United States Government Accountability Office

GAO Report to Congressional Committees

RISK-BASED 

CAPITAL 

Bank Regulators Need 

to Improve 

Transparency and 

Overcome 

Impediments to 

Finalizing the 

Proposed Basel II 

Framework 

February 2007 

 

GAO-07-253 
What GAO Found

United States Government Accountability Office

Why GAO Did This Study

Highlights

Accountability Integrity Reliability

February 2007

RISK-BASED CAPITAL

Bank Regulators Need to Improve 

Transparency and Overcome 

Impediments to Finalizing the Proposed 

Basel II Framework 

Highlights of GAO-07-253, a report to 

Congressional Committees 

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 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. 

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. 

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. 
Contents 

Letter 1

Results in Brief 3

Background 9

The Transition to Basel II Has Been Driven by Limitations of Basel 

I and Advances in Risk Management at Large Banking 

Organizations 14

Federal Regulators Are Proposing a Regulatory Capital Framework 

that Differs from the International Basel II Accord in Several 

Respects 19

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 36

Core Banks Are Incorporating Basel II into Ongoing Efforts to 

Improve Risk Management, but Challenges Remain 53 

U.S. Regulators Are Integrating Preparations for Basel II into Their 

Current Supervisory Process but Face a Number of Impediments 59 

Conclusions 74

Recommendations 77

Agency Comments and Our Evaluation 79 

Appendix I Scope and Methodology 83 

Appendix II U.S. and International Transition to Basel II 86 

Appendix III Basel II Descriptive Overview 88 

Appendix IV Comments from the Board of Governors of the 

Federal Reserve System 93 

Appendix V Comments from the Office of the Comptroller of 

the Currency 96 

Page i GAO-07-253 Risk-Based Capital
Appendix VI Comments from the Federal Deposit Insurance 

Corporation and the Office of Thrift Supervision 98 

Appendix VII Comments from the Department of the 

Treasury 100 

Appendix VIII GAO Contacts and Staff Acknowledgments 102 

Related GAO Products 103 

Tables 

Table 1: Major Types of Banking Risks 9 

Table 2: U.S. Basel I Credit Risk Categories 15 

Table 3: Differences in U.S.-Proposed Implementation of Basel II 

and International Accord 28 

Figures 

Figure 1: The Three Pillars of Basel II 21 

Figure 2: Banks that Meet U.S.-Proposed Criteria for Mandatory 

Adoption of Basel II 24 

Figure 3: Sensitivity to Credit Risk for Mortgages under Basel I and 

Basel IA 30 

Figure 4: U.S. Regulatory Capital Requirements 33 

Figure 5: Leverage Ratio vs. Basel II Credit Risk Required Capital 

for Externally Rated Corporate Exposures, by Rating 48 

Figure 6: Leverage Ratio vs. Basel II Credit Risk Required Capital 

for Mortgages, by Probability of Default 50 

Figure 7: Computation of Capital Requirements for Wholesale and 

Retail Credit Risk under Basel II 89 

Page ii GAO-07-253 Risk-Based Capital
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

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Page iii GAO-07-253 Risk-Based Capital
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.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.

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 

 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. 

Page 1 GAO-07-253 Risk-Based Capital
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.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.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

 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. 

Page 2 GAO-07-253 Risk-Based Capital
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. 

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, 

Results in Brief 

Page 3 GAO-07-253 Risk-Based Capital
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.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 

 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. 

Page 4 GAO-07-253 Risk-Based Capital
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.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 riskbased 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’

 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. 

Page 5 GAO-07-253 Risk-Based Capital
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; 

Page 6 GAO-07-253 Risk-Based Capital
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 

Page 7 GAO-07-253 Risk-Based Capital
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 

Page 8 GAO-07-253 Risk-Based Capital
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. 

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 

Background 

Risk Definition

Credit risk The potential for loss resulting from the failure of a borrower or 

counterparty to perform on an obligation. 

Market risk The potential for loss resulting from movements in market prices, 

including interest rates, commodity prices, stock prices, and foreign 

exchange rates. 

Interest rate risk A type of market risk that involves the potential for loss due to 

adverse movements in interest rates.a

Operational risk The risk of loss resulting from inadequate or failed internal 

processes, people, and systems or from external events. 

Liquidity risk 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. 

Concentration risk 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. 

Page 9 GAO-07-253 Risk-Based Capital
Risk Definition

Reputational risk The potential for loss arising from negative publicity regarding an 

institution’s business practices. 

Compliance risk The potential for loss arising from violations of laws or regulations 

or nonconformance with internal policies or ethical standards. 

Strategic risk 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. 

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 

Page 10 GAO-07-253 Risk-Based Capital
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. 

Four federal banking regulators supervise the nation’s banks and thrifts, 

and each serves as primary federal regulator over certain types of 

institutions: 

U.S. Regulators 

Responsible for 

Implementing Basel II 

• 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.

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-

 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.

Page 11 GAO-07-253 Risk-Based Capital
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. 

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.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.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 offbalance 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 

Existing Regulatory 

Capital Framework 

 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. 

Page 12 GAO-07-253 Risk-Based Capital
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.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 wellcapitalized 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 riskbased capital ratio of 6 percent or greater, and (3) a leverage ratio of 5 

percent or greater.11

 10See 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). 

11See, e.g., 12 C.F.R. § 6.4(b)(1) (OCC). 

Page 13 GAO-07-253 Risk-Based Capital
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. 

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).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. 

The Transition to 

Basel II Has Been 

Driven by Limitations 

of Basel I and 

Advances in Risk 

Management at Large 

Banking 

Organizations 

Basel I Is a Simple 

Framework with Broad 

Risk Categories That Is 

Inadequate for Large 

Banking Organizations 

 12In 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).

Page 14 GAO-07-253 Risk-Based Capital
Table 2: U.S. Basel I Credit Risk Categories 

Risk weight Major assets 

0% 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. 

20% Claims on banks in Organization for Economic Cooperation and 

Development countries, obligations of government-sponsored enterprises, 

or cash items in the process of collection. 

50% Most one-to-four family residential mortgages; certain privately issued

mortgage-backed securities and municipal revenue bonds. 

100% 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. 

200% 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). 

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 riskbased 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 

Page 15 GAO-07-253 Risk-Based Capital
purposes. For example, the U.S. Basel I framework recognizes collateral 

and guarantees in only a limited range of cases.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.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. 

 13As 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). 

14The 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. 

Page 16 GAO-07-253 Risk-Based Capital
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.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.16

By contrast, federal regulators amended the U.S. framework in 2001 to 

better address risk for asset securitizations.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 riskweighting 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 

Basel I Does Not Reflect 

Financial Innovations and 

Risk Management 

Practices at Large Banking 

Organizations 

 15Securitization 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. 

1661 Fed. Reg. 47358 (Sept. 6, 1996). 

1766 Fed. Reg. 59614 (Nov. 29, 2001). 

Page 17 GAO-07-253 Risk-Based Capital
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.

Page 18 GAO-07-253 Risk-Based Capital
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.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. 

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. 

Federal Regulators 

Are Proposing a 

Regulatory Capital 

Framework that 

Differs from the 

International Basel II 

Accord in Several 

Respects 

Basel II Is an International 

Framework Based on 

Shared Regulatory 

Objectives but Subject to 

National Implementation 

 18See 71 Fed. Reg. 55830 (Sept. 25, 2006) (Basel II NPR); 71 Fed. Reg. 77446 (Dec. 26, 2006) 

(Basel IA). 

Page 19 GAO-07-253 Risk-Based Capital
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 AIRB) 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. 

Page 20 GAO-07-253 Risk-Based Capital
Figure 1: The Three Pillars of Basel II 

Pillar I Pillar II Pillar III

Other approaches available in the international accord

Currently required in the U.S. proposed rule

Supervisory

review

Market discipline

(via disclosure)

Supervisory roles:

• Evaluate banks’ internal capital

adequacy assessments and

 compliance with minimum

 capital requirements

• Expect and be able to require

banks to hold capital in excess

 of minimum, to address risks

 not fully captured under Pillar 1

• Intervene early to prevent

 capital from falling below

 minimum levels

Requires banks to publicly 

disclose qualitative and 

quantitative information on:

• capital structure

• capital adequacy

• risks covered in Pillar 1

• interest rate risk

Source: GAO.

Minimum capital

requirements

Standardized

approach

Foundation

internal 

ratings-based

approach

Advanced

internal

ratings-based

approach 

(A-IRB)

Standardized

approach

Basic 

indicator

approach

Advanced

measurement

approaches

(AMA)

Credit

risk

Operational

risk

Market

risk

Risk measurement

approaches

U.S. proposed rules specifically request 

comment on this approach as an option

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. 

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:

Page 21 GAO-07-253 Risk-Based Capital
• 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. 

Page 22 GAO-07-253 Risk-Based Capital
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).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.20 Regulators estimate that, according to 

currently proposed criteria, 11 organizations would be required to comply 

with Basel II.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. 

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 

 19For 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. 

20These 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. 

21A 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. 

Page 23 GAO-07-253 Risk-Based Capital
Figure 2: Banks that Meet U.S.-Proposed Criteria for Mandatory Adoption of Basel II 

42%

(11 banks) 58%

(8,732 banks)

Share of U.S. banking industry assets Likely Basel II core banks by asset size

0 200 400 600 800 1,000 1,200

Bank of America

JP Morgan Chase

Citibank

Wachovia

Wells Fargo

Washington Mutual

HSBCa

State Street

Bank of New York

Northern Trust

Deutsche Banka

Dollars in billions

Likely Basel II core banks

All other banks

Sources: 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. 

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. 

Page 24 GAO-07-253 Risk-Based Capital
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.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 

 225 U.S.C. § 553. 

Page 25 GAO-07-253 Risk-Based Capital
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.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

 23QIS-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.

Page 26 GAO-07-253 Risk-Based Capital
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.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.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. 

 24A 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). 

25During 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. 

Page 27 GAO-07-253 Risk-Based Capital
Table 3: Differences in U.S.-Proposed Implementation of Basel II and International Accord 

United States International Accord

Scope of application • 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. 

• 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 • 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. 

• Transitional floors in which required riskbased 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 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. 

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 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. 

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 

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. 

Includes such an adjustment.

Page 28 GAO-07-253 Risk-Based Capital
United States International Accord

Loss given default (LGD) • 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. 

• 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.

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.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.27 Specifically, Basel IA proposes 

six risk-weight categories based on LTV ratios that would replace Basel I’s 

 2671 Fed. Reg. 77446 (Dec. 26, 2006). 

27LTV 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. 

Page 29 GAO-07-253 Risk-Based Capital
single risk category for most mortgages.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 AIRB 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 

 

Required capital (percentage)

Loan-to-value (LTV) ratio

Basel I

Basel IA

Source: GAO analysis of information from the Basel IA Draft NPR and Congressional Research Service.

0

2

4

6

8

10

12

LTV <60 60< LTV <80 80< LTV <85 85< LTV <90 90< LTV <95 LTV >95

28Under 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. 

Page 30 GAO-07-253 Risk-Based Capital
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.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 riskbased 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 

 2971 Fed. Reg. 77463. 

Page 31 GAO-07-253 Risk-Based Capital
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.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.31

 30A 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). 

31For 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. 

Page 32 GAO-07-253 Risk-Based Capital
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

Risk-based capital ratios

Minimum

requirementsa

Well-capitalized

Adequately capitalized

Total capital to

risk-weighted assets

Covers on- and off-balance sheet assets

As proposed, banks will use one of three risk-based regimes,

based largely on size and complexity:

• Basel II

• Basel IA

• Basel I

Calculates explicit capital requirements for only credit risk,

market risk, (where relevant), and operational risk (Basel II only)

Source: GAO.

Tier 1 capital to

risk-weighted assets

Tier 1 capital to

total average assets

Covers only on-balance

sheet assets

Applies to all banks

Simple capital to assets ratio

intended to broadly cover all

risks faced by a bank

Leverage ratio

U.S. specific requirement

Internationally adopted requirement

10%

8% 4%

6%

4%d

5% b

c

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 riskbased 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. 

Page 33 GAO-07-253 Risk-Based Capital
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. 

The U.S. Proposal Differs 

in Other Ways from the 

International Accord

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.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 

 32SEC, Alternative Net Capital Requirements for Broker-Dealers That Are Part of 

Consolidated Supervised Entities, 69 Fed. Reg. 34428 (June 21, 2004). 

Page 34 GAO-07-253 Risk-Based Capital
with Basel standards and consent to groupwide supervision by SEC.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.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. 

 33Holding 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. 

34According 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. 

Page 35 GAO-07-253 Risk-Based Capital
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.

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. 

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 

Basel II Preparations Have 

Contributed to Improved 

Risk Management at 

Participating Banks 

Page 36 GAO-07-253 Risk-Based Capital
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. 

Page 37 GAO-07-253 Risk-Based Capital
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. 

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 

Basel II Models Could 

Improve the Risk 

Sensitivity of Capital 

Requirements but Also 

Have Limitations 

More Risk-Sensitive Capital 

Requirements Could Improve 

Safety and Soundness

Page 38 GAO-07-253 Risk-Based Capital
credit losses from default are more likely. Finally, although more risksensitive 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. 

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. 

A-IRB Approach for Credit Risk 

Has Strengths and Weaknesses 

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.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 

 35“Studies on the Validation of Internal Rating Systems,” Basel Committee on Banking 

Supervision Working Paper, no. 14, May 2005. 

Page 39 GAO-07-253 Risk-Based Capital
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.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 AIRB approach represent simplifications of very complex real-world 

phenomena, meant to approximate such severe scenarios. 

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 

AMA for Operational Risk Also 

Has Strengths and Weaknesses 

 36Hugh Thomas and Zhiqiang Wang, “Interpreting the Internal Ratings-Based Capital 

Requirements in Basel II,” Journal of Banking Regulation, vol. 6, no. 3 (2005). 

Page 40 GAO-07-253 Risk-Based Capital
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.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 expertdesigned 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 

 37Scenario 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. 

Page 41 GAO-07-253 Risk-Based Capital
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. 

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. 

Using Bank Models for 

Regulatory Capital Purposes 

Increases Importance of 

Validation and Supervisory 

Review of Bank Models 

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

Page 42 GAO-07-253 Risk-Based Capital
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.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.

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 

 38The 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. 

39Allen 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). 

Page 43 GAO-07-253 Risk-Based Capital
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.

The QIS-4 showed, on average, large drops in minimum required riskbased 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-4.40 The U.S. regulators, who have included this increase in 

Quantitative Impact Study 

Raised Concerns about Large 

Drops in Required Capital 

 40A 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. 

Page 44 GAO-07-253 Risk-Based Capital
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 

Page 45 GAO-07-253 Risk-Based Capital
review of the institutions’ systems.41 Nevertheless, QIS-4 raised a number

of questions that have significantly changed the way U.S. regulators are 

planning to implement Basel II. 

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. 

The Parallel Run, Transitional 

Floors and Leverage Ratio 

Would Help Prevent Large 

Declines in Required Capital 

during a Transition Period 

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 

 41For 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. 

Page 46 GAO-07-253 Risk-Based Capital
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.42

 42As 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 riskweighted assets as total qualifying capital. 71 Fed. Reg. 55921. 

Page 47 GAO-07-253 Risk-Based Capital
Figure 5: Leverage Ratio vs. Basel II Credit Risk Required Capital for Externally 

Rated Corporate Exposures, by Rating 

Required capital (percentage)

Moody’s rating

Leverage ratio

Basel II credit risk

Sources: GAO analysis of information from the Basel II NPR, Federal Reserve System, Moody's Investors Service, and QIS-4 Summary.

AAA Aa A Baa Ba B C

Higher requirement

0

5

10

15

20

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. 

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 

Page 48 GAO-07-253 Risk-Based Capital
requirement does not include off-balance sheet exposures, which include 

many securitizations and derivatives, resulting in an incomplete picture of 

capital adequacy.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.44

 43In contrast, Fannie Mae and Freddie Mac, regulated by the Office of Federal Housing 

Enterprise Oversight, must meet a leverage capital requirement that includes both onbalance sheet assets as well as off-balance sheet obligations, along with a risk-based capital 

requirement. 12 C.F.R. § 1750.4. 

44The 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. 

Page 49 GAO-07-253 Risk-Based Capital
Figure 6: Leverage Ratio vs. Basel II Credit Risk Required Capital for Mortgages, by Probability of Default 

0

1

2

3

4

5

6

0.2% 0.4% 0.6% 0.8% 1.0% 1.2% 1.4% 1.6% 1.8% 2.0% 2.2% 2.4% 2.6% 2.8% 3.0%

Required capital (percentage)

Annual probability of default

Leverage ratio

Basel II credit risk

Higher requirement

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. 

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 

Basel II Required Capital Could 

Vary over the Business Cycle 

Page 50 GAO-07-253 Risk-Based Capital
defaults and losses are higher in poor economic times.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.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 

 45These estimates are generally based on the recessionary period between 2000 and 2002, 

which was relatively mild by historical standards. 

4671 Fed. Reg. 55855. 

Page 51 GAO-07-253 Risk-Based 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. 

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.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. 

Impact of Basel II on Total 

Capital Held Is Uncertain 

Because Banks Hold Capital for 

a Variety of Reasons 

 47In 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. 

Page 52 GAO-07-253 Risk-Based Capital
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. 

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.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 

Core Banks Are 

Incorporating Basel II 

into Ongoing Efforts 

to Improve Risk 

Management, but 

Challenges Remain 

Core Banks Are Working 

to Integrate Basel II into 

Existing Efforts to 

Improve Risk Management 

and Capital Allocation 

Practices

 48See 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). 

Page 53 GAO-07-253 Risk-Based Capital
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.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. 

 49See OCC Bulletin, OCC 2000-16 (May 30, 2000). 

Page 54 GAO-07-253 Risk-Based Capital
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 

Page 55 GAO-07-253 Risk-Based Capital
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 

Page 56 GAO-07-253 Risk-Based Capital
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 SarbanesOxley Act of 2002.50 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, highquality exposures. In other cases, the officials said that they needed to

collect additional information specified in the regulatory criteria. For 

 50Pub. L. No. 107-204, 116 Stat. 745 (July 30, 2002). 

Page 57 GAO-07-253 Risk-Based Capital
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. 

Page 58 GAO-07-253 Risk-Based Capital
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.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. 

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 

U.S. Regulators Are 

Integrating 

Preparations for Basel 

II into Their Current 

Supervisory Process 

but Face a Number of 

Impediments 

Regulators Have Been 

Building on Experience 

Overseeing Risk 

Management 

 51All 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. 

Page 59 GAO-07-253 Risk-Based Capital
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.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.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.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 

 52The 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). 

53Covered 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. 

54The 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. 

Page 60 GAO-07-253 Risk-Based Capital
against actual daily trading results to determine how effectively the VAR 

measure has identified the boundaries of losses.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 riskweighted 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 

 55See, e.g., 12 C.F.R. Part 3, App. B § 4(e) (OCC). 

Page 61 GAO-07-253 Risk-Based Capital
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 

Page 62 GAO-07-253 Risk-Based Capital
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.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 

 56Because 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. 

Page 63 GAO-07-253 Risk-Based Capital
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.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 

 5771 Fed. Reg. 55830, 55911-12. 

Page 64 GAO-07-253 Risk-Based Capital
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.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 

 58However, such discussions would not be considered a supervisory issue because banks 

are not yet required to meet any Basel II requirements. 

Page 65 GAO-07-253 Risk-Based Capital
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. 

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, 

Hiring and Training 

Supervisory Staff Is an 

Important Part of 

Regulators’ Basel II 

Preparations, but 

Retaining Staff Is a Key 

Challenge 

Page 66 GAO-07-253 Risk-Based Capital
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.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 highquality 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 

Regulatory Cost Estimates of Basel II

Several regulatory officials emphasized the 

difficulty of separating costs for Basel II from 

costs that would have been incurred anyway 

as part of efforts to oversee banks’ evolving 

risk management practices. Some officials

also noted that they had few staff dedicated 

solely to Basel II efforts. However, in the 

regulatory impact study that it compiled for 

the Office of Management and Budget’s

review of the NPR, OCC estimated its own 

costs for training, guidance, and supervision 

at roughly $7 million through 2005 and at 

approximately $3 million annually between 

2006 and 2011. In a similar regulatory impact 

study, OTS estimated its costs at roughly $4 

million through 2005, with another $2 million 

probable for 2006. OTS officials said that 

future costs would be sensitive to the number 

of thrifts that opted into Basel II. While the 

Federal Reserve was not required to compile 

a similar cost estimate for the Office of 

Management and Budget, officials noted that 

its costs and OCC’s were likely to be higher 

than the FDIC’s and OTS’s, given the number 

of Basel II banks for which the Federal 

Reserve and OCC were the primary federal 

regulator. 

 59Typically 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. 

Page 67 GAO-07-253 Risk-Based Capital
a recent Basel Committee paper would help clarify the allowable range of 

practice.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 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 

Regulators Are 

Coordinating Domestically 

and Internationally, but 

Lack of a Final Rule Is a 

Complicating Factor 

 60The 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. 

Page 68 GAO-07-253 Risk-Based Capital
coordination efforts were effective, the delays in various stages of the rulemaking 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 

Page 69 GAO-07-253 Risk-Based Capital
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 homehost 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. 

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. 

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.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

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 

Regulators’ Differing 

Perspectives and Goals Fuel 

Ambiguity 

 61GAO, Financial Regulation: Industry Changes Prompt Need to Reconsider U.S.

Regulatory Structure, GAO-05-61 (Washington, D.C.: Oct. 6, 2004). 

Page 70 GAO-07-253 Risk-Based Capital
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. 

Page 71 GAO-07-253 Risk-Based Capital
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. 

Lack of Transparency and 

Ongoing Ambiguity Contribute 

to Questions about the Overall 

Appropriateness of the Basel II 

Page 72 GAO-07-253 Risk-Based Capital
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. 

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 

Questions about Reliability of

Bank Data Remain an Issue 

Page 73 GAO-07-253 Risk-Based Capital
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. 

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. 

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. 

Questions about Pillar 3 

Disclosure Requirements 

Remain 

Conclusions 

Page 74 GAO-07-253 Risk-Based Capital
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 lowfrequency 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 

Page 75 GAO-07-253 Risk-Based Capital
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 

Page 76 GAO-07-253 Risk-Based Capital
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. 

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 

Recommendations 

Page 77 GAO-07-253 Risk-Based Capital
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 

Page 78 GAO-07-253 Risk-Based Capital
regulations as well as whether more fundamental changes are warranted 

for setting appropriate required regulatory capital levels. 

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 rulemaking 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 

Agency Comments 

and Our Evaluation 

Page 79 GAO-07-253 Risk-Based Capital
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 

Page 80 GAO-07-253 Risk-Based Capital
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. 

Page 81 GAO-07-253 Risk-Based Capital
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. 

Orice M. Williams, Director 

Financial Markets and Community Investment 

Thomas J. McCool, Director 

Center for Economics 

Page 82 GAO-07-253 Risk-Based Capital
Appendix I: Scope and Methodology 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);1

 the Basel II and Basel IA Advance Notices of 

Proposed Rulemaking (ANPR);2

 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.3

 1

71 Fed. Reg. 55380 (Sept. 25, 2006) (Basel II NPR); 71 Fed. Reg. 77446 (Dec. 26, 2006) 

(Basel IA). 

2

68 FR 45900 (Aug. 4, 2003) (Basel II ANPR); 70 FR 61068 (Oct. 20, 2005) (Basel IA ANPR). 

3

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. 

Page 83 GAO-07-253 Risk-Based Capital
Appendix I: Scope and Methodology 

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.4

 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. 

 4

61 Fed. Reg. 47358 (Sept. 6, 1996). 

Page 84 GAO-07-253 Risk-Based Capital
Appendix I: Scope and Methodology 

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. 

Page 85 GAO-07-253 Risk-Based Capital
Appendix II: U.S. and I

to Basel II 

nternational Transition

Page 86 GAO-07-253

Appendix II: U.S. and International Transition 

to Basel II 

1988

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

1989

International transition to Basel II U.S. transition to Basel II

July: Basel Committee issues Basel Capital Accord (Basel I), international 

risk-based capital requirements for banks in G10 countries, to be fully 

implemented by 1992.

Agencies fully phase in Basel I as part of broader changes to capital 

regulation. The U.S. prompt corrective action provisions require adequately 

capitalized and well-capitalized institutions to meet or exceed Basel I 

risk-based capital requirements as well as a leverage requirement.

January: Basel Committee amends Basel I to incorporate market risks. 

The Market Risk Amendment introduces the use of institutions’ internal 

models of risk to determine regulatory capital requirements.

June: Basel Committee proposes for comment incremental revisions to 

Basel I for credit risk (standardized approach), plans to develop an 

alternative internal ratings-based (IRB) approach, and proposed capital 

charges for other major risks, including operational risk.

January: Basel Committee releases revised proposal based on consultation with industry and supervisors. The Committee aims to encourage 

improved risk management practices in part through capital incentives for 

banks to move to the more risk-sensitive IRB approach.

June: Basel Committee issues final revised framework for Basel II 

(international accord). It reiterates objectives of broadly maintaining the level 

of aggregate required capital while also providing incentives to adopt the more 

advanced approaches. The framework includes changes such as a 1.06 

scaling factor by which capital requirements for credit risk would be multiplied 

in order to maintain capital neutrality with previously estimated results.

April-May: Basel Committee releases results of a global quantitative impact 

study (QIS-3) and issues third consultative paper for comment.

Bank regulatory agencies—OCC, OTS, Federal Reserve, and FDIC 

(hereafter “agencies”)—implement Basel I with a transition period to 1992.

September: OCC, Federal Reserve, and FDIC issue final rule implementing 

the Market Risk Amendment, requiring institutions with significant trading 

activity to use internal models to measure and hold capital in support of 

market risk exposure.

August: Agencies release advance notice of proposed rulemaking (ANPR) 

on Basel II for comment. The proposed rule requires the advanced 

approaches for credit and operational risk to be applied by only the large 

and/or internationally active banks and holding companies. Existing capital 

rules would be retained for all other banks.

June: SEC releases alternative net capital rule that permits certain 

broker-dealers to use internal mathematical models to calculate market and 

derivatives-related credit risk. To apply the rule, a broker-dealer’s ultimate 

holding company must consent to groupwide supervision and report capital 

adequacy measures consistent with Basel standards.

Risk-Based Capital
Appendix II: U.S. and International Transition

to Basel II 

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. 

2005

2006

2007

2008

2009

2010

2011

2012 Full implementation (first date available for Basel II)

Full implementation (first date available for Basel II)

Third transitional floor period (85% floor)

Second transitional floor period (90% floor)

Second transitional floor period (80% floor) First transitional floor period (95% floor)

First transitional floor period (90% floor) Parallel run begins

Parallel run begins

June: European Union issues final rule implementing Basel II 

(EU Capital Directive).

June: Basel Committee releases results of a global quantitative impact 

study (QIS-5) of estimated changes in minimum required capital 

under Basel II.

September: Agencies release for comment official NPRs for Basel II and for 

market risk. The Basel II NPR requests comment on whether and how the 

standardized approach should be provided to banks as an option in addition 

to the advanced approach for credit risk.

December: Agencies issue draft Basel IA NPR. The proposal requests comment on whether and how Basel IA should be provided to Basel II banks as an 

option in addition to the advanced approach for credit risk. 

March: Comment periods for Basel II and Basel IA NPRs close.

June:a Agencies expect to issue final Basel II rule.

March: Federal Reserve releases draft Basel II NPR to allow industry time to 

comment and prepare. In addition to previously announced safeguards, it 

states that agencies would view a 10 percent or greater decline in aggregate 

risk-based capital requirements (compared to Basel I) as a material drop 

warranting changes to the Basel II framework.

April: Agencies announce delay in Basel II rulemaking process, after results

of a quantitative impact study (QIS-4) estimated material reductions in 

aggregate capital requirements and significant variations in results across

institutions and portfolios. Agencies later state that such results would be 

unacceptable in an actual capital regime.

September: Agencies announce one-year delay in implementation and 

additional safeguards to prevent unacceptable declines in required capital as

estimated in QIS-4. The agencies retain the leverage requirement, add a

transition year, and establish stricter transition period limits on capital 

reductions for individual institutions.

October: Agencies issue Basel IA ANPR. It revises Basel I to address

competitive inequities between large and small institutions by providing a

more risk-sensitive framework similar to the standardized approach under the 

Basel II international accord.

International transition to Basel II U.S. transition to Basel II

Floor

applies to

individual

institution’s

capital

reduction.

Floor

applies to

individual

institution’s

capital

reduction.

Source: GAO.

Page 87 GAO-07-253 Risk-Based Capital
Appendix III: Basel II 

Descriptive Overview

Page 88 GAO-07-253

Appendix III: Basel II Descriptive Overview 

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. 

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. 

Pillar 1: Minimum Capital 

Requirements 

Credit Risk 

Risk-Based Capital
Appendix III: Basel II 

Descriptive Overview

Figure 7: Computation of Capital Requirements for Wholesale and Retail Credit Risk under Basel II 

( )

( )

M

Wholesale

capital formula

Retail

capital formula

1.06

(scaling

factor)

Wholesale and

retail capital

requirements

High volatility

commercial

real esate

Other

wholesale

Residential

mortgage

Qualifying

revolving (e.g.,

credit card)

Other

retail

+ x =

K= LGDxN -(ELGDxPD) x N-1(PD)+ RxN-1(0.999)

1-R ( ) 1+(M-2.5)xb1-1.5xb

b=[0.11852-0.05478xln(PD)]2

Estimated by banks

Defined by regulators

Source: GAO analysis of information from the Basel II NPR.

PD, LGD, EAD 

Wholesale exposures Retail exposures

RR R R R

PD PD PD

Risk inputs: 

PD = Probability of default 

LGD = Loss given default

EAD = Exposure at default

M = Maturity of exposure

R = Correlation factor

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. 

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. 

Page 89 GAO-07-253 Risk-Based Capital
Appendix III: Basel II 

Descriptive Overview

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. 

Operational 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-businessday 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. 

Market Risk

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. 

Page 90 GAO-07-253 Risk-Based Capital
Appendix III: Basel II 

Descriptive Overview

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 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 riskbased 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 

Pillar 2: Supervisory 

Review 

Pillar 3: Market Discipline 

in the Form of Increased 

Disclosure 

Page 91 GAO-07-253 Risk-Based Capital
Appendix III: Basel II 

Descriptive Overview

changes in a bank’s risk-based capital requirements. Federal regulators 

have proposed detailed reporting schedules to collect both public and 

confidential disclosure information. 

Page 92 GAO-07-253 Risk-Based Capital
Appendix IV: Comments from the Board of Appendix IV Governors of the Federal Reserve System : Comments from the Board of 

Governors of the Federal Reserve System 

Page 93 GAO-07-253 Risk-Based Capital
Appendix IV: Comments from the Board of 

Governors of the Federal Reserve System 

Page 94 GAO-07-253 Risk-Based Capital
Appendix IV: Comments from the Board of 

Governors of the Federal Reserve System 

Page 95 GAO-07-253 Risk-Based Capital
Appendix V: Comments from the Office of the Appendix V Comptroller of the Currency : Comments from the Office of the 

Comptroller of the Currency 

Page 96 GAO-07-253 Risk-Based Capital
Appendix V: Comments from the Office of the

Comptroller of the Currency

Page 97 GAO-07-253 Risk-Based Capital
Appendix VI: Comments from the Federal 

Deposit Insurance Corporation and the Office Appendix VI: Comments from the Federal of Thrift Supervision 

Deposit Insurance Corporation and the Office 

of Thrift Supervision 

Page 98 GAO-07-253 Risk-Based Capital
Appendix VI: Comments from the Federal 

Deposit Insurance Corporation and the Office 

of Thrift Supervision 

Page 99 GAO-07-253 Risk-Based Capital
Appendix VII: Comments from the Appendix VII: Comments from the Department of the Treasury 

Department of the Treasury 

Page 100 GAO-07-253 Risk-Based Capital
Appendix VII: Comments from the 

Department of the Treasury 

Page 101 GAO-07-253 Risk-Based Capital
Appendix VIII: GAO Contacts and Staff Acknowledgments 

Page 102 GAO-07-253

Appendix VIII: GAO Contacts and Staff 

Acknowledgments 

Orice M. Williams (202) 512-5837 or williamso@gao.gov

Thomas J. McCool (202) 512-2642 or mccoolt@gao.gov

 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. 

GAO Contacts 

Staff 

Acknowledgments 

Risk-Based Capital
Related GAO Products 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. 

(250291) Page 103 GAO-07-253 Risk-Based Capital
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