November 2006

Perspectives on the Basel II Capital Adequacy Framework

Since 1999, the Basel Committee on Banking Supervision, which consists of the bank supervisors of almost all developed countries, has been struggling to adopt a new capital adequacy framework for commercial banks. The Basel Committee’s bank capital proposal, known as Basel II, has been amended several times and still has not been universally accepted. Indeed, after some recent testing, the differences among bank supervisors may have grown even wider. At a November 14 AEI conference sponsored by Booz Allen Hamilton and presented jointly with the Professional Risk Managers’ International Association, panelists considered many of the issues associated with the current proposal and also addressed why no global consensus among bank supervisors has emerged in the past seven years.

R. Christopher Whalen
Institutional Risk Analytics

Large banks instigated the Basel II process, partly in order to take credit for the advances that had been made in the profession since the beginnings of the Basel capital framework and partly to better model and predict the risk of the different kinds of business with which banks become involved. Likewise, regulators also wanted to have a better understanding of the risk undertaken by banks. Smaller banks were not averse to some reduction in capital requirements, but they were very concerned that the accord would place them at a disadvantage, since they lacked the resources to carry out the modeling and hire expensive credit personnel. This disadvantage could lead large banks to target smaller ones for acquisition. Furthermore, under the Basel II accord, most small community banks would end up meeting the economic capital levels needed to support the business that they do, whereas the large money-center banks that deal in complex transactions would arguably need much more capital.

George E. French
Federal Deposit Insurance Corporation

The commitment to avoid substantial reductions in capital requirements was a central element of the Basel II accord. U.S. banking agencies in particular recognize that substantially reducing capital requirements could harm the safety and soundness of the nation’s banking system. However, according to the Basel Committee’s Fourth Quantitative Impact Study (QIS-4), the median total capital requirement for banks would be reduced by 26.3 percent and the Tier 1 Capital Requirement by 30.8 percent. The QIS-4 and FDIC calculations also estimate that the accord will result in lower capital requirements for complex risks, such as securitizations and over-the-counter derivatives. In addition, QIS-4 indicates that banks with similar exposures to risk would face remarkably different capital requirements. This prospect is especially alarming, considering the fact that there is no precedent for large differences in regulatory capital requirements across U.S. banks. It is possible that this phenomenon could accelerate consolidation of banks and potentially threaten the dual banking system. As U.S. regulators prepare to implement the Basel accord, it is essential that they take these factors into account.

Mark J. Tenhundfeld
American Bankers Association

The federal banking agencies’ proposed rules to implement the Basel II capital requirements are inconsistent with the Basel accord’s intended goal of arriving at capital requirements that better reflect the risk a bank is taking. First, the proposed capital adequacy framework is more restrictive than that found in other countries, thereby placing U.S. banks at a disadvantage compared to foreign banks. Second, because not all U.S. banks would be subject to the proposal, implementing it could lead to competitive imbalances domestically, possibly facilitating the acquisition by banks that are subject to more risk-sensitive rules of those operating under out-of-date capital standards. Finally, the agencies’ proposal will need to be accompanied by other proposals that take into account the diversity within the banking industry. Rather than imposing a one-size-fits-all policy, banks should have a menu of capital options in order to achieve the most efficient respective capital standards.

Gary R. Wilhite
Wachovia Bank

Basel II is a good development in regulation, superior to Basel I in the way in which the newer accord takes risk into account. However, U.S. rulemaking has strayed from the framework agreed to in Basel, which could lead to an enormously expensive compliance exercise for U.S. banks, which in turn raises serious issues of competitiveness. The United States and its financial system would benefit from a return to the cooperation and the collaboration that produced progress in Basel, as well as a move toward implementing rules much closer to the international accord. The risk-sensitive framework has many benefits, both in terms of increasing the safety of the banking system by ensuring adequate capital levels and enhancing the efficiency of capital deployment in the United States.

Peter J. Wallison
AEI

The purpose of Basel II was to introduce into bank capital computations the element of risk that market discipline would otherwise provide were banks not perceived as backed by the government. In essence, the Basel accord attempts to replicate through complex modeling what the market would do in the absence of regulation. However, experience has shown that abstract models can predict very poorly what actually happens. Case in point, the Office of Management and Budget projection for this year’s deficit was off by $172 billion. Moreover, QIS-4 shows that using the advanced Basel II approach results in substantially lower capital requirements, as well as huge differences in how banks rate the risk of the same portfolio. A better way of arriving at proper capital requirements is to use the market itself by having banks issue subordinated debt. Among other stipulations, this debt could not be insured by any government agency or backed by any credit enhancement device, collateralized, or convertible into equity. The market’s response to the subordinated debt would be a good indicator of the adequacy of the bank’s current level of capitalization. Because lower capital requirements increase the risk of bank failure, which can lead to economic decline and other systemic crises, it is essential that we have some reliable way to determine whether banks are taking increasing risks. At the moment, because the Basel II formulas do not adequately replicate what the market would do, we should retain the leverage ratio as a stop-gap measure.

AEI research assistant Daniel Geary prepared this summary.