatory officials noted that they had hired some staff
specifically for Basel II that they would probably not have hired
otherwise, they said that not all staff involved in Basel II oversight
needed to have specialized skills. Generalist safety and soundness
examiners with traditional skill sets will continue to examine banks,
including those under Basel II. National teams will, however, assist
these examiners with the more technical aspects of the new capital
regime.
Several regulatory officials noted that having staff with specialized
skills in quantitative risk management models and quantitative analysis
would be even more necessary under Basel II, while examiners would
generally need good skills in credit, capital markets, and information
technology. Regulatory officials said that they had set up national
teams of staff with this specialized expertise and were providing
training to both specialist staff as well as generalist examiners.
Officials from all four regulators emphasized the importance of
training to their Basel II implementation efforts. According to
regulatory documentation and officials, supervisory staff have been
trained in numerous areas, including model validation, internal control
reviews, economic capital, operational risk, validation of credit
rating and scoring models, QIS-4, and possible ways that banks could
try to manipulate their Basel II systems.
Regulatory officials said that they faced several human capital
challenges in implementing Basel II. First, several officials said that
regulators would be challenged by the increased complexity of issues
requiring examiner judgment under Basel II and the need to apply Basel
II requirements consistently across banks. For example, examiners will
need to review the rank ordering of ratings for loans in banks' two-
dimensional ratings systems developed for Basel II and make greater use
of debt-rating models that will require examiners to review management
overrides and assess model validation.[Footnote 59] OCC officials also
noted that examiners currently have to exercise judgment on
increasingly complex issues, including validating models and overrides,
as banks increasingly use models. Federal Reserve officials said the
key to successfully meeting this challenge will be high-quality
training and effective supervisory guidance that incorporates comments
from the industry. Second, several regulators said consistently
applying Basel II across banks would also be a challenge, especially
for the AMA approach to operational risk, because of the flexibility
allowed under the NPR. OCC officials said that the forthcoming
supervisory guidance and a recent Basel Committee paper would help
clarify the allowable range of practice.[Footnote 60] Both OCC and the
Federal Reserve noted that their national teams of quantitative experts
should help regulators meet the challenge of consistent application
across banks. Third, regulators said that hiring new personnel had been
challenging and that retaining and continued training of supervisory
staff presented ongoing challenges. For instance, increased competition
for staff with these skills among the regulators themselves and between
the regulators and industry made hiring and retaining staff more
challenging. While some regulatory officials had some staffing
concerns, they also expressed confidence that they could fulfill their
new regulatory responsibilities from Basel II. Several regulatory
officials also said that they would continue assessing staffing needs
as Basel II moved forward and as the exact number of Basel II banks
became clearer, they would be reassessing the ideal number of staff
they needed with specialized skills.
Regulators Are Coordinating Domestically and Internationally, but Lack
of a Final Rule Is a Complicating Factor:
Regulators are coordinating their work with other U.S. regulators and
with those in other countries in order to provide more effective and
consistent oversight, but the lack of a final rule makes this
coordination more complicated. The four regulators' strategic plans all
place priority on this effort, and several regulatory officials from
these agencies emphasized the importance of coordination, given the
complexity of Basel II and the regulators' varied perspectives.
Domestically, regulators use several mechanisms to coordinate with
their counterparts, including an interagency steering group (which also
coordinates with an association of state bank supervisors), joint
supervisory work and examinations, interagency training, formal and
informal examiner meetings, and outreach to banks. While examiners
generally said that their Basel II coordination efforts were effective,
the delays in various stages of the rule-making process indicate some
difficulties at the policy-making level.
U.S. regulators are also working to coordinate with regulators from
other Basel II countries. For example, they are participating in the
Accord Implementation Group, one of a number of subgroups that the
Basel Committee formed to promote international consistency and address
other Basel II issues. The United States, as a home regulator (a
regulator overseeing domestic banks), communicates its qualification
strategies and processes to host regulators (foreign regulators
overseeing U.S. banks in their countries, or U.S. regulators overseeing
foreign banks in the United States). For their home responsibilities,
U.S. regulators coordinate supervisory work based on the Accord
Implementation Group's home-host principles, including determining
whether a bank's capital model for a global business is ready for Basel
II. Home regulators will rely on the work of foreign host regulators
that approve banks' local models and processes and will share
appropriate information, such as regulatory memorandums, with host
regulators. The United States is also a host regulator and as such will
share appropriate sections of supervisory plans, scopes, and product
memorandums regarding reviews of local models and processes. U.S.
regulators are also participating in supervisory colleges, or working
groups of supervisors that are formed on an as-needed basis to share
information about and coordinate supervision of international banking
organizations. One regulatory official noted that the colleges have
been and will continue to be critical to the success of the
international Basel II effort.
U.S. regulators face challenges regarding international implementation
of Basel II, in part because the United States is implementing Basel II
one year later than many other countries, including countries in the
European Union. U.S. regulators are working with U.S. and foreign banks
and regulators to address the implications of this so-called gap year.
For example, in several instances, U.S. regulators are trying to
evaluate the advanced systems of foreign banks' U.S. subsidiaries to
provide foreign regulators with feedback on those systems to be used in
foreign regulators' evaluations of banks attempting to become Basel II
compliant in their home countries in 2007, before the United States
implements Basel II in 2008. Similarly, according to U.S. regulatory
officials, some U.S. banks operating abroad are prevented by their host
supervisors from using advanced systems in the host jurisdiction before
they are allowed to do so at home, and some U.S. regulatory officials
said they are working with the foreign regulators in cases where U.S.
banks want or need to use advanced approaches in the host jurisdiction
prior to a final rule in the United States. Further, as stated earlier,
countries have a limited degree of national discretion, which, in part,
requires U.S. and foreign regulators to address challenges that
internationally active banks are experiencing due to differences
between U.S. rules and those of other countries. U.S. regulators are
working to find effective mechanisms for cooperation and information to
resolve these issues, such as the supervisory colleges previously
discussed. One regulatory official said that international home-host
efforts could tend to focus on the global parent company but added that
that regulator's focus was on making sure that the allocation of
capital within that company was appropriate and covered the risk for
the bank in the United States.
Regulators Face Impediments in Finalizing the Rule That if Left
Unresolved Could Result in Ongoing Regulatory Ambiguity for Banks and
Uncertainty about the Appropriateness of the Basel II Framework:
Although U.S. regulators have committed to working together to issue a
final rule and use prudential safeguards that would limit regulatory
capital reductions during a parallel run and transition period, they
face a number of ongoing impediments in agreeing on a final rule to
implement Basel II. First, regulators have somewhat differing
perspectives and goals, which fuels ambiguity and contributes to
questions about the appropriateness of the Basel II framework. Second,
a lack of transparency and ongoing ambiguity of some items in the NPR
may contribute to ongoing questions about the appropriateness of Basel
II as a framework. Finally, regulators will need to address banks'
concerns regarding Pillar 3 disclosure requirements and the need to
balance protecting proprietary information and providing for public
disclosure of capital calculations to encourage market discipline.
Regulators' Differing Perspectives and Goals Fuel Ambiguity:
Each federal regulator oversees a different set of institutions and
represents an important regulatory perspective, which has made reaching
consensus on some issues more difficult than others. U.S. regulators
generally agree on the broad underlying principles at the core of Basel
II, including increased risk sensitivity of capital requirements and
capital neutrality. In a 2004 report, we found that although regulators
communicate and coordinate, they sometimes had difficulty
agreeing.[Footnote 61] As we reported, in November 2003 members of the
House Financial Services Committee warned in a letter to the bank
regulatory agencies that the discord surrounding Basel II had weakened
the negotiating position of the United States and resulted in an
agreement that was less than favorable to U.S. financial institutions.
However, regulatory officials also told us that the final outcome of
the Basel II negotiations was better than it would have been with a
single U.S. representative because of the agencies' varying
perspectives and expertise.
These differing regulatory perspectives have contributed to difficulty
achieving a final rule and agreeing to specific operational details as
well as contributing in part to delays of the Basel II implementation
process and ongoing questions and unresolved issues. For example,
officials from FDIC--the deposit insurer and regulator of many smaller
banks--while acknowledging the limitations of Basel I for the largest
banks, have expressed concerns regarding required capital levels under
Basel II and potential competitive inequities between large and small
banks in the United States, if small banks are required to hold more
regulatory capital than large banks for some similar risks. FDIC
officials have also expressed some serious reservations about the
availability of sufficient data underlying certain aspects of the
models, as well as the calibration of the models themselves. Officials
from the Federal Reserve and OCC--as the regulators of the vast
majority of core banks--while acknowledging the uncertain impact on
capital requirements and data limitations, have highlighted the
limitations of Basel I, the advances in risk management at large banks,
the safeguards in the NPR to ensure capital adequacy, and regulator
experience in reviewing economic capital models. OTS officials, noting
the thrift industry's mortgage-heavy portfolios, have emphasized the
potential limitations on risk sensitivity imposed by the leverage
ratio. Specifically, they noted the potential impact on mortgages
because, as discussed previously, required capital for high-quality
mortgages could fall significantly under Basel II making the leverage
ratio a potential regulatory capital floor for some institutions.
As U.S. regulatory officials work to finalize Basel II, overcoming
these differences will likely be an ongoing challenge. While regulatory
officials said that they would work collaboratively to address comments
on the NPR, how they will reconcile potentially differing view points
is not clear. Further, while officials have said that they will monitor
progress and modify the Basel II rule as necessary during the
transition period to ensure that capital requirements are appropriate
for credit, operational, and market risks, they have not specified how
that monitoring will take place or under what circumstances regulators
will revisit the rule. Given these differences, failure to take steps
to clarify remaining questions and improve the transparency through
regular public reporting of the process going forward would result in
ongoing questions and ambiguity about Basel II as a viable framework
for regulatory capital.
Lack of Transparency and Ongoing Ambiguity Contribute to Questions
about the Overall Appropriateness of the Basel II:
Although regulators have developed a set of safeguards that reduce the
chances of significant reductions in required regulatory capital during
the planned parallel run and transitional period, regulatory officials
and others remain uncertain about the potential impact of the final
Basel II framework on the safety and soundness of the banking system.
Specifically, some regulatory officials are concerned about the use of
banks' models under Basel II because, while these models have been used
for internal risk assessment and management for years, with the
exception of certain market risk models, they are relatively unproven
as a regulatory capital tool. Others are concerned about potential
drops in required regulatory capital once the parallel run and
transition period have been completed. Regulatory concerns regarding
possible large drops in aggregate levels of minimum required risk-based
capital were reinforced after QIS-4 showed large reductions in minimum
regulatory required capital for credit risk using inputs from the
banks' models. As a result, U.S. regulators have disagreed on how and
how quickly to implement Basel II. And some industry observers have
questioned whether to proceed at all.
Further, regulators have requested comments on over 60 questions in the
NPR. For example, as stated earlier regulators have asked for comment
on whether banks should have the option of using a U.S. version of the
standardized approach rather than the advanced approach and for how
long. However, at the time of this review, the NPR did not discuss what
form a standardized approach would take in the United States or whether
it would mirror the international Basel Accord. Similarly, regulators
have not explained how they plan to calculate the 10-percent reduction
in aggregate minimum regulatory capital compared with Basel I and what
would happen if the 10-percent reduction was triggered, other than it
will warrant "modifications to the supervisory risk functions or other
aspects of this framework." Under one scenario, for example, aggregate
minimum required capital could potentially fall by over 10 percent in
an economy in which borrowers were very unlikely to default, triggering
a reexamination of Basel II by federal regulators, according to the
NPR. However, this 10-percent reduction might not be an indicator of a
fundamental flaw in the Basel II framework but rather a cyclical
movement that could be reversed in bad economic times--that is, if
Basel II is intended to be on average equal to Basel I over the
business cycle. But this interpretation is only one possible
interpretation of capital neutrality. Alternatively, a 10-percent
reduction could indicate a problem if average (i.e., through the cycle)
capital requirements were falling significantly relative to Basel I
capital levels during less favorable economic conditions.
While several officials said that they would prefer not to define how
the regulators will assess the 10-percent trigger explicitly, and
instead use their own discretion in maintaining capital levels, bank
officials have expressed interest in knowing how the trigger will
function. Moreover, it is unclear what would happen if a 10-percent
reduction relative to Basel I were triggered. For example, would banks
have to recalibrate their models, would a floor be imposed, or would a
multiplier be added, and how would economic conditions be factored into
the determination process? Part of this process will have to include
determining appropriate levels of aggregate required capital and
acceptable cyclical variation. However, the NPR does not clearly state
the regulators' views on these issues or their plans for making such
determinations. Without additional clarity in the final rule, these
issues will result in ongoing uncertainty for banks and lingering
questions about required capital levels and how Basel II's
implementation in the United States will affect banks' regulatory
capital levels.
Questions about Reliability of Bank Data Remain an Issue:
As mentioned, the appropriateness of the capital requirements generated
by the Basel II models depends in part on the sufficiency of the data
inputs used by banks, though views vary about some data requirements
for their portfolios. For example, officials at several core banks had
differing views about whether the 2001 recession represented a
sufficiently stressed economic period for calibrating their models.
Specifically, officials at one bank said that the 2001 recession was a
sufficiently stressed period to meet data requirements for their
portfolios, but officials at another bank were uncertain, and officials
at a third bank stated that 2001 was likely not sufficient. Because the
2001 recession was relatively mild by historical standards, stressed
scenarios and parameters based on it could underestimate the risk
associated with future downturns. Officials at several banks stated
that they already used or would use internal and external data to
capture time periods prior to 2001. Officials at several banks also
told us that a supervisory formula for calculating "downturn" loss
given default was helpful where they had insufficient default data; and
many banks had also purchased, or planned to purchase, external data
covering a longer time period to help estimate the effect of downturns
on their parameter estimates.
However, to address these data sufficiency challenges and their effect
on the ability of core banks to use the advanced approaches for all
portfolios, regulators will have to decide whether and how to qualify
banks to move to the advanced approaches when adequate data to assess
the risks of certain portfolios is limited. The NPR, for example,
requests comment on how to address the limited data availability and
lack of industry experience with incorporating economic downturn
conditions into LGD estimates. Given the importance of bank data
requirements, lack of clarity in the final rule could result in ongoing
questions about the reliability and sufficiency of the results
generated by the banks' models. For example, without clarification,
banks' varying interpretations of the rule could result in capital
requirements that are not comparable or that increase reliance on
examiner judgment through the supervisory review process (Pillar 2),
thereby resulting in negotiations about capital adequacy between a bank
and its regulator.
Questions about Pillar 3 Disclosure Requirements Remain:
Finally, regulators will need to resolve banks' concerns regarding
Pillar 3's disclosure requirements, since officials from some banks
said that those disclosures could be costly but of questionable value.
Officials from some core banks raised the possibility that they would
need to make significant investments to meet public disclosure
requirements under Pillar 3 but that the usefulness of the disclosures
was uncertain. Some officials were concerned that the information
required might be too detailed or complex for the markets to understand
in a useful way. For example, officials at a few banks noted that
because banks used different methodologies to manage risk, comparing
disclosures across organizations would be difficult. Similarly, another
official pointed out that comparing disclosures from banks in different
countries would also be difficult if the banks were not operating under
the same rules. Still, other officials were concerned that proprietary
or strategic business information would be made public. However,
officials from a few banks noted that the disclosures could help the
markets better understand a bank's risk profile. Regulators will need
to determine if the banks' concerns merit changes to the disclosure
requirements.
Conclusions:
Basel I has served regulators and banks well for many years and for
many smaller institutions, it is expected to continue to do so.
However, for a group of large, complex banking organizations it
increasingly fails to adequately align regulatory required capital and
risks. Basel II represents a fundamental shift in the regulatory
capital framework by seeking to leverage banks' risk management systems
and internal models for use in estimating risk more precisely than the
broad risk buckets used under Basel I, thereby helping to strengthen
the safety and soundness of the banking system. Effective capital
adequacy regulation requires balancing the costs to business of holding
capital and the need to provide protection to depositors and the
federal deposit insurance fund.
Given the limitations of Basel I, the goal of better aligning
regulatory capital with risks, and the use of safeguards during the
parallel run and transition period to ensure that a large drop in
capital does not occur, we support the regulators' plans to continue to
finalize the Basel II rule and proceed with the parallel run and
transition period in order to determine whether the Basel II framework
can be relied on to adequately capture risks for regulatory capital
purposes. It is appropriate for the regulators to proceed for several
reasons.
* First, it will provide the regulators with critical information they
currently lack to assess the appropriateness of the Basel II framework
relative to Basel I.
* Second, the proposed rules, issued in September 2006, contain
important safeguards that will help prevent large declines in
regulatory capital. The safeguards will help mitigate any risk to the
system by requiring capital to be held based on current Basel I rules
during the parallel run and allowing only limited reductions during
each of 3 transition years, which will vary depending on when a bank is
qualified.
* Third, maintaining the current leverage ratio and PCA will further
guard against any large declines in bank capital.
* Finally, foreign regulators are moving to Basel II creating potential
competitive disadvantages for U.S. banks vis-à-vis foreign banks.
While Basel II seeks to establish a closer relationship between
regulatory capital and risk for the largest and most internationally
active banking organizations, there are many issues that will require
ongoing supervision and monitoring, including the ability of these
banks' models to adequately measure risks for regulatory capital
purposes and the regulators' ability to oversee them. For example, the
Basel II models are driven by low-frequency catastrophic events that
are inherently difficult to estimate, which creates challenges for
regulators both in developing appropriate models and supervising models
developed by banks. Regulators already face resource constraints in
hiring and retaining talent that are more binding than the resource
constraints faced by the banks they regulate and this issue is likely
to become more significant under Basel II. Yet, it is a critical point
because under Basel II regulators' judgment will likely play an
increasingly important role in determining capital adequacy. We
recognize that these issues and others need to be addressed, and moving
forward is not without risks. However, as mentioned, the proposed
safeguards and retention of the leverage ratio should help mitigate
potential negative effects from moving forward while allowing the banks
and regulators to gather information to assess the appropriateness of
the Basel II framework.
As the regulators finalize Basel II, clarification of a number of
issues would make the final rule more transparent, the impact on
capital more predictable, and the treatment of portfolios with
insufficient data more consistent. Specifically, the proposed rule is
ambiguous on a number of important issues that, if left unresolved,
could continue to result in regulatory ambiguity for banks and concerns
for industry observers, including (1) what regulators plan to do when
banks have limited data available, especially for new financial
products or portfolios that lack data on the impact of a major economic
downturn, and how they will ensure that portfolios with insufficient
data are treated prudently and consistently, such as considering
options like a higher risk-weight or substituting Basel IA or the Basel
Committee's standardized approach for these portfolios; (2) how
regulators will calculate the 10-percent aggregate reduction in minimum
regulatory capital and what would happen if this is triggered; and (3)
the criteria for determining an appropriate average level of aggregate
capital and appropriate cyclical variation in regulatory capital. Also,
to address growing concerns from some large banks about Basel II
becoming an expensive compliance exercise, the regulators have
requested comments on many technical issues, as well as whether banks
should have the option of using a U.S. version of the standardized
approach. However, it is uncertain from the NPR what form a
standardized approach would take, whether it would mirror the
international Basel Accord, and how long banks would be able to use it.
Although the regulators have been operating in accordance with the
Administrative Procedure Act in their Basel II rule-making process, the
process could benefit from increased transparency to respond to broader
questions and concerns about transitioning to Basel II in the United
States. Specifically, the differing perspectives the regulators bring
to the Basel II negotiations make it difficult for them to explicitly
define the criteria they plan to use to judge Basel II's success. This
difficulty has, in turn, resulted in considerable uncertainty about,
and some opposition to, Basel II among industry and other interested
parties and stakeholders. As a result, although the regulators have
indicated that they plan to revise the framework as needed during the
transition, publicly reporting results of the parallel runs and
comparisons of Basel II and Basel I results for core banks is
particularly important given concerns about implementing Basel II in
the United States. Going forward, public reports could be used to
provide greater transparency on a number of issues and could help allay
concerns among banks and industry stakeholders about the transition to
Basel II. Issues that would benefit from greater transparency include
(1) the results of coordination and communication efforts among SEC and
the banking regulators; (2) changes to the Basel II rules during the
transition period and the safeguards, if any, that regulators believe
are appropriate in the absence of the transitional floors; and (3)
updates to supervisory guidance incorporating Basel II rule changes.
Without added transparency, the implementation will continue to
generate questions and concerns about the adequacy of the proposed
framework. Moreover, regulators have not articulated whether the
safeguards will be retained at the end of the parallel run and
transition period if the new capital framework results in significant
declines in regulatory required capital or significant changes in the
regulatory approach.
Finally, Basel II raises a number of competitiveness concerns that
warrant further study and review. First, how Basel II will impact U.S.
banks' competitiveness internationally remains unknown. But this issue
will continue to be an ongoing concern, especially if the U.S.
implementation of Basel II results in higher regulatory required
capital or greater compliance costs for U.S. banks than for foreign
banks. Second, competitiveness issues also exist between U.S.
institutions such as investment banks and commercial banks. SEC, which
has implemented the Basel Accord for consolidated supervised entities,
plans to revisit its rules based on the Federal Reserve's
interpretation of Basel II as applied to financial holding companies.
Finally, Basel II also raises competitiveness concerns between large
and small U.S. banks. Lower capital requirements for some assets could
provide large banks with a competitive advantage; however, retaining
the leverage ratio will help maintain the domestic competitive
landscape. Going forward, regulators will need to monitor the ability
of U.S. banks to compete internationally and balance their
competitiveness with the need to protect the public interests.
Moreover, the Basel IA NPR, as proposed, attempts to mitigate potential
competitive inequities created by Basel II between large and small U.S.
banks by leveling the playing field to some degree. However, these
competitive concerns will continue into the transition period, and it
is too soon to tell whether these concerns are justified or whether
they will be adequately addressed by Basel IA.
Recommendations:
To help reduce the uncertainty about the impact of Basel II on required
levels of regulatory capital, improve the transparency of the process,
and address the impediments regulators face in moving to Basel II, we
are making the following four recommendations. We recommend that, as
part of the process leading to the parallel run and during the proposed
transition period(s), the heads of the Federal Reserve, FDIC, OCC and
OTS take, at a minimum, the following steps:
* Clarify and reach agreement on certain issues in the final rule,
including:
- How to treat portfolios at Basel II banks that may lack the data to
meet regulatory standards for the advanced approaches. To ensure that
portfolios with insufficient data are treated prudently and
consistently, regulators should consider options such as a higher risk-
weight, or substituting Basel IA or the Basel Committee's standardized
approach for these portfolios.
- How to calculate the 10-percent reduction in aggregate minimum
regulatory capital and what will happen if the 10-percent reduction is
triggered.
- What the criteria will be for determining an appropriate average
level of required capital and appropriate cyclical variation in minimum
required capital.
* Issue a new NPR before finalizing the Basel II rule, if the final
rule differs materially from the NPR or if a U.S. standardized approach
is an option in the final rule. While this step may add months to the
process, the additional time may help provide more transparency and
allow banks and stakeholders to provide feedback before the rule is
finalized.
* Issue public reports at least annually on the progress and results of
implementation efforts and any resulting regulatory adjustments. This
reporting should include an articulation of the criteria for judging
the attainment of their goals for Basel II implementation and for
determining its effectiveness for regulatory capital-setting purposes.
These reports should also include analyses of (1) the results of the
parallel runs and transition periods and a comparison of Basel II and
Basel I results for the core banks and (2) the effect(s), if any, of
Basel II or differences between U.S. and international rules on the
competitiveness of U.S. banks.
Finally, at the end of the last transition period, we recommend that
the regulators reevaluate whether the advanced approaches of Basel II
can and should be relied on to set appropriate regulatory capital
requirements in the longer term. Depending on the information collected
during the transition, any reevaluation should include a range of
options, including consideration of additional minor modifications to
U.S. Basel II regulations as well as whether more fundamental changes
are warranted for setting appropriate required regulatory capital
levels.
Agency Comments and Our Evaluation:
We provided the heads of the Federal Reserve, FDIC, OCC, OTS, SEC, and
the Department of the Treasury with a draft of this report for their
review and comment. We received written comments from the Federal
Reserve, OCC, FDIC and OTS in a joint letter, and Treasury. These
comments are summarized below and reprinted in appendixes IV through
VII. The banking agencies and SEC also provided technical comments that
we incorporated in the report where appropriate.
In its comments, the Federal Reserve said it concurred with our initial
finding that Basel I is particularly inadequate for large banking
organizations and agreed with our conclusion that the regulators should
continue their efforts to finalize the U.S. Basel II capital rule and
proceed with the parallel run and transition periods. In commenting on
our conclusion that the U.S. Basel II process has lacked transparency,
the Federal Reserve commented that it and the other regulators have
attempted to be as transparent as possible in their implementation
efforts, consistent with the letter and spirit of the Administrative
Procedure Act. However, the Federal Reserve commented that it
understood that the Basel II proposals contain a considerable amount of
ambiguity and that it expects to reduce this ambiguity as it works with
the other regulators to finalize the Basel II rule. We agree that the
regulators have been operating within the parameters of the
Administrative Procedure Act in their rule-making process, but they
have been less transparent with regard to broader questions and
concerns about transitioning to Basel II in the United States.
Especially going forward, additional public reporting would be useful
to provide greater transparency on a number of issues and could help
allay concerns among banks and industry stakeholders about the
transition to Basel II. In addition, the Federal Reserve concurred with
our recommendations and said it will seek to implement them.
Similarly, in its comments, OCC said it appreciated our recognition of
the limitations of Basel I for large and/or internationally active
banks and welcomed our conclusion that the regulators should finalize
the rule and proceed with the parallel run and transition period. OCC
commented that its position has been that the regulators should move
forward on Basel II with strong safeguards in place during a transition
period and assess the need for adjustments during this period before
removing any safeguards. OCC also noted that U.S. proposals leave two
existing U.S. capital safeguards in place that are not temporary--the
leverage ratio and the prompt corrective action framework. OCC also
said it welcomed our recommendations, which it, along with the other
regulators, will consider as part of the overall review of comments
received on the NPR. With regard to our recommendation on whether a new
NPR might be necessary before proceeding to a final rule, OCC said it
believed that will ultimately depend on whether actual changes made to
the NPR in the subsequent version of the Basel II rule are sufficiently
different so as to require another round of notice and comment and that
it was premature to make that determination until all comments had been
received and evaluated and the regulators decide what changes to make.
OCC also pointed out that further delay could have ramifications for
international competition and said it will ensure that the rule-making
process complies with the letter and spirit of the Administrative
Procedure Act.
In their joint letter, FDIC and OTS commented that Basel II efforts to
improve the risk sensitivity of capital requirements for large, complex
banks has been rooted in the regulators' shared objectives and said
that ensuring the achievement of these shared objectives will remain of
paramount importance to the regulators' deliberations and review of
comments on the NPR. They also said that the regulators share a
commitment to maintaining a safe and sound banking industry and that
retention of the existing leverage ratio and prompt corrective action
framework, and other safeguards in the NPR, underscore that commitment.
In addition, they commented that, given the considerable costs and
complexity of the advance approach and its attendant uncertainties and
risks, FDIC and OTS noted that serious consideration should be given to
the implementation of a U.S. version of the Basel II standardized
approach as an option for all U.S. banks. Similar to OCC, FDIC and OTS
also said they will consider our recommendations as part of the overall
review of the comments received on the NPR.
In its comments, Treasury agreed that there are a number of significant
Basel II implementation challenges and uncertainties for the large,
complex banking organizations that will be subject to Basel II
requirements and for federal banking regulators. Treasury stated its
view that the regulators needed to reach a consensus on the major
requirements of a final rule soon after the NPR comment period closes
for Basel II and IA if the United States is going to meet the January
2008 goal for Basel II implementation. Treasury noted that further
delay would add to uncertainty and potentially create burdens for
domestic and foreign banks. Treasury also expressed concern with our
recommendation to issue a new NPR before finalizing the Basel II rule,
saying that the overlapping comment period for Basel II and Basel IA,
which is similar to the standardized approach for credit risk in the
international Basel Accord, provides commenters the ability to opine on
implementation and other issues and options. We realize that an
additional NPR would further delay the Basel II process; however, under
certain circumstances an additional NPR would be a necessary step to
provide more transparency to the process and to ensure that the final
rule is comprehensive and that the implications are fully considered.
In response to comments on this recommendation from the Federal
Reserve, OCC, and the Treasury, we have clarified the wording of our
recommendation to more clearly state the need for a new NPR if the
regulators intend to issue a final rule that is materially different
from the NPR or if they intend to provide a U.S. standardized approach.
We are sending copies of this report to interested congressional
committees, the Chairman of the Federal Reserve Board, Chairman of the
Federal Deposit Insurance Corporation, the Comptroller of the Currency,
the Director of the Office of Thrift Supervision, the Chairman of the
Securities and Exchange Commission, and the Secretary of the Treasury.
We will also make copies available to others on request. In addition,
the report will be available at no charge on GAO's Web site at
http://www.gao.gov.
If you or your staff have any questions regarding this report, please
contact Orice M. Williams at (202) 512-5837 or williamso@gao.gov or
Thomas J. McCool at (202) 512-2642 or mccoolt@gao.gov. Contact points
for our Offices of Congressional Relations and Public Affairs may be
found on the last page of this report. GAO staff who made major
contributions to this report are listed in appendix VIII.
Signed by:
Orice M. Williams, Director:
Financial Markets and Community Investment:
Signed by:
Thomas J. McCool, Director:
Center for Economics:
[End of section]
Appendix I: Scope and Methodology:
The objectives of this report were to describe (1) the developments
leading to the transition to Basel II, (2) the proposed changes to the
U.S. regulatory capital framework, (3) the potential implications of
Basel II's quantitative approaches and their potential impact on
required capital, (4) banks' preparations and related challenges, and
(5) U.S. regulators' preparations and related challenges.
For all our objectives, we reviewed a variety of documents, including
regulators' statements; congressional testimony; the international
Basel II Accord (entitled "International Convergence of Capital
Measurement and Capital Standards: A Revised Framework") and other
documents from the Basel Committee on Banking Supervision, such as the
1988 Basel Capital Accord (Basel I); the Basel II and Basel IA Notices
of Proposed Rulemaking (NPR);[Footnote 62] the Basel II and Basel IA
Advance Notices of Proposed Rulemaking (ANPR);[Footnote 63] literature
from the Congressional Research Service, bank trade associations,
academic articles, and our previous reports on banking regulation. We
also interviewed senior supervisory officials at the Board of Governors
of the Federal Reserve and the Federal Reserve Bank of New York
(Federal Reserve), Office of the Comptroller of the Currency (OCC),
Federal Deposit Insurance Corporation, Office of Thrift Supervision,
and the Securities and Exchange Commission (SEC). We interviewed a
former U.S. regulatory official, a foreign banking regulatory official,
a state regulator and an association of state banking regulators. In
addition, we interviewed officials from all core and a selected group
of opt-in banks, two bank trade associations, an international banking
association, and two credit rating agencies. Finally, we attended
several conferences held by regulators and trade associations that
included discussions related to Basel II.
To describe the developments leading to the transition to Basel II and
the proposed changes to the U.S. capital framework, in addition to the
foregoing, we reviewed a variety of documents, including the Market
Risk Amendment and official comments on the Basel II and Basel IA
ANPRs.[Footnote 64]
As noted throughout the report, the rules for Basel II and Basel IA in
the United States were not yet final when we completed our audit work,
limiting our ability to assess the potential impact of regulatory
changes. To describe the potential implications of Basel II's
quantitative approaches and their potential impact on required capital,
we used data from the fourth quantitative impact study, Moody's
Investors Service, and regulatory, bank, and academic studies to
analyze and illustrate how proposed regulatory changes could affect
capital requirements for a variety of assets under a variety of
economic conditions. For example, we combined risk parameter estimates
from those sources to estimate Basel II credit risk capital
requirements for externally-rated corporate exposures and mortgages and
compared those estimates to required capital under the leverage ratio.
We analyzed the advanced internal ratings-based approach to credit risk
and advanced measurement approaches to operational risk based on the
proposed rules, academic studies, Basel Committee documents, and our
interviews with core and opt-in bank officials, and regulators.
To describe banks' preparations and related challenges, as stated
previously, we interviewed officials from each of the likely core
banks. To identify the likely core banks, we used data available from
public regulatory filings to determine those whose total assets and/or
foreign exposure met the proposed criteria in the Basel II NPR as of
December 31, 2005. We also collected information through interviews and
written data collection instruments from a sample of five possible opt-
in banks, selected on the basis of input from the regulators and bank
associations, size, and primary federal regulator.
To describe regulators' preparations and challenges, we reviewed a
variety of documents as listed above, as well as other documents from
the federal banking regulators, such as the Federal Reserve's
Supervisory Letter 99-18 (SR 99-18), OCC's Bulletin 2000-16, the Market
Risk Rule, and regulators' strategic and annual performance
plans.[Footnote 65] At the Federal Reserve and OCC, we also interviewed
bank examiners for two of the largest U.S. banking organizations and
reviewed examination reports to understand how regulators oversee risk
management processes at core banks and how the regulators are planning
to incorporate Basel II into their examinations and oversight
processes.
We conducted our work in Washington, D.C; Chicago, San Francisco, and
New York, between April 2006 and January 2007 in accordance with
generally accepted government auditing standards.
[End of section]
Appendix II: U.S. and International Transition to Basel II:
[See PDF for Image]
Source: GAO.
Note: Dates shown for both the international and U.S. parallel run and
transition periods are for the advanced risk measurement approaches.
[A] Denotes estimated date.
[End of figure]
[End of section]
Appendix III: Basel II Descriptive Overview:
Pillar 1: Minimum Capital Requirements:
Pillar 1 of the U.S. Basel II proposal features explicit minimum
capital requirements, designed to ensure bank solvency by providing a
prudent level of capital against unexpected losses for credit,
operational, and market risk. The advanced approaches, which are the
only measurement approaches currently proposed in the United States,
will make capital requirements depend in part on a bank's own
assessment, based on historical data, of the risks to which it is
exposed.
Credit Risk:
Under the advanced internal ratings-based (A-IRB) approach, banks must
establish risk rating and segmentation systems to distinguish risk
levels of their wholesale (most exposures to companies and governments)
and retail (most exposures to individuals and small businesses)
exposures, respectively. Banks use the results of these rating systems
to estimate several risk parameters that are inputs to supervisory
formulas. Figure 7 illustrates how credit risk will be calculated under
the Basel II A-IRB. Banks must first classify their assets into
exposure categories and subcategories defined by supervisors: for
wholesale exposures those subcategories are high-volatility commercial
real estate and other wholesale; for retail exposures those
subcategories are residential mortgages, qualifying revolving exposures
(e.g., credit cards), and other retail. Banks then estimate the
following risk parameters, or inputs: the probability a credit exposure
will default (probability of default or PD), the expected size of the
exposure at the time of default (exposure at default or EAD), economic
losses in the event of default (loss given default or LGD) in expected
and "downturn" (recession) conditions, and, for wholesale exposures,
the maturity of the exposure (M). In order to estimate these inputs,
banks must have systems for classifying and rating their exposures as
well as a data management and maintenance system. The conceptual
foundation of this proposal is that a statistical approach, based on
historical data, will provide a more appropriate measure of risk, and
capital, than a simple categorization of asset types, which does not
differentiate precisely between risks. Regulators provide a formula for
each exposure category that determines the required capital on the
basis of these inputs. If all the assumptions in the supervisory
formula were correct, the resulting capital requirement would exceed a
bank's credit losses in a given year with 99.9 percent probability.
That is, credit losses at the bank would exceed the capital requirement
with a one in one thousand chance in a given year, which could result
in insolvency if the bank only held capital equal to the minimum
requirement.
Figure 7: Computation of Capital Requirements for Wholesale and Retail
Credit Risk under Basel II:
[See PDF for image]
Source: GAO analysis of information from the Basel II NPR.
Notes:
This figure focuses on wholesale and retail nondefaulted exposures, an
important component of the total credit risk calculation. The total
credit risk capital requirement also covers defaulted wholesale and
retail exposures, as well as risk from securitizations and equity
exposures. A bank's qualifying capital is also adjusted, depending on
whether its eligible credit reserves exceed or fall below its expected
credit losses.
Banks may incorporate some credit risk mitigation, including
guarantees, collateral, or derivatives, into their estimates of PD or
LGD to reflect their efforts to hedge against unexpected losses.
[End of figure]
In contrast to Basel I, required capital by the A-IRB approach, as
previously described, will depend on the risk characteristics of a
particular asset rather than on broad risk weights for entire asset
categories, as in Basel I. For example, mortgage loans vary
significantly in quality, and the capital requirement will depend on
the probability of default, along with the other inputs, while the
capital requirement for most mortgages is fixed under Basel I.
Operational Risk:
To determine minimum required capital for operational risk, banks would
be able to use their own quantitative models of operational risk that
incorporate elements required in the NPR. To qualify to use the
advanced measurement approaches (AMA) for operational risk, a bank must
have operational risk management processes, data and assessment
systems, and quantification systems. The elements that banks must
incorporate into their operational risk data and assessment system are
internal operational loss event data, external operational loss event
data, results of scenario analysis, and assessments of the bank's
business environment and internal controls. Banks meeting the AMA
qualifying criteria would use their internal operational risk
quantification system to calculate the risk-based capital requirement
for operational risk, subject to a solvency standard specified by
regulators, to produce a capital buffer for operational risk designed
to be exceeded only once in a thousand years.
Market Risk:
Regulators have allowed certain banks to use their internal models to
determine required capital for market risk since 1996 (known as the
Market Risk Amendment or MRA). Under the MRA, a bank's internal models
are used to estimate the 99th percentile of the bank's market risk loss
distribution over a 10-business-day horizon, in other words a solvency
standard designed to exceed trading losses for 99 out of 100 10-
business-day intervals. The bank's market risk capital requirement is
based on this estimate, generally multiplied by a factor of three. The
agencies implemented this multiplication factor to provide a prudential
buffer for market volatility and modeling error. The OCC, Federal
Reserve, and FDIC are proposing to incorporate their existing market
risk rules and are proposing modifications to the market risk rules, to
include modifications to the MRA developed by the Basel Committee, in a
separate NPR issued concurrently with the proposal for credit and
operational risk. OTS is proposing its own market risk rule, including
the proposed modifications, as a part of that separate NPR.
Regulatory officials generally said that changes to the rules for
determining capital adequacy for market risk were relatively modest and
not a significant overhaul. The regulators have described the
objectives of the new market risk rule as including enhancing the
sensitivity of required capital to risks not adequately captured in the
current methodologies of the rule and enhancing the modeling
requirements consistent with advances in risk management since the
implementation of the MRA. In particular, the rule contains an
incremental default risk capital requirement to reflect the growth in
traded credit products, such as credit default swaps, that carry some
default risk as well as market risk.
Pillar 2: Supervisory Review:
The Pillar 2 framework for supervisory review is intended to ensure
that banks have adequate capital to support all risks, including those
not addressed in Pillar 1, and to encourage banks to develop and use
better risk management practices. Banks adopting Basel II must have a
rigorous process of assessing capital adequacy that includes strong
board and senior management oversight, comprehensive assessment of
risks, rigorous stress testing and validation programs, and independent
review and oversight. In addition, Pillar 2 requires supervisors to
review and evaluate banks' internal capital adequacy assessments and
monitor compliance with regulatory capital requirements. Under Pillar
2, supervisors must conduct initial and ongoing qualification of banks
for compliance with minimum capital calculations and disclosure
requirements. Regulators must evaluate banks against established
criteria for their (1) risk rating and segmentation system, (2)
quantification process, (3) ongoing validation, (4) data management and
maintenance, and (5) oversight and control mechanisms. Regulators are
to assess a bank's implementation plan, planning and governance
process, and parallel run performance. Under Pillar 2, regulators
should also assess and address risks not captured by Pillar 1 such as
credit concentration risk, interest rate risk, and liquidity risk.
Importantly, the Pillar 2 of the international Basel II framework is
already largely in place in the United States. For example, Pillar 2
allows supervisors the ability to require banks to hold capital in
excess of the minimum, an authority that federal regulators already
possess under prompt corrective action provisions.
Pillar 3: Market Discipline in the Form of Increased Disclosure:
Pillar 3 is designed to encourage market discipline by requiring banks
to disclose additional information and allowing market participants to
more fully evaluate the institutions' risk profiles and capital
adequacy. Such disclosure is particularly appropriate given that Pillar
I allows banks more discretion in determining capital requirements
through greater reliance on internal methodologies. Banks would be
required to publicly disclose both quantitative and qualitative
information on a quarterly and annual basis, respectively. For example,
such information would include a bank's risk-based capital ratios and
their capital components, aggregated information underlying the
calculation of their risk-weighted assets, and the bank's risk
assessment processes. In addition, federal regulators propose to
collect, on a confidential basis, more detailed data supporting the
capital calculations. Federal regulators would use this additional
data, among other purposes, to assess the reasonableness and accuracy
of a bank's minimum capital requirements and to understand the causes
behind changes in a bank's risk-based capital requirements. Federal
regulators have proposed detailed reporting schedules to collect both
public and confidential disclosure information.
[End of section]
Appendix IV: Comments from the Board of Governors of the Federal
Reserve System:
Board Of Governors Of The Federal Reserve System:
Washington, D.C. 20551:
Susan Schmidt Bies:
Member Of The Board:
January 26, 2007:
Ms. Orice M. Williams:
Director:
Financial Markets and Community Investment:
U.S. General Accountability Office:
Washington, DC 20548:
Dear Ms. Williams:
The Federal Reserve appreciates the opportunity to review and comment
on a draft of the GAO's report on the U.S. implementation of the Basel
II capital accord (GAO-07-253).
The Federal Reserve concurs with the report's initial finding that the
Basel I capital rule is particularly inadequate for large banking
organizations and increasingly fails to align regulatory capital
requirements with risk for large and internationally active banking
organizations. The report usefully discusses several of the principal
flaws of the Basel I framework for large banking organizations: its
simple, non-granular risk-bucketing system; its limited recognition of
credit risk mitigation techniques; its lack of explicit coverage of
operational risk; and its limitations in reflecting financial market
innovations (such as securitization and derivatives). In addition, the
report acknowledges that the Basel I framework has not kept pace with
the more advanced risk measurement practices at large banking
organizations.
The Federal Reserve also agrees with the report's conclusion that the
agencies should continue their efforts to finalize the U.S. Basel II
capital rule and proceed with the parallel run and transition period to
Basel II. As noted in the report, finalization of the U.S. Basel II
rule would be appropriate for at least the following reasons: (i) the
parallel run and transition period will generate crucial information
for the agencies in their future assessments of the strengths and
weaknesses of the Basel II rule for the U.S. banking system; (ii) Basel-
II transitional floors will prevent each bank's regulatory capital
requirements from declining precipitously during the transition period;
and (iii) any further delay in the U.S. implementation of Basel II
creates potential competitive disadvantages for U.S. banks as compared
to foreign banks. The report further indicates that small U.S. banking
organizations have raised concerns that the proposed bifurcated
implementation of Basel II in the United States may create competitive
inequities between small and large U.S. banking organizations. The
agencies have issued a Basel IA proposal for smaller U.S. banking
organizations to help address these potential competitive inequities.
Of course, we intend to review and analyze carefully all public
comments on the outstanding Basel II and Basel IA proposals before
making any final decisions about the new regulatory capital framework.
The report also concludes that the U.S. Basel II implementation process
has lacked transparency or clarity and, as a consequence, there is
uncertainty about and some opposition to the Basel II framework. The
Federal Reserve and the other Federal banking agencies have attempted
to be as transparent and clear as possible in our Basel II
implementation efforts, consistent with the letter and spirit of the
Administrative Procedure Act. In the past few years, these efforts have
included issuing for public comment proposed Basel II wholesale credit
and operational risk supervisory guidance and an advance notice of
proposed rulemaking in September 2003; issuing for public comment
proposed Basel II retail credit supervisory guidance in October 2004;
issuing two interagency press releases in 2005 on the timeframe and
scope of our Basel II implementation efforts; issuing public results of
our 41h Basel II quantitative impact study in February 2006; issuing
for public comment a Basel II notice of proposed rulemaking (NPR) in
September 2006 (with an extensive 6-month comment period); and hosting
numerous meetings with bank trade associations and individual banking
organizations throughout 2006 to discuss the NPR. The agencies also
expect to issue all the Basel II supervisory guidance for a second
round of public comment in the near future. Many of these actions went
far beyond our obligations under the Administrative Procedure Act to
provide the public (including the banking industry) with fair notice of
our rulemaking activities.
Notwithstanding these significant efforts by the agencies to promote
the transparency of the U.S. Basel II implementation process, we
understand that the outstanding Basel II proposals contain a
considerable amount of ambiguity. The agencies expect to reduce this
ambiguity substantially as we work to finalize the Basel II rule.
Moreover, during the transition period, as we acquire additional
experience with the new regulatory capital framework, we expect to be
able to further reduce any residual uncertainties that remain in the
Basel II rule. Of course, there are limits on how specific and concrete
the agencies can make the Basel II rule. Basel II has been designed to
be an adaptable regulatory capital framework; as such, many of the
ultimate requirements of any final Basel II rule will take the form of
general principles in order to preserve the risk measurement and
management flexibility of banking organizations.
In addition, the report makes a number of recommendations to the
agencies about how to improve the transparency and clarity of the U.S.
Basel II implementation process going forward. The Federal Reserve
concurs with these recommendations and will seek to (i) provide
additional clarity about how the Basel II rule would treat portfolios
for which a bank does not have sufficient historical performance data
(or an acceptable and reliable risk parameter quantification
methodology); (ii) clarify the criteria we will use for determining an
appropriate average level of required capital, and appropriate cyclical
variation in required capital, in the U.S. banking system; (iii) issue
a second Basel II NPR if the agencies decide to permit Basel II banks
to use a standardized option or if the agencies intend to issue a final
Basel II rule that would differ substantially from the Basel II NPR;
(iv) issue periodic public reports on the U.S. Basel II implementation
process during the parallel run and transition periods; and (v) re-
evaluate, at the end of the transition period, whether the advanced
approaches of Basel II provide an appropriate regulatory capital
framework for U.S. banking organizations. Indeed, with respect to the
final recommendation, we expect to perform such an evaluation not only
at the end of the transition period but also during the transition
period.
Federal Reserve staff has separately provided GAO staff with technical
and correcting comments on the draft report. We hope that these
comments were helpful.
Thank you for your efforts on this important matter. The Federal
Reserve appreciates the professionalism of, and the careful analysis
performed by, the GAO's review team.
Sincerely:
Signed by:
Susan Schmidt Bies:
[End of section]
Appendix V: Comments from the Office of the Comptroller of the
Currency:
Comptroller of the Currency:
Administrator of National Banks:
Washington, DC 20219:
January 26, 2007:
Ms. Orice M. Williams:
Director, Financial Markets and Community Investment:
United States Government Accountability Office:
Washington, DC 20548:
Dear Ms. Williams:
We have received and reviewed your draft report titled "Risk-Based
Capital: Bank Regulators Need to Improve Transparency and Overcome
Impediments to Finalizing the Proposed Basel II Framework." The report
fulfills a statutory mandate resulting from concerns about the possible
effects of updating risk-based capital rules.
We appreciate the GAO's recognition of the limitations of Basel I for
large, complex and/or internationally active banks. The OCC believes
that the continued safety and soundness of our banking system demands
that we move away from our current simplistic risk-based capital system
for large, internationally active banks to one that substantially
enhances risk management and more closely aligns capital with risk. The
draft report acknowledges the crucial role of Basel II in the
development and utilization of enhanced risk management systems in our
largest banks.
In this context, we very much welcome your straightforward statement in
the report that GAO "support[s] the regulators' plans to continue to
finalize the Basel II rules and proceed with the parallel run and
transition period in order to determine whether the Basel II framework
can be relied on to adequately capture risks for regulatory capital
purposes." This has been the essence of the OCC's position on Basel II:
move forward to finalize the rules; begin implementation with strong
temporary safeguards in place during a transition period; and assess
the need for adjustments to the framework during that transition period
before removing the temporary safeguards. Of course, we also note that
the proposals leave in place two existing U.S. capital safeguards that
are not temporary and are in addition to the capital required
internationally by the Basel II framework: the leverage ratio, and the
additional capital effectively required by the prompt corrective action
framework (i.e., the additional capital required to be designated "well
capitalized," as nearly all U.S. banks are).
The draft report contains various statements and recommendation for the
banking agencies to consider in the assessment of comments on the Basel
11 notice of proposed rulemaking (NPR).
Several of these statements and recommendations concern the approach to
safeguards and the transition period just described. In particular, the
draft report:
* Describes and supports certain of the safeguards contained in the NPR
that limit potential reductions in regulatory capital during the
parallel run and transition periods;
* Recommends that the agencies improve transparency during the
transition period by issuing public reports on the progress and results
of implementation; and:
* Recommends that, before the end of the transition period, the
agencies undertake an analysis to determine whether changes are needed
to the Basel II rule.
In addition, the draft report:
* Highlights competitive equity issues associated with the U.S.
rulemakings, including the need for the agencies to ensure that capital
adequacy regulations not be a significant source of competitive
inequality, both domestically and among internationally active banks;
and:
* Recommends that the agencies clarify and reach agreement on certain
provisions of the NPR that are ambiguous or unclear.
We welcome these and the other substantive comments and recommendations
made in the draft report, which we and the other banking agencies will
consider as part of the overall review of comments received on the NPR.
With respect to your comment about whether a new NPR might be necessary
before proceeding to a final rule, we believe that will ultimately
depend on the whether the actual changes made to the NPR in the
subsequent version of the rule are sufficiently different so as to
require another round of notice and comment. It is of course premature
to make that determination until all the comments have been received
and evaluated and the agencies decide what changes will be made. We
also note that further delay resulting from an additional NPR could
itself have ramifications for international competition. In any event,
we will ensure that the rulemaking process remains compliant with both
the letter and the spirit of the Administrative Procedure Act.
I appreciate this opportunity to provide the OCC's comments on the
draft report, and I extend my thanks for the professionalism with which
you and your staff have conducted this review. Technical comments were
provided to your analysts separately.
Sincerely,
Signed by:
John C. Duga:
Comptroller of the Currency:
[End of section]
Appendix VI Comments from the Federal Deposit Insurance Corporation and
the Office of Thrift Supervision:
Federal Deposit Insurance Corporation:
Office of Thrift Supervision:
January 25, 2007:
Ms. Orice M. Williams Director:
Financial Markets and Community Investment:
U.S. Government Accountability Office:
441 G Street, N.W.
Washington, D.C. 20548:
Dear Ms. Williams:
The Federal Deposit Insurance Corporation and the Office of Thrift
Supervision appreciate the opportunity to comment on the GAO's draft
report, Risk-Based Capital: Bank Regulators Need to Improve
Transparency and Overcome Impediments to Finalizing the Proposed Basel
II Framework. This letter summarizes our agencies' overall reaction to
the report. Technical comments on the report have been provided by our
respective staffs.
The report rightly notes that the agencies share a number of important
regulatory objectives. The Basel II effort to improve the risk-
sensitivity of capital requirements for large, complex banks has been
rooted in these shared objectives. As summarized in the report, these
objectives include:
* To further strengthen the soundness and stability of the
international banking system;
* To maintain sufficient consistency that capital adequacy regulation
will not be a source of competitive inequality among internationally
active banks;
* To promote the adoption of stronger risk management practices by the
banking industry; and:
* To broadly maintain the aggregate level of minimum capital
requirements, while also providing incentives to adopt the more
advanced risk-sensitive approaches of the revised framework.
As noted in the report, the agencies also share the goal of avoiding
unintended consequences, such as the creation of a significant
competitive disadvantage for any class of banks.
Ensuring the achievement of these shared objectives will remain of
paramount importance to the agencies' deliberations and review of
comments on the Notice of Proposed Rulemaking (NPR). While the agencies
sometimes approach issues from different perspectives, as the report
notes, we share a commitment to maintaining a safe and sound banking
industry. The retention of the existing leverage requirements and
Prompt Corrective Action framework, and other safeguards contained in
the NPR, underscore that commitment.
The report notes that the implementation of the advanced approach is
not without risk, and that its ultimate impact on the safety-and-
soundness of the U.S. banking system is uncertain. Given the
considerable costs and complexity of the advanced approach and its
attendant uncertainties and risks, our agencies believe serious
consideration should be given to the implementation of a U.S. version
of the Basel II standardized approach as an option for all U.S. banks.
Our decisions in this regard will benefit greatly from the comments we
receive on this and other issues.
The report makes a number of recommendations that our agencies will
consider as part of the overall review of comments received on the NPR.
Our agencies appreciate the professionalism of the GAO's review team
and the significant efforts that went into the development of these
recommendations.
Sincerely,
Signed by:
Sheila C. Bair:
Chairman:
Federal Deposit Insurance Corporation:
Signed by:
John M. Reich:
Director:
Office of Thrift Supervision:
[End of section]
Appendix VII: Comments from the Department of the Treasury:
Department Of The Treasury:
Washington, D.C.
Under Secretary:
January 26. 2007:
Orice M. Williams:
Director, Financial Markets and Community Investment:
United States Government Accountability Office:
411 G Street, NW:
Washington, DC 20508:
Dear Ms. Williams:
Thank you for providing the United States Department of the Treasury
the opportunity to comment on the Government Accountability Office's
(GAO) report entitled "Risk-Based Capital: Bank Regulators Need to
Improve Transparency and Overcome Impediments to Finalizing the
Proposed Basel II Framework. "
In general, the GAO draft report provides a comprehensive overview of
the Basel II process and U.S. implementation efforts. As the draft
report noted, the Basel II process is important for encouraging ongoing
improvements in bank risk management and measurement processes, and in
making regulatory capital requirements more risk-sensitive for U.S.
banking institutions.
We agree that there remain a number of significant Basel II
implementation challenges and uncertainties for the large complex
banking organizations subject to Basel II requirements and for the
federal banking regulators. Despite these challenges, we believe that
the federal banking regulators should reach a consensus on the major
requirements of a final rule soon after the Basel II and Basel IA
comment periods end in late March. Reaching such a consensus and
providing key implementation information to relevant banking
institutions as soon as possible thereafter is essential if the U.S. is
going to meet the January 2008 goal for Basel II implementation. In
that regard, we note that the U.S. implementation schedule is already
one year behind other member countries of the international Basel
Committee on Banking Supervision. Further delay will add to uncertainty
and potentially create burdens for both domestic and foreign banks.
While regulators retain appropriate discretion in implementing Basel II
to ensure that the proper safeguards remain in place, given that other
countries are moving forward, it is incumbent upon the federal banking
regulators to also move forward with Basel II implementation.
Finally, we would note that the GAO draft report recommended that the
federal banking regulators issue a new notice of proposed rulemaking
(NPR) before finalizing the Basel II rule given the. number of open-
ended questions and the potential option of providing the Basel II
standardized approach to all U.S. banks. We are quite concerned about
further delaying this important process. We also note that the
simultaneous proposal of the Basel IA NPR (which is similar to the
standardized approach to credit risk option in the international
accord) and the Basel II NPR for notice and comment, provide commenters
with the ability to opine on implementation and other issues and
options. In addition, we note that the extended time period toward fall
implementation of Basel II (a parallel-year run in 2008 and three-year
transition period) provides ample opportunity for the federal banking
regulators to fully consider the impact of Basel II and related issues.
Again, we would like to thank you for this opportunity to provide our
views an your draft report. Please let us know if you have any
additional questions.
Sincerely,
Signed by:
Robert K. Steel:
Under Secretary for Domestic Finance:
[End of section]
Appendix VIII: GAO Contacts and Staff Acknowledgments:
GAO Contacts:
Orice M. Williams (202) 512-5837 or williamso@gao.gov Thomas J. McCool
(202) 512-2642 or mccoolt@gao.gov:
Staff Acknowledgments:
In addition to the contacts named above, Barbara I. Keller (Assistant
Director); Emily Chalmers; Michael Hoffman; Austin Kelly; Clarette Kim;
James McDermott; Suen-Yi Meng; Marc Molino; and Andrew Nelson made key
contributions to this report.
[End of section]
Related GAO Products:
Deposit Insurance: Assessment of Regulators' Use of Prompt Corrective
Action Provisions and FDIC's New Deposit Insurance System, GAO-07-242.
Washington, D.C.: February 15, 2007.
Financial Regulation: Industry Changes Prompt Need to Reconsider U.S.
Regulatory Structure, GAO-05-61. Washington, D.C.: October 6, 2004.
Risk-Focused Bank Examinations: Regulators of Large Banking
Organizations Face Challenges, GAO/GGD-00-48. Washington, D.C.: January
24, 2000.
Risk-Based Capital: Regulatory and Industry Approaches to Capital and
Risk, GAO/GGD-98-153. Washington, D.C.: July 20, 1998.
Bank and Thrift Regulation: Implementation of FDICIA's Prompt
Regulatory Action Provisions, GAO/GGD-97-18. Washington, D.C.: November
21, 1996.
FOOTNOTES
[1] Capital is generally defined as a firm's long-term source of
funding, contributed largely by a firm's equity stockholders and its
own returns in the form of retained earnings. One important function of
capital is to absorb losses. The federal banking regulators are the
Federal Reserve System (Federal Reserve), Federal Deposit Insurance
Corporation (FDIC), Office of the Comptroller of the Currency (OCC),
and Office of Thrift Supervision (OTS).
[2] The Basel Committee on Banking Supervision (Basel Committee) seeks
to improve the quality of banking supervision worldwide, in part by
developing broad supervisory standards. The Basel Committee consists of
central bank and regulatory officials from 13 member countries:
Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the
Netherlands, Spain, Sweden, Switzerland, United Kingdom, and United
States. The Basel Committee's supervisory standards are also often
adopted by nonmember countries.
[3] Federal Deposit Insurance Reform Conforming Amendments Act of 2005,
Pub. L. No 109-173 § 6(e) (Feb. 15, 2006).
[4] The Basel II NPR and Basel IA NPR were published in the Federal
Register on September 25, 2006, and December 26, 2006, respectively.
The comment periods for both NPRs will close on March 26, 2007.
[5] The standardized approach for credit risk creates several
additional risk categories but does not rely on banks' internal models
for estimating risk parameters used to calculate risk-based capital
requirements.
[6] As discussed later in this report, banks and bank holding companies
are subject to minimum leverage requirements, as measured by a ratio of
tier 1 capital to total assets. Prompt corrective action (PCA) is a
supervisory framework for banks that requires regulators to take
increasingly stringent forms of corrective action against banks as
their leverage and risk-based capital ratios decline.
[7] In this report, the term "bank" refers generally to insured
depository institutions (banks and thrifts) as well as bank holding
companies. Where the distinction is significant, the term "bank holding
company" refers to the insured institution's ultimate holding company.
[8] Tier 1 capital is considered most stable and readily available for
supporting a bank's operations. It covers core capital elements, such
as common stockholder's equity and noncumulative perpetual preferred
stock. Tier 2 describes supplementary capital elements and includes
loan loss reserves, subordinated debt, and other instruments. Total
capital consists of both tier 1 and tier 2 capital.
[9] Banks holding the highest supervisory rating have a minimum
leverage ratio of 3 percent; all other banks must meet a leverage ratio
of at least 4 percent. Bank holding companies that have adopted the
Market Risk Amendment or hold the highest supervisory rating are
subject to a 3 percent minimum leverage ratio; all other bank holding
companies must meet a 4 percent minimum leverage ratio.
[10] See GAO, Deposit Insurance: Assessment of Regulators' Use of
Prompt Corrective Action Provisions and FDIC's New Deposit Insurance
System, GAO-07-242 (Washington, D.C.: Feb. 15, 2007), which responds to
a legislative mandate that GAO review federal banking regulators'
administration of the prompt corrective action program (P. L. 109-173,
Federal Deposit Insurance Reform Conforming Amendments Act of 2005,
Section 6(a), Feb. 15, 2006).
[11] See, e.g., 12 C.F.R. § 6.4(b)(1) (OCC).
[12] In addition to the risk weights in table 2, a dollar-for-dollar
capital charge applies for certain recourse obligations. See 66 Fed.
Reg. 59620 (Nov. 29, 2001).
[13] As implemented in the United States, Basel I assigns reduced risk
weights to exposures collateralized by cash on deposit; securities
issued or guaranteed by central governments of Organization for
Economic Cooperation and Development countries, U.S. government
agencies, and U.S. government-sponsored enterprises; and securities
issued by multilateral lending institutions. Basel I also has limited
recognition of guarantees, such as those made by Organization for
Economic Cooperation and Development countries, central governments,
and certain other entities. See 12 C.F.R. Part 3 (OCC); 12 C.F.R. Parts
208 and 225 (Federal Reserve); 12 C.F.R. Part 325 (FDIC); and 12 C.F.R.
Part 567 (OTS).
[14] The Basel Committee defines operational risk as the risk of loss
resulting from inadequate or failed internal processes, people, and
systems or from external events, including legal risks, but excluding
strategic and reputational risk. Examples of operational risks include
fraud, legal settlements, systems failures, and business disruptions.
[15] Securitization is the process of pooling debt obligations and
dividing that pool into portions (called tranches) that can be sold as
securities in the secondary market. Banks can use securitization for
regulatory arbitrage purposes by, for example, selling high-quality
tranches of pooled credit exposures to third-party investors, while
retaining a disproportionate amount of the lower-quality tranches and
therefore, the underlying credit risk.
[16] 61 Fed. Reg. 47358 (Sept. 6, 1996).
[17] 66 Fed. Reg. 59614 (Nov. 29, 2001).
[18] See 71 Fed. Reg. 55830 (Sept. 25, 2006) (Basel II NPR); 71 Fed.
Reg. 77446 (Dec. 26, 2006) (Basel IA).
[19] For operational risk, the U.S.-proposed rule permits a bank to
propose an alternative approach to the AMA in limited circumstances,
but regulators expect use of such an alternative approach to occur on a
very limited basis. See 71 Fed. Reg. 55840-41.
[20] These foreign banking organizations indicated they may adopt the
foundation internal ratings-based approach for credit risk, which uses
internal models to some extent. However, the United States has proposed
to adopt only the advanced IRB approach.
[21] A bank is required to adopt Basel II if it meets the following
proposed criteria: at least $250 billion in assets, or at least $10
billion in on-balance sheet foreign exposure.
[22] 5 U.S.C. § 553.
[23] QIS-4 estimated aggregate reductions in minimum required capital
for every wholesale and retail exposure category (except credit cards,
for which minimum required capital would increase significantly) across
the 26 banking organizations that participated in the study. The study
also estimated a reduction in minimum required capital for
securitization exposures and a relatively small increase for equity
exposures.
[24] A bank transitioning to Basel II must first satisfactorily
complete a one-year parallel run period in which it calculates
regulatory capital according to both Basel I and Basel II (its actual
regulatory capital requirement would be determined by Basel I).
[25] During each transition period (lasting at least 1 year), banks
would be subject to limits on the amount by which a bank's risk-based
capital requirements could decline and would be required to calculate
capital requirements according to both Basel I and Basel II.
[26] 71 Fed. Reg. 77446 (Dec. 26, 2006).
[27] LTV ratios are a measure of credit risk for mortgages and are
commonly used in the underwriting process. A higher LTV ratio indicates
a higher level of risk.
[28] Under U.S. Basel I, most first-lien, one-to-four family mortgages
meet certain required criteria (i.e., they meet prudent underwriting
standards and are not 90 days or more past due or in nonaccrual status)
to receive a 50 percent risk weight. Those mortgages not meeting the
criteria receive a 100 percent risk weight.
[29] 71 Fed. Reg. 77463.
[30] A leverage limit is required unless a federal banking agency
rescinds it upon determining (with the concurrence of the other federal
banking agencies) that the measure no longer is an appropriate means
for carrying out the purpose of PCA. 12 U.S.C. § 1831o(c)(1)(B)(ii).
[31] For example, OTS notes that, if Basel II is adopted as proposed,
the capital of institutions with concentrations of low-risk assets
could be constrained by a leverage requirement at a capital level well
above that suggested by the risk reflected by a bank's internal model
that meets supervisory qualification criteria. Conversely, the leverage
requirement may not impose any meaningful constraint on relatively
higher-risk institutions (in particular, since the leverage ratio as
currently formulated does not address off-balance sheet risks). As a
result, OTS notes that low credit risk lenders may have a regulatory
capital arbitrage incentive to pursue riskier lending.
[32] SEC, Alternative Net Capital Requirements for Broker-Dealers That
Are Part of Consolidated Supervised Entities, 69 Fed. Reg. 34428 (June
21, 2004).
[33] Holding companies that already have a principal regulator (e.g.,
bank or financial holding companies regulated by the Federal Reserve)
would be examined by their principal regulator, rather than SEC.
[34] According to SEC, one firm, faced with less than 6 months between
publication of SEC rules and the European Union deadline, opted to
implement Basel I as an interim measure. That firm plans to adopt the
Basel II advanced approach for credit risk in the first quarter of
2007.
[35] "Studies on the Validation of Internal Rating Systems," Basel
Committee on Banking Supervision Working Paper, no. 14, May 2005.
[36] Hugh Thomas and Zhiqiang Wang, "Interpreting the Internal Ratings-
Based Capital Requirements in Basel II," Journal of Banking Regulation,
vol. 6, no. 3 (2005).
[37] Scenario analysis is defined in the Basel II NPR as a "systematic
process of obtaining expert opinions from business managers and risk
management experts to derive reasoned assessments of the likelihood and
loss impact of plausible high-severity operational losses that may
occur at a bank." 71 Fed. Reg. 55852, 55920.
[38] The Basel Committee has stated both that a limited amount of
national discretion can be used to adapt the Basel II standards to
different conditions of national markets, and that national authorities
are free to put in place supplementary measures of capital adequacy.
[39] Allen N. Berger, "Potential Competitive Effects of Basel II on
Banks in SME Credit Markets in the United States," Journal of Financial
Services Research, vol. 29, no. 1 (2006).
[40] A bank's credit risk-weighted assets would be multiplied by the
scaling factor, which would yield an increase in minimum required
capital for credit risk of 6 percent.
[41] For example, Basel II banks will have to qualify before moving to
the advanced approaches, and, as mentioned above, validate models used
to calculate A-IRB credit risk parameters. During the transition
period, the parallel run and transitional floors also guard against
precipitous reductions in capital requirements.
[42] As noted previously, the proposed Basel II minimum risk-based
capital requirements are that banks hold 4 percent of risk-weighted
assets as tier 1 capital and 8 percent of risk-weighted assets as total
qualifying capital. 71 Fed. Reg. 55921.
[43] In contrast, Fannie Mae and Freddie Mac, regulated by the Office
of Federal Housing Enterprise Oversight, must meet a leverage capital
requirement that includes both on-balance sheet assets as well as off-
balance sheet obligations, along with a risk-based capital requirement.
12 C.F.R. § 1750.4.
[44] The Federal Reserve has noted that if this takes place, the
disincentive does not present a regulatory capital problem from a
prudential perspective so long as appropriate risk-based capital
charges are levied against all assets that are retained by a bank.
[45] These estimates are generally based on the recessionary period
between 2000 and 2002, which was relatively mild by historical
standards.
[46] 71 Fed. Reg. 55855.
[47] In order for a bank holding company to be eligible to become a
financial holding company, which allows it to engage in securities and
insurance businesses, all its commercial banks must be well-
capitalized. As mentioned previously, well-capitalized banks must meet
capital ratios for risk-based and leverage capital that are above the
minimum requirements.
[48] See Federal Reserve, Assessing Capital Adequacy in Relation to
Risk at Large Banking Organizations and Others with Complex Risk
Profiles, SR 99-18 (July 1, 1999).
[49] See OCC Bulletin, OCC 2000-16 (May 30, 2000).
[50] Pub. L. No. 107-204, 116 Stat. 745 (July 30, 2002).
[51] All four regulators said that their primary focus was on Basel II,
rather than on Basel IA, and that the additional risk categories and
other changes reflected in Basel IA would not be a significant
regulatory oversight effort in comparison to Basel II; therefore, we
also focus on regulators' preparations for Basel II.
[52] The effective date of the Market Risk Rule was January 1, 1997,
but the date for mandatory compliance was January 1, 1998. 61 Fed. Reg.
47357-78. In September 2006, the banking regulators issued a Notice of
Proposed Rulemaking proposing revisions to the Market Risk Rule to
enhance its risk sensitivity and introduce public disclosure
requirements. 71 Fed. Reg. 55958 (Sept. 25, 2006).
[53] Covered positions include all positions (both debt and equity) in
a bank's trading account and all foreign exchange and commodity
positions, whether or not they are in the trading account.
[54] The qualitative requirements reiterate the basic elements of sound
risk management. According to the final rule, the quantitative
requirements are designed to ensure that an institution has adequate
levels of capital and that capital charges are sufficiently consistent
across institutions with similar exposures. These requirements call for
each bank to use common quantitative standards when using its internal
model to generate its estimate of VAR.
[55] See, e.g., 12 C.F.R. Part 3, App. B § 4(e) (OCC).
[56] Because only the Federal Reserve, OCC, and OTS will be the primary
federal regulators of the core banks (at current asset levels), this
discussion focuses on the examination procedures for those regulators.
Once Basel II is implemented, FDIC may be the primary federal regulator
for some opt-in banks.
[57] 71 Fed. Reg. 55830, 55911-12.
[58] However, such discussions would not be considered a supervisory
issue because banks are not yet required to meet any Basel II
requirements.
[59] Typically banks have rated loan quality along a single dimension,
but Basel II requires that borrowers be rated in two areas, or
dimensions, default probability and loss severity in the event of
default.
[60] The NPR says that regulators will jointly issue supervisory
guidance describing agency expectations for wholesale, retail,
securitization, and equity exposures, as well as for operational risk.
71 Fed. Reg. 55842. The NPR notes that the regulators have previously
issued for public comment draft supervisory guidance on corporate and
retail exposures and operational risk. Id. n. 23. The forthcoming
guidance will be designed to clarify the requirements of the NPR and
help provide a consistent and transparent process to oversee
implementation of the advanced approaches.
[61] GAO, Financial Regulation: Industry Changes Prompt Need to
Reconsider U.S. Regulatory Structure, GAO-05-61 (Washington, D.C.: Oct.
6, 2004).
[62] 71 Fed. Reg. 55380 (Sept. 25, 2006) (Basel II NPR); 71 Fed. Reg.
77446 (Dec. 26, 2006) (Basel IA).
[63] 68 FR 45900 (Aug. 4, 2003) (Basel II ANPR); 70 FR 61068 (Oct. 20,
2005) (Basel IA ANPR).
[64] In 1996, the United States and other Basel Committee members
adopted the Market Risk Amendment to Basel I, which requires capital
for market risk exposures arising from banks' trading activities.
[65] 61 Fed. Reg. 47358 (Sept. 6, 1996).
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