United States Government Accountability Office

GAO Report to the Subcommittee on Financial 

Institutions and Consumer Credit, 

Committee on Financial Services, House 

of Representatives 

RISK-BASED 

CAPITAL 

New Basel II Rules 

Reduced Certain 

Competitive Concerns, 

but Bank Regulators 

Should Address 

Remaining 

Uncertainties 

September 2008 

 

GAO-08-953 
What GAO Found

United States Government Accountability Office

Why GAO Did This Study

Highlights

Accountability Integrity Reliability

September 2008

RISK-BASED CAPITAL 

New Basel II Rules Reduced Certain Competitive 

Concerns, but Bank Regulators Should Address

Highlights of GAO-08-953, a report to the Remaining Uncertainties

Subcommittee on Financial Institutions 

and Consumer Credit, Committee on 

Financial Services, House of 

Representatives 

Basel II, the new risk-based 

capital framework based on an 

international accord, is being 

adopted by individual countries. 

It includes standardized and 

advanced approaches to 

estimating capital requirements. 

In the United States, bank 

regulators have finalized an

advanced approaches rule that 

will be required for some of the 

largest, most internationally 

active banks (core banks) and 

proposed an optional 

standardized approach rule for 

non-core banks that will also 

have the option to remain on 

existing capital rules. In light of 

possible competitive effects of 

the capital rules, GAO was asked 

to examine (1) the markets in 

which banks compete, (2) how 

new capital rules address U.S. 

banks’ competitive concerns, and 

(3) actions regulators are taking 

to address competitive and other 

potential negative effects during 

implementation. Among other 

things, GAO analyzed data on 

bank products and services and 

the final and proposed capital 

rules; interviewed U.S. and 

foreign bank regulators, officials 

from U.S. and foreign banks; and 

computed capital requirements 

under varying capital rules. 

What GAO Recommends

GAO recommends that the U.S. 

bank regulators (1) clarify how 

they will use regulatory flexibility 

built into the rules and (2) fully 

develop plans, on a joint basis, 

for the required study of the 

impacts of Basel II. The bank 

regulators generally agreed with 

our recommendations in a joint 

response to this report. 

Large and internationally active U.S.-based banks (core banks) that will 

adopt the Basel II advanced approaches compete among themselves and in 

some markets with U.S.-based non-core banks, investment firms, and 

foreign-based banks. Non-core banks compete with core banks in retail 

markets, but in wholesale markets core banks often compete with

investment firms and foreign-based banks. Because holding capital is costly 

for banks, differences in regulatory capital requirements could influence 

costs, prices, and profitability for banks competing under different capital 

requirements. 

The new U.S. capital rules addressed some earlier competitive concerns of 

banks; however, other concerns remain. By better aligning the advanced 

approaches rule with the international accord and proposing an optional 

standardized approach rule, U.S. regulators reduced some competitive 

concerns for both core and non-core banks. For example, the U.S. wholesale 

definition of default for the advanced approaches is now similar to the 

accord’s. Core banks continue to be concerned about the leverage 

requirement (a simple capital to assets calculation), which they believe 

places them at a competitive disadvantage relative to firms not subject to a 

similar requirement. Foreign regulators have been working with U.S. 

regulators to coordinate Basel II implementation for U.S. banks with foreign 

operations. The proposed standardized approach addresses some concerns 

non-core banks raised by providing a more risk sensitive approach to 

calculating regulatory requirements. But other factors likely will reduce 

differences in capital for banks competing in the United States; for example,

the leverage requirement establishes a floor that may exceed the capital

required under the advanced and standardized approaches. 

Many factors have affected the pace of Basel II implementation in the 

United States and, while the gradual implementation is allowing regulators 

to consider changes in the rules and reassess banks’ risk-management 

systems, regulators have not yet taken action to address areas of

uncertainty that could have competitive implications. For example, the final 

rule provides regulators with considerable flexibility and leaves open 

questions such as which banks may be exempted from the advanced 

approaches. Although the rule provides that core banks can apply for 

exemptions and regulators should consider these in light of some broad 

categories, such as asset size or portfolio mix, the rule does not further 

define the criteria for exemptions. Some industry participants we spoke 

with said that uncertainties about the implementation of the advanced 

approaches have been a problem for them. Moreover, regulators have not 

fully developed plans for a required study of the impacts of Basel II before 

full implementation. Lack of specificity in criteria, scope, methodology, and 

timing will affect the quality and extent of information that regulators will

have to help assess competitive and other impacts, determine whether there 

are any material deficiencies requiring future changes in the rules, and 

determine whether to permit core banks to fully implement Basel II. To view the full product, including the scope 

and methodology, click on GAO-08-953. 

For more information, contact Orice M. 

Williams at (202) 512-8678 or 

williamso@gao.gov.
Contents 

Letter 1

Results in Brief 4

Background 7

Core Banks Compete among Themselves and with Other Financial 

Entities That Will Operate under Different Capital Regimes 12 

New U.S. Capital Rules Have Reduced Some Competitive Concerns 

about Basel II 22

Bank Regulators Have Taken Limited Actions to Address 

Additional Competitive Effects of Basel II Implementation on 

U.S. Banking Organizations 39 

Conclusions 49

Recommendations 52

Agency Comments and Our Evaluation 52 

Appendix I Objectives, Scope, and Methodology 55 

Appendix II Three Pillars of the Advanced Approaches 58 

Appendix III Basel II Timeline 62 

Appendix IV Comments from Federal Banking Regulators 64 

Appendix V GAO Contact and Staff Acknowledgments 67 

Related GAO Products 68 

Tables 

Table 1: Percentage of Selected Assets of Core Banks in Certain 

Retail and Wholesale Markets, December 31, 2007 14 

Table 2: Percentage of Total Assets in Selected Classes, by Bank 

Holding Company Size, December 31, 2007 15 

Page i GAO-08-953 Risk-Based Capital 
Table 3: Significant Technical Differences between the U.S. NPR on 

Advanced Approaches and the New Basel Accord, and the

Treatment of These Differences in the U.S. Final Rule on 

Advanced Approaches 25 

Figures 

Figure 1: The Three Pillars of Basel II 8 

Figure 2: Foreign Exposures of U.S.-based Core Banks, as of 

December 31, 2007 19 

Figure 3: Required Capital for Short-term Corporate Loans under 

the Advanced Approach and Bank Holding Company 

Leverage Requirement, by Probability of Default 30 

Figure 4: Risk Sensitivity of Proposed Standardized Approach vs. 

Prudently Underwritten Residential Mortgages under 

Basel I, by LTV 34 

Figure 5: Required Capital for Externally Rated Corporate Loans 

under Basel I, Proposed Standardized Approach, and 

Advanced Approach, by Rating 35 

Figure 6: Required Capital for Externally-rated Corporate Loans 

under the Advanced Approach and Depository Institution 

Leverage Requirement, by Rating 37 

Figure 7: Computation of Wholesale and Retail Capital 

Requirements under the Advanced Internal Ratings-based 

Approach for Credit Risk 59 

Page ii GAO-08-953 Risk-Based Capital 
Abbreviations 

A-IRB advanced internal ratings-based approach 

AMA advanced measurement approaches

CSE consolidated supervised entity 

EAD exposure at default 

FDIC Federal Deposit Insurance Corporation 

FFIEC Federal Financial Institutions Examination Council 

LTV loan-to-value

LGD loss given default 

M maturity of the exposure 

MRA market risk amendment 

NPR Notice of Proposed Rulemaking 

OCC Office of the Comptroller of the Currency 

OMB Office of Management and Budget 

OTS Office of Thrift Supervision 

PCA prompt corrective action 

PD probability of default 

QIS-4 fourth quantitative impact study 

SEC Securities and Exchange Commission 

SME small- and medium-sized enterprise 

 

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Page iii GAO-08-953 Risk-Based Capital
United States Government Accountability Office

Washington, DC 20548 

September 12, 2008 

The Honorable Carolyn B. Maloney 

Chair 

The Honorable Judy Biggert 

Ranking Member 

Subcommittee on Financial Institutions 

 and Consumer Credit 

Committee on Financial Services 

House of Representatives 

Ensuring that banks maintain adequate capital is essential to the safety 

and soundness of the banking system.1

 Basel II, the newly revised riskbased capital framework, aims to better align minimum capital 

requirements with enhanced risk-measurement techniques and to 

encourage banks to develop a more disciplined approach to risk 

management. Basel II rests on an international accord (the New Basel 

Accord) adopted by the Basel Committee on Banking Supervision (Basel 

Committee) in June 2004.

2

 The New Basel Accord includes a standardized 

approach and advanced approaches, more complex approaches that large,

internationally active banks are encouraged to use. U.S. federal banking

regulators have been working to finalize capital rules based on this accord. 

Since our February 2007 report on Basel II, U.S. federal banking regulators 

have finalized the advanced approaches rules that are required for some of 

the largest and most internationally active banking organizations (core 

banks), which account for about half of U.S. banking assets.3

 Some other 

banks may choose to comply with the advanced approaches rule as well. 

These rules lay out a phased implementation schedule, which generally

requires core banks to have Basel II implementation plans approved by 

their boards of directors by October 1, 2008. In addition, in July 2008, U.S. 

 1

In this report, the term bank generally refers to depository institutions (commercial banks

and thrifts) as well as bank holding companies. Where the distinction is significant, we

refer to bank holding companies as the depository institution’s ultimate U.S. holding 

company. Since thrift holding companies are not subject to Basel capital requirements, 

they are not included in the term bank in this report. 

2

In June 2004, the Basel Committee published “Basel II: International Convergence of 

Capital Measurement and Capital Standards: A Revised Framework.” 

3

GAO, Risk-Based Capital: Bank Regulators Need to Improve Transparency and 

Overcome Impediments to Finalizing the Proposed Basel II Framework, GAO-07-253 

(Washington, D.C.: Feb. 15, 2007). 

Page 1 GAO-08-953 Risk-Based Capital
banking regulators published for comment a proposed rule on the 

standardized approach, a simpler version of the new regulatory capital

framework that could be adopted by banks that were not required to adopt 

the advanced approaches (non-core banks). 

Though the goal of Basel II was to improve the safety and soundness of the 

banking system through better risk management and create a level playing 

field for internationally active banks, the development of Basel II has 

generated concerns among banks, banking regulators, and other interested 

parties that potentially different capital requirements and implementation

costs for various categories of U.S. and foreign banks could have 

competitive effects.4

 These concerns arose, in part, because U.S. banks 

that all have been operating under the same risk-based capital rules—

known as Basel I—may be operating under different capital rules in the 

future—Basel II advanced approaches, Basel II standardized approach, or

Basel I. In addition, because the New Basel Accord identified certain areas 

for national discretion, the capital regimes being adopted in various 

countries differ from that being implemented in the United States. 

The risk-management systems for financial institutions and the 

information systems on which they rest have been called into question by 

the failure of some of these systems during the market turbulence that 

began with subprime mortgages in 2007. While this turmoil is not the focus 

of this report, it is an important factor that is leading banking

organizations and their regulators to reassess capital requirements and 

other aspects of bank regulation and supervision.5

 These assessments 

could lead to changes in the Basel II rules or could influence the 

implementation of those rules in the United States. In addition, as a result

of concerns about the ability of U.S. financial institutions to compete with 

institutions based in foreign countries, the U.S. Department of the 

Treasury has proposed a restructuring of the complex U.S. regulatory 

system. 6 Various congressional committees have held hearings that 

 4

In this report, we discuss competitive concerns that could arise from the differential 

impact of capital rules or their implementation on firms providing similar products or 

services. 

5

For a more detailed discussion about risk-management practices in place during the

market turmoil, see the following reports: Senior Supervisors Group, Observations on Risk

Management Practices during the Recent Market Turbulence (New York: Mar. 6, 2008) 

and International Monetary Fund, Global Financial Stability Report: Containing Systemic

Risk and Restoring Financial Soundness (Washington, D.C.: April 2008).

6

Department of the Treasury, Blueprint for a Modernized Financial Regulatory Structure

(Washington, D.C.: March 2008). 

Page 2 GAO-08-953 Risk-Based Capital
addressed this issue and in the past, we have recommended that the U.S.

regulatory system be restructured.7

In light of concerns about possible competitive effects, you requested that 

we review the competitive implications of Basel II for non-core U.S. banks 

in comparison to core banks adopting the advanced approaches and how 

differences in the implementation of Basel II in foreign countries might 

affect the competitiveness of internationally active banks operating in the 

United States. Specifically, this report examines (1) the nature of the 

competitive environment in which U.S. banking organizations operate, 

(2) the extent to which the new capital rules address competitive concerns 

of U.S. banking organizations internationally and domestically, and (3) 

actions regulators are taking to address competitive and other potential 

negative effects of the new capital rules during implementation. 

To meet our objectives, we reviewed the New Basel Accord, the U.S. 

proposed rules on the advanced approaches and standardized approach,

the U.S. final advanced approaches rule, supervisory guidance, and related 

materials. In addition, we reviewed research related to the impact of Basel 

II in the United States and the European Union. We interviewed officials at 

the federal bank regulatory agencies responsible for implementing Basel 

II, including examination and policy staff. We also interviewed officials 

from all of the core banks and other domestic and foreign banks with 

operations in the United States. In addition, we interviewed officials from 

several foreign bank regulatory agencies; domestic and foreign trade 

associations; credit rating agencies; and several academics and 

consultants with banking expertise. To describe the competitive 

environment in which U.S. banking organizations operate, we analyzed 

various data sources on the products and services that U.S. and foreign 

banking organizations offer domestically and internationally. To assess the 

competitive impact of the different capital rules on U.S. banks, we 

computed capital requirements for certain products under the varying

rules and reviewed academic and other studies of the impact of regulatory 

capital on bank behavior. 

We conducted this performance audit from May 2007 to September 2008 in

accordance with generally accepted government auditing standards. Those 

standards require that we plan and perform the audit to obtain sufficient, 

 7

Some earlier work includes GAO, Financial Regulation: Industry Changes Prompt Need

to Reconsider U.S. Regulatory Structure, GAO-05-61 (Washington, D.C.: Oct. 6, 2004) and 

GAO, Financial Regulation: Industry Trends Continue to Challenge the Federal 

Regulatory Structure, GAO-08-32, (Washington, D.C.: Oct. 12, 2007). 

Page 3 GAO-08-953 Risk-Based Capital
appropriate evidence to provide a reasonable basis for our findings and 

conclusions based on our audit objectives. We believe that the evidence 

obtained provides a reasonable basis for our findings and conclusions 

based on our audit objectives. Appendix I discusses our scope and 

methodology in further detail. 

Core banks—large and internationally active U.S. banks that will be 

required to adopt the advanced approaches for Basel II—compete with 

other core banks and in some markets with non-core U.S.-based banks, 

other financial institutions, and foreign-based banks. Core banks that will 

adopt the advanced approaches have varying business models such that 

some focus on domestic retail banking activities such as residential 

mortgages, some focus on wholesale activities such as lending to large

corporate clients domestically and abroad, and others are engaged in the 

full range of these activities. In retail markets such as those for residential 

mortgages, core banks often compete with smaller non-core banks that are 

not likely to adopt the advanced approaches. In wholesale markets, core 

banks often compete with investment firms. Core banks compete globally 

with investment firms and also with foreign-based banks. In addition, 

banks that are subsidiaries or branches of foreign-based banks are active 

in U.S. markets at both the retail and wholesale levels. While Basel II likely 

will apply to foreign–based banks in their home countries, the specifics of 

the rules and their implementation in other countries will differ from those 

in the United States, in part, because the New Basel Accord identified a

number of areas for national discretion. Because holding capital is costly 

for banks, differences in regulatory capital requirements could influence 

costs, prices, and profitability for banks competing under different capital 

requirements. 

Results in Brief 

U.S. regulators addressed some of the banking industry’s competitive 

concerns with the advanced approaches rule for core banks and the 

proposal of an optional standardized approach rule for other banks. 

However, some of the industry’s competitive concerns about the U.S. 

capital framework remain. In developing the rules, regulators analyzed 

some competitive issues raised by banks. By adopting a final advanced 

approaches rule that is closer to the New Basel Accord, U.S. regulators 

reduced the differences between the U.S. rule as originally proposed and 

the New Basel Accord that had the potential to lead to greater 

implementation costs. For example, in the final advanced approaches rule

banks will use a single wholesale definition of default for both their U.S. 

and foreign operations, thus reducing the cost of operating in multiple 

countries. Nonetheless, core banks are concerned about continuing to be 

subject to the leverage requirement, which they believe could place them

Page 4 GAO-08-953 Risk-Based Capital
at a competitive disadvantage relative to certain foreign-based banks and 

investment firms, which do not have a similar requirement. In efforts to 

mitigate other differences, U.S. regulators have been working with foreign 

regulators, bilaterally and as members of international bodies, to 

coordinate Basel II implementation for U.S.-based internationally active 

banks. The proposed standardized approach rule issued by U.S. regulators 

in July 2008 addresses some concerns raised by non-core banks—those 

banks not required to adopt the advanced approaches. These banks were 

concerned that core banks would have a competitive advantage because 

they would be able to hold less capital for some assets. The proposed 

standardized approach would allow for additional risk-sensitivity over 

Basel I with respect to the capital treatment for certain assets, including 

residential mortgages. Among other factors, the leverage requirement may 

reduce differences in capital among banks competing in the United States

because it establishes a floor that may exceed capital required under the 

advanced or standardized approaches for certain low-risk assets. 

Since we last reported on Basel II in February 2007, the regulators have 

made significant progress by jointly issuing the advanced approaches rule

and a proposed rule for an optional standardized approach. However, 

while the gradual implementation is allowing regulators to consider 

changes in the rules and reassess banks’ risk management systems, 

regulators have not taken action to address some areas of uncertainty that

could have competitive implications or other negative effects. For 

example, the regulatory flexibility that the advanced approaches rule 

provides will help regulators deal with the rule’s unforeseen 

consequences, but leaves uncertainties such as which banks will 

ultimately be exempted from using the advanced approaches. While the 

regulators have stated that they may exempt some core banks from using 

the advanced approaches, they have only provided broad categories such 

as asset size and portfolio mix rather than specific criteria for making 

these decisions. And, in the proposed standardized approach rule, 

regulators have asked for comments on the question of whether large and 

internationally active core banks should be able to use the proposed 

standardized approach. These uncertainties may continue to reflect the 

difficulties that resulted from the differing perspectives the regulators 

brought to negotiations during the development of Basel II. In addition, 

some industry participants we spoke with said that uncertainty about the 

implementation of the advanced approaches rule has been a problem for 

them. Finally, regulators have undertaken some planning for a study of the

impact of the advanced approaches, but plans are not fully developed. The 

advanced approaches rule called for a study of the rule’s impact to 

determine whether major changes in the rule needed to be made before

banks would be permitted to fully implement the new rule. However, the 

Page 5 GAO-08-953 Risk-Based Capital
regulators have not developed criteria by which to assess Basel II, have 

not specified whether the scope of the study will go beyond core banks to 

consider, for example, investment firms, or developed a methodology to 

analyze opportunities for regulatory arbitrage. Lack of development or 

specificity in criteria, scope, methodologies, and timing will affect the 

quality and extent of information that regulators will use to help assess 

competitive and other impacts, determine whether there are any material

deficiencies that require changes in the rules, and determine whether core 

banks should fully implement Basel II. 

To further limit any potential negative effects and to reduce the 

uncertainty about Basel II implementation, we are making two 

recommendations to the heads of the Federal Deposit Insurance 

Corporation (FDIC), Board of Governors of the Federal Reserve System 

(Federal Reserve), Office of the Comptroller of the Currency (OCC), and 

Office of Thrift Supervision (OTS). Specifically, where possible, these 

regulators should reduce the uncertainty built into the Basel II rules by 

better clarifying the use of certain regulatory flexibilities, particularly with 

regard to how they will exercise exemptions from the advanced 

approaches requirements and the extent to which core banks will be 

allowed to adopt the standardized approach. In addition, to improve 

understanding of potential competitive effects, we recommend that the 

regulators fully develop plans, on a joint basis, for the required study of 

the impacts of Basel II. 

We requested comment on a draft of this report from the heads of the 

Federal Reserve, FDIC, OCC, OTS, Securities and Exchange Commission 

(SEC), and Department of the Treasury. We received written comments 

from the Federal Reserve, FDIC, OCC, and OTS, who provided a joint 

letter, which is reprinted in appendix IV. In their joint letter, the banking 

regulators said that they were in general agreement with our 

recommendations. Specifically, the regulators said that they will work 

together to resolve, at the earliest possible time, the question posed for 

comment in the proposed standardized approach rule regarding whether 

and to what extent core banks should be able to use the standardized 

approach. With regard to clarifying certain regulatory flexibilities, the 

regulators said they will continue to make decisions concerning the 

exemption of core banks from the advanced approaches based on the 

specifics of a bank’s request; they have already commenced discussions to 

ensure a clear and consistent interpretation of these provisions is 

conveyed to U.S. banks. In addition, regarding the need to jointly plan the 

required study, the regulators said that they will begin to prepare more 

formal plans for the study once they have a firmer picture of banks 

implementation plans. The banking regulators also provided technical 

Page 6 GAO-08-953 Risk-Based Capital
comments, which we incorporated in the report where appropriate. We 

did not receive comments from SEC or the Department of the Treasury. 

Basel II rests on the New Basel Accord, which established a more risksensitive regulatory framework that was intended to be sufficiently 

consistent internationally but that also took into account individual 

countries’ existing regulatory and accounting systems. The U.S. bank 

regulators have been adapting the New Basel Accord for use by U.S. 

banks. 

The New Basel Accord sets forth minimum requirements, which regulators 

may complement with additional capital requirements, such as a leverage

ratio. The New Basel Accord also identifies a number of areas for national 

discretion, thus requiring regulators from different countries to work 

together to understand how each country is implementing the New Basel 

Accord and to ensure broad consistency in the application of the 

regulatory framework across jurisdictions. The New Basel Accord consists 

of three pillars: (1) minimum capital requirements, (2) supervisory review 

of an institution’s internal assessment process and capital adequacy, and 

(3) effective use of disclosure to strengthen market discipline as a 

complement to supervisory efforts.8

 As shown in figure 1, Pillar 1 

establishes several approaches (of increasing complexity) to measuring 

credit and operational risks.9

 The advanced approach for credit risk (also 

known as the advanced internal ratings-based approach) uses risk 

parameters determined by a bank’s internal systems as inputs into a 

formula developed by supervisors for calculating minimum regulatory 

capital. In addition, banks with significant trading assets—assets banks 

use to hedge risks or to speculate on price changes in markets for 

themselves or their customers—must calculate capital requirements for 

market risk under Pillar 1.10 Pillar 2 explicitly recognizes the role of 

Background 

The New Basel Accord 

 8

For more detailed description of Basel II and its history, see our earlier report GAO-07-253. 

9

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

to perform on an obligation. Operational risk is the risk of loss resulting from inadequate or 

failed internal processes, people, and systems or from external events. 

10Market risk is the potential for loss resulting from movements in market prices, including

interest rates, commodity prices, stock prices, and foreign exchange rates. 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). Generally, under the MRA,

a bank’s internal models are used to estimate the 99th percentile of the bank’s market risk

loss distribution over a 10-business-day horizon, in other words a solvency standard

designed to exceed trading losses for 99 out of 100 10-business-day intervals. 

Page 7 GAO-08-953 Risk-Based Capital
supervisory review, which includes assessments of capital adequacy 

relative to a bank’s overall risk profile and early supervisory intervention 

that are already part of U.S. regulatory practices. Pillar 3 establishes 

disclosure requirements that aim to inform market participants about 

banks’ capital adequacy in a consistent framework that enhances 

comparability. See appendix II for more information on the three pillars of

the advanced approaches. 

Figure 1: The Three Pillars of Basel II 

Pillar 1 Pillar 2 Pillar 3

Other approaches available in the international accord

Required in the U.S. final rule for core banks

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 ratios

• capital components

• risk assessment process

• aggregate information

 underlying risk estimates

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

Currently proposed in the U.S. standardized

approach as an option for non-core banks

After extensive discussions and consultation that included issuing an 

advanced notice of proposed rulemaking in 2003 and a Notice of Proposed 

Rulemaking (NPR) in 2006, the U.S. banking regulators issued a final rule

on the advanced approaches that became effective on April 1, 2008.11

Under the rule, only certain banks—core banks—will be required to adopt 

 1172 Fed. Reg. 69288 (Dec. 7, 2007). 

Page 8 GAO-08-953 Risk-Based Capital
the advanced approaches for credit and operational risk. Core banks are 

those with consolidated total assets (excluding assets held by an insurance 

underwriting subsidiary of a bank holding company) of $250 billion or 

more or with consolidated total on-balance sheet foreign exposure of $10 

billion or more. Publicly available information shows that, as of July 2008,

12 banks met the rule’s basic criteria for being a core bank. A depository 

institution also is a core bank if it is a subsidiary of another bank that uses 

the advanced approaches. Under the rule, a core bank’s primary federal 

regulator may determine that application of the advanced approaches is 

not appropriate in light of a core bank’s asset size, level of complexity, risk 

profile, or scope of operations. In addition, banks that are not required to 

adopt the advanced approaches, but meet certain qualifications, may 

voluntarily choose to comply with the advanced approaches. Generally, 

core banks had or will have from April 2008 until April 2010 to begin the 

four phases that lead to the full implementation of Basel II.12 As a result, 

core banks could be ready for full implementation between April 2012 and 

April 2014. By January 1, 2008, banks in the European Union, Canada, and 

Japan had moved off of Basel I and begun implementing some version of 

the New Basel Accord’s advanced approaches or standardized approach 

for all of their banks. Banks located in the European Union, Canada, and

Japan expect to have fully implemented Basel II sometime in 2010. 

Non-core banks—those that do not meet the definition of a core bank— 

will have the option of adopting the advanced approaches, a standardized 

approach when finalized, or remaining on Basel I. The proposed 

standardized approach rule, published in July 2008, provides for a more 

risk-sensitive approach than Basel I by classifying banks’ assets into more 

risk categories and assessing different capital requirements according to 

 12The four phases are (1) the parallel run—four consecutive quarters in which a bank meets

the qualification requirements and is subject to the Basel I rules but simultaneously 

calculates its risk-based capital ratios under the advanced approaches; (2) the first 

transitional period—a period of at least four consecutive quarters in which the bank 

computes its risk-based capital ratios using the Basel I rule and the advanced approaches

rule, and required risk-based capital must be at least 95 percent of the Basel I requirement; 

(3) the second transitional period— a period of at least four consecutive quarters in which 

the bank computes its risk-based capital ratios using the Basel I rule and the advanced

approaches rule, and required risk-based capital must be at least 90 percent of the Basel I 

requirement; and (4) the third transitional period— a period of at least four consecutive 

quarters in which the bank computes its risk-based capital ratios using the Basel I rule and 

the advanced approaches rule, and required risk-based capital must be at least 85 percent 

of the Basel I requirement. 

Page 9 GAO-08-953 Risk-Based Capital
the riskiness of the category.13 While Basel I has 5 risk categories, the 

proposed standardized approach rule includes 16 categories. In contrast to

the advanced approaches, the standardized approach relies more on 

external risk assessments—conducted by rating agencies—than on a 

bank’s own assessments of a certain product’s or borrower’s risk. The 

proposed U.S. standardized approach generally is consistent with the 

standardized approach outlined in the New Basel Accord, but diverges 

from the New Basel Accord to incorporate more risk sensitive treatment, 

most notably in the approaches for residential mortgages and equities held 

by banks. 

The U.S. regulatory capital framework also includes minimum leverage 

capital requirements. Banks, thrifts, and bank holding companies are 

subject to minimum leverage standards, measured as a ratio of Tier 1 

capital to total assets. The minimum leverage requirement is either 3 or 4

percent, depending on the type of institution and a regulatory assessment 

of the strength of its management and controls.14 Leverage ratios are a 

commonly used financial measure of risk. Greater financial leverage, as 

measured by lower proportions of capital relative to assets, increases the 

riskiness of a firm, all other things being equal. If the leverage capital 

requirement is greater than the risk-based level required then the leverage 

requirement would be the binding overall minimum requirement on an 

institution. Depository institutions also are subject to the Federal Deposit 

Insurance Corporation Improvement Act of 1991, which created a new 

Additional U.S. Capital 

Requirements 

 13Banks must hold total capital equal to at least 8 percent of the total value of their riskweighted assets and Tier 1 capital of at least 4 percent. 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. All assets are assigned a risk weight according to the credit risk of the obligor or the 

nature of the exposure 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 weight

categories are broadly intended to assign higher-risk weights to—and require banks to hold 

more capital for—higher-risk assets, and vice versa. See 12 C.F.R. Part 3 (OCC); 12 C.F.R 

Part 208 and Part 225, App. A & B (Federal Reserve); 12 C.F.R. Part 325 (FDIC); and 12 

C.F.R. Part 567 (OTS).

14Banks and thrifts 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. See 12 C.F.R. §§ 

3.6 (OCC), 208 & App. B (FRB), 325.3 (FDIC), and 567.8 (OTS). Bank holding companies 

that have adopted the MRA 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. 12 C.F.R. Part 225, App. D. Thrift holding companies are not subject to 

specific risk-based or leverage ratios, but are instead required by OTS to hold adequate 

capital at the holding company level. 

Page 10 GAO-08-953 Risk-Based Capital
supervisory framework known as prompt corrective action (PCA) that 

links supervisory actions closely to these banks’ capital ratios. PCA, which 

applies only to depository institutions and not bank holding companies, 

requires regulators to take increasingly stringent forms of corrective 

action against banks as their leverage and risk-based capital ratios 

decline.15 Under this rule, regulators also can require banks to hold more 

than minimum levels of capital to engage in certain activities. In addition, 

under the Bank Holding Company Act, the Federal Reserve can require 

that bank holding companies hold additional capital to engage in certain 

activities. 

U.S. Regulators 

Responsible for 

Implementing Basel II 

In the United States, the four federal bank regulators oversee the 

implementation of Basel II for banks and SEC oversees the 

implementation of Basel capital rules for investment firms. The financial 

institutions that will be involved in the implementation of Basel II are 

organized as bank holding companies, thrift holding companies, or 

consolidated supervised entities (CSE). At a consolidated level the Federal 

Reserve supervises bank holding companies that are subject to Basel 

capital requirements, OTS supervises thrift holding companies that are not 

subject to Basel capital requirements, and SEC supervises CSEs that 

voluntarily choose to be subject to consolidated oversight including Basel 

capital reporting requirements.16 Each of these types of holding companies

has subsidiaries that are depository institutions that could be required to 

adopt Basel II. Each of these banking institutions is regulated by a primary 

federal regulator according to the rules under which it is chartered. 

• FDIC serves as the primary federal regulator of state chartered banks that

are not members of the Federal Reserve System (state nonmember banks). 

It is also the deposit insurer for all banks and thrifts and has backup 

supervisory authority for all banks it insures. 

 15See GAO, Deposit Insurance: Assessment of Regulators’ Use of Prompt Corrective 

Action 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). 

16Three of the four CSEs are also thrift holding companies. See GAO, Financial Market 

Regulation: Agencies Engaged in Consolidated Supervision Can Strengthen Performance 

Measurement and Collaboration, GAO-07-154 (Washington, D.C.: Mar. 15, 2007) on the

overlapping responsibilities of OTS and SEC with regard to these firms. 

Page 11 GAO-08-953 Risk-Based Capital
• The Federal Reserve serves as the primary federal regulator for state 

chartered banks that are members of the Federal Reserve System (state 

member banks). 

• OCC serves as the primary federal regulator for national (i.e., federally 

chartered) banks. Many of the nation’s largest banks are federally 

chartered. 

• OTS serves as the primary federal regulator for all federally insured thrifts. 

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 2004, SEC established a voluntary, alternative net capital rule for 

broker-dealers whose ultimate holding company consents to groupwide 

supervision by SEC as a CSE. This alternative net capital rule permits the 

use of statistical models for regulatory capital purposes. At the holding 

company level, CSEs are required to compute and report to SEC capital 

adequacy measures consistent with the standards in the Basel Accord, and 

SEC expects them to maintain certain capital ratios, though they are not 

required to do so. According to SEC, all CSEs have implemented Basel II. 

Primary U.S. broker-dealers affiliated with CSEs are required to comply 

with a capital requirement that SEC says is not identical to the Basel 

standards but makes use of statistical models in its computation. 

Depository institutions within the CSEs are subject to the same 

requirements as other banks of similar sizes and exposures including riskbased capital requirements, the leverage ratio, and PCA; however, there is 

no leverage requirement at the consolidated level for CSEs. 

Core banks face a range of competitors including non-core U.S. banks, other 

financial institutions, and foreign-based banks. Core banks that have varying

business models—some focus on domestic retail banking activities, some on

wholesale activities, and others are engaged in the full range of these 

activities—are overseen by a number of different bank regulators. Banks of

different sizes that are likely to be under different capital regimes are more

likely to compete with each other in retail markets, where they offer products

such as residential mortgages to the same customers, than in wholesale

markets. In certain wholesale markets, core banks often compete with U.S.

investment firms. U.S.-based core banks also compete with foreign-based 

banks in foreign markets and in U.S. markets where foreign-based banks are

very active. Since core banks compete with other financial institutions across

various product and geographic markets, differences in capital rules or the 

Core Banks Compete 

among Themselves 

and with Other 

Financial Entities 

That Will Operate 

under Different 

Capital Regimes 

Page 12 GAO-08-953 Risk-Based Capital
implementation of those rules may have competitive effects by influencing 

such things as the amount of capital institutions hold, how banks price loans,

and the cost of implementing capital regulations. 

Core banking organizations—those that meet the requirements in terms of 

asset size and foreign exposure for mandatory adoption of the Basel II 

advanced approaches—have adopted a variety of business models, but all 

compete with some other core banks. Some of the core banks are active in

retail markets, some in wholesale markets, and some in the full range of 

banking activities. As illustrated in table 1, which is based on publicly 

available information, five core banking organizations—including one that 

is foreign-based—have at least 25 percent of their assets in retail markets 

and one of these, the only thrift that is a core banking organization 

(Washington Mutual Bank), has more than 60 percent of its assets in retail 

markets, while a few institutions have almost no activity in these markets. 

In addition, two core banks that appear less active in retail markets—with 

about 15 percent of their assets in these markets—may still have a major 

presence there because of their overall size. In wholesale markets, table 1 

shows that some banks are active in making commercial and industrial 

loans while others hold a larger percentage of their assets as trading 

assets—assets held to hedge risks or speculate on price changes for the 

bank or its customers. However, the thrift institution has very little activity

in these markets. The three smaller U.S.-based core banks, which are 

classified as core banks because they have large foreign exposures, engage 

primarily in custodial activities where they manage the funds of their 

clients. In this area they compete with the largest U.S. banks that are also 

engaged in these activities. 

Core Banks Compete with 

Other Core and Non-core 

Banks 

Page 13 GAO-08-953 Risk-Based Capital
Table 1: Percentage of Selected Assets of Core Banks in Certain Retail and Wholesale Markets, December 31, 2007 

(Dollars in millions) 

Certain retail products as

percent of assets Certain wholesale products as percent of assets

Institution Total assets Mortgages Credit cards

Trading 

assets

Commercial 

& industrial 

loans 

Commercial 

real estate

Securities 

available for 

sale or held

to maturityb

Top level parent based in the United States

Citigroup Inc. $2,187,631 11.1% 4.0% 24.6% 9.4% 1.0% 8.8%

Bank of America Corp. 1,720,688 23.0 4.7 11.7 10.3 6.0 13.9

JPMorgan Chase & Co. 1,562,147 11.0 4.9 29.3 9.0 1.6 5.2

Wachovia Corp. 782,896 30.0 0.3 7.1 10.5 9.9 14.6

Wells Fargo & Co. 575,442 30.1 3.4 1.3 13.8 9.7 12.7

Washington Mutual Banka325,809 59.5 3.0 0.8 1.0 13.5 10.6

Bank of New York Mellon 

Corp. 

197,839 2.3 0 3.3 3.4 1.3 24.5

State Street Corp. 142,937 0 0 3.5 0.1 0 52.2

Northern Trust Corp. 67,611 13.6 0.0 1.3 9.6 3.4 12.6

Top level parent based in a foreign country 

Taunus Corp. (Germany) 668,199 3.2 0.4 30.1 1.4 1.2 0.5

HSBC North America 

Holding Inc. (United 

Kingdom) 

487,755 24.6 10.5 11.7 8.2 1.7 6.5

Barclays Group US (United

Kingdom) 

343,736 3.9 1.9 15.1 0 3.3 0.2

Source: GAO analysis of publicly available Federal Reserve and OTS data. 

a

Data are for the federal savings bank rather than the consolidated entity. The federal savings bank 

comprises 99.4 percent of the consolidated entity’s total assets. 

b

Securities available for sale or held to maturity include mortgage-backed securities, asset-backed 

securities, and others. 

Core banks are in some ways similar to non-core banks. For example, 

banks of all sizes continue to participate in some activities historically 

associated with banking, such as taking deposits and making loans. As 

table 2 shows, bank holding companies of different sizes hold similar 

proportions of certain loans such as residential mortgages and commercial 

and industrial loans. 

Page 14 GAO-08-953 Risk-Based Capital
Table 2: Percentage of Total Assets in Selected Classes, by Bank Holding Company Size, December 31, 2007 

(Dollars in millions) 

Certain retail 

products as percent 

of assets Certain wholesale products as percent of assets 

Size category by

assets 

Number of 

bank holding

companies 

Total

assets Mortgages

Credit 

cards

Trading 

assets

Commercial 

& industrial 

loans 

Commercial 

real estate

Securities 

held for sale 

or until

maturitya

Core bank holding 

companies 

11 $8,736,881 15.9% 3.7% 18.1% 8.6% 3.6% 9.9%

Non-core bank holding companies 

Consolidated 

assets between

$100 billion and 

$250 billion 

9 1,402,048 23.1 2.4 1.5 14.1 15.4 13.8

Consolidated 

assets between

$10 billion and 

$100 billion 

48 1,431,394 15.6 0.5 0.9 15.0 25.3 18.3

Consolidated 

assets between

$3 billion and

$10 billion 

100 558,077 16.7 0.2 0.4 11.9 29.9 21.2

Consolidated 

assets between 

$1 billion and 

$3 billion 

283 468,831 15.5 0.3 0.2 10.5 39.6 17.4

Consolidated 

assets between

$500 million and

$1 billion 

465 325,611 17.2 0.2 0.1 10.4 39.0 17.3

Consolidated 

assets less than 

$500 million 

4,148 649,948 17.4 0.1 0.1 2.9 32.4 19.6

Source: GAO analysis of publicly available Federal Reserve data. 

Note: Metropolitan Life Insurance Company is excluded from the table because, while it is large 

enough to be a core bank, it is involved primarily in insurance activities. For 4,103 of the smaller bank 

holding companies, consolidated data is not reported to the Federal Reserve. For those bank holding

companies we grouped the banks in the holding company and reported that data instead. Bank 

holding companies that do not have to report asset distributions at the holding company level 

generally do not engage in activities outside of their banks. This table also does not include thrifts or 

thrift holding companies that are active in banking markets especially in retail areas.

a

Securities available for sale or held to maturity include mortgage-backed securities, asset-backed 

securities, and others. 

Page 15 GAO-08-953 Risk-Based Capital
According to research conducted by Federal Reserve staff and other 

experts, banks of different sizes compete with each other for retail 

products such as residential mortgages.17 As illustrated in table 2, bank 

holding companies in all size ranges hold a relatively large percentage of 

their assets—from 15.5 to 23.1 percent—in residential mortgages. 

Customers can obtain mortgages from banks across the United States and 

generally can obtain pricing information from brokers or directly through 

the Internet or financial publications. For small thrifts, which make up a 

portion of the small non-core banking institutions in the United States but 

are not included in table 2, the proportion of mortgages is much higher.18

Unlike residential mortgages, only a few banks, including several core 

banks, are active in the credit card market, but some non-core banks are 

active in this market as well; and all credit card issuers generally compete 

for the same customers.19

For wholesale products, the competitive landscape is more complex. As 

table 2 illustrates, in some areas core banks differ substantially from noncore banks and are thus not likely to compete with them in those markets. 

For example, non-core banks hold a very small percentage of their assets 

as trading assets, an area where some core banks are very active, and core 

banks hold a relatively small proportion of their assets in commercial real 

estate, an area where non-core banks are very active. While table 2 shows 

that core and non-core banks are both active in the commercial and 

industrial loan markets, the market for loans from large banks may be 

 17Paul S. Calem and James F. Follain, “Regulatory Capital Arbitrage and the Potential 

Competitive Impact of Basel II in the Market for Residential Mortgages,” Journal of Real

Estate Finance and Economics, vol. 35 (2007), and Diana Hancock, Andreas Lehnert,

Wayne Passmore, and Shane M. Sherlund, An Analysis of the Potential Competitive

Impacts of Basel II Capital Standards on U.S. Mortgage Rates and Mortgage

Securitization, Federal Reserve Board Working Paper (April, 2005); Mark J. Flannery, 

Likely Effects of Basel II Capital Standards on Competition within the 1-4 Family 

Residential Mortgage Industry, manuscript, (Gainesville, Fla.: October, 2006).

18Consolidated data for thrift holding companies that would be comparable to the 

information in table 2 is not readily available from OTS. By looking at those thrifts that

make up a high percentage of the assets of the holding company, we see that thrifts and 

thus their holding companies hold a higher percentage of their assets in retail markets 

especially mortgage markets. They have only a small percentage of their assets in 

wholesale markets and these are concentrated in commercial real estate. Those thrift 

holding companies where the thrift is not a large part of the holding company are often in a 

wide range of businesses outside of banking including insurance, retail sales, and 

manufacturing. As a result only a few of these such as GE Capital Company and Ameriprise 

Financial Inc. would be competing with bank holding companies.

19W.W. Lang, L.J. Mester, and T.A. Vermilyea, Competitive Effects of Basel II on U.S. Bank 

Credit Card Lending, Federal Reserve Working Paper 07-9 (Philadelphia, Pa.: March 2007).

Page 16 GAO-08-953 Risk-Based Capital
quite different from those for smaller banks. According to a bank official

and other experts, larger banks do not price commercial and industrial 

loans individually; instead, these loans generally are part of a package of 

products and services offered to major corporate clients. Financial market 

experts told us that often these loans are discounted to establish a 

relationship with the customer. Because smaller banks do not offer a full 

range of products and services, they likely are not competing for the same 

customers as larger banks. In addition, we and others have shown that 

smaller banks tend to serve the needs of smaller businesses with which 

they can establish a personal relationship.20 Because obtaining credit 

information on small businesses is difficult, community banks often have 

an advantage with these customers in that they may have better 

information about small businesses in their local market than do large 

national or internationally active banks. As a result, the largest banks are 

unlikely to be competing with community banks in these markets. At the 

same time, research conducted by Federal Reserve staff has shown that 

large non-core banks may compete with core banks for corporate 

customers.21

In Some Markets, Core 

Banks Compete with Other 

U.S. Financial Institutions 

Core banks are much more likely than smaller or regional non-core banks 

to participate in activities often associated with investment banking. For 

example, core banks are much more likely to hold trading assets that 

typically are used to hedge risks or speculate on certain market changes 

either for the banking organization or its customers (see table 2). 

In addition, core banks are involved in international activities where they 

often provide investment banking products and services in the major 

capital markets around the world. In the United States and abroad, U.S.-

based core banks, especially Citigroup and JPMorgan Chase, compete with 

the four major U.S. investment firms—Goldman Sachs, Merrill Lynch, 

Morgan Stanley, and Lehman Brothers. The core banks also are involved in

custodial and asset management activities domestically and 

internationally. In this capacity, core U.S.-based banks compete with 

foreign-based banks, with investment firms, and with asset management 

 20See, GAO Small Business Administration: Additional Measures Needed to Assess 7(a) 

Loan Program’s Performance, GAO-07-769 (Washington, D.C.: July 13, 2007). 

21See Allen N. Berger, “Potential Competitive Effects of Basel II on Banks in SME Credit 

Markets in the United States,” Journal of Financial Services Research, 29:1 (2006), pp. 5-

36. 

Page 17 GAO-08-953 Risk-Based Capital
firms that do not own depository institutions and are not subject to 

regulatory capital requirements. 

U.S.-Based Banks Compete 

with Foreign-Based Banks 

in Foreign and U.S. 

Markets 

Basel capital requirements were established, in large part, to limit 

competitive advantages or disadvantages due to differences in capital

requirements across countries; however, the New Basel Accord allows for 

certain areas of national discretion and this could create competitive 

advantages or disadvantages for banks competing in various countries. In

addition, because a major part of Basel II involves direct supervision of the 

risk management processes of individual banks, further opportunities 

exist for differences across countries to develop as the new rules are 

implemented. 

While all but one of the core banks has some foreign exposure, some of 

the nine U.S.-based core banks have foreign exposures that are large 

relative to the size of the institution (see fig. 2). As noted above, most of 

these banks are engaged in asset management and investment banking 

activities globally. In addition, one of the banks is heavily engaged in retail 

banking activities in a wide range of countries where each country likely 

comprises a separate market. To the extent that U.S.-based banking 

institutions that have subsidiaries in foreign countries face more stringent 

capital requirements for the parent institution at home, U.S.-based banks 

could be disadvantaged in foreign markets. 

Page 18 GAO-08-953 Risk-Based Capital
Figure 2: Foreign Exposures of U.S.-based Core Banks, as of December 31, 2007 

Cayman

Islands

Bermuda

Mauritius

Bahamas

Hong Kong

7 - 8 core banks

5 - 6 core banks

3 - 4 core banks

1 - 2 core banks

No core banks

Sources: GAO analysis of SEC Form 10-Ks and information from Mergent Online; Map Resources (map).

Number of U.S.-based core 

banks operating subsidiaries

within a country

Luxembourg

Belgium

Country (number of 

U.S.-based core 

banks operating

subsidiaries)

United Kingdom (7)

Ireland (7)

Luxembourg (6)

Germany (5)

Netherlands (5)

France (3)

Italy (3)

Belgium (2)

UK

Ireland

France

Netherlands

Spain

Italy

Germany

Core institutions Foreign exposure (in billions) European highlights

N/A

N/A

Citigroup Inc.

JP Morgan Chase & Co.

Bank of America Corp.

Wachovia Corp.

Bank of New York Mellon Corp.

Northern Trust Corp.

State Street Corp.

Wells Fargo & Co.

Washington Mutual Bank

$971.4

486.4

125.2

72.3

61.7

27.5

19.8

9.4

0.0

Much of the competition between U.S.- and foreign-based banks takes 

place in the United States, where foreign based-banks are very active 

through their subsidiaries, branches, and offices. Foreign-based banks 

account for about $2.8 trillion of the approximately $15 trillion of U.S. 

banking assets and subsidiaries of those banks account for 11 of the 50 

largest U.S. bank holding companies. Further, as noted in table 1, three of 

the core banks in the United States are subsidiaries of foreign-based 

banks. Two of these operate primarily in wholesale markets, while the 

third, HSBC, is active in both retail and wholesale banking markets in the 

United States. In addition, some large U.S. non-core banks that are 

Page 19 GAO-08-953 Risk-Based Capital
subsidiaries of foreign-based banks are likely to adopt the advanced

approaches in the United States. 

The extent to which differences in capital requirements will affect 

competition in the United States between U.S.-based and foreign-based 

banks will depend, in part, on how the U.S. activities of the foreign-based 

banks are organized. For capital purposes, although foreign-based banks 

with U.S. subsidiaries will likely follow the Basel II rules in their home 

countries, the U.S. subsidiaries are regulated as U.S. banks within the 

United States and will follow U.S. rules. However, branches of foreign 

banks are not required to meet the U.S. rules. As a result, some foreignbased banks that have substantial U.S. operations, but conduct their 

banking activities in the United States through branches, will be following 

the Basel II rules in their home country rather than in the United States. 

Differences in Capital 

Requirements Have the 

Potential to Create 

Competitive Disparities 

Because holding capital is costly for banks, differences in regulatory 

capital requirements could influence costs, prices, and profitability for 

banks competing under different capital frameworks. If regulatory capital 

requirements increase the amount of capital banks hold relative to what 

they would hold in the absence of regulation, then the requirements would 

increase banks’ costs and reduce their profitability.22 Depending on the 

structure of markets, these higher costs could be passed on to bank 

customers in the form of higher prices—interest rates on loans or fees for 

services—or absorbed as reduced lending and profits. For example, higher

capital costs driven by higher capital requirements could result in a 

competitive disadvantage for banks that compete for similar customers 

with banks subject to different capital rules. Conversely, lower capital 

requirements that allow banks to reduce the capital they hold for a 

particular asset could allow them to price those assets more aggressively,

thereby increasing market share or earning higher returns at existing 

prices. 

Bank officials with whom we spoke and some empirical evidence we 

reviewed suggested that regulatory capital requirements are one of several 

key factors banks consider in deciding how much capital to hold. Other 

factors include management views on the amount of capital the firm needs 

 22Holding capital involves balancing the needs of creditors and equity investors. More

capital reassures creditors that banks will be able to repay loans, which reduces the cost of 

borrowing. But more capital also means that banks retain more shareholder equity, which

reduces return on equity, an important benchmark for investors. 

Page 20 GAO-08-953 Risk-Based Capital
internally and market expectations.23 These multiple and overlapping 

motivations for holding capital make it difficult to isolate the impact of 

regulatory capital on the amount of capital banks hold.24 Nevertheless, 

there is some evidence that banks hold more than the minimum required 

capital—a buffer—in part to reduce the risk of breaching that minimum 

requirement. For example, one study of United Kingdom banks found that 

an increase in required capital was followed by an increase in actual 

capital, although the increase was only about half the size of the increase 

in required capital.25 Thus, changes in minimum required capital could 

cause banks to change the amount of capital they hold to maintain a 

similar buffer of capital, consistent with the other goals of the bank. The 

study also found that banks with small buffers reacted more to a given 

change in individual capital requirements—and banks with larger buffers

reacted little, if at all—supporting the view that the capital buffer is a form 

of insurance against falling below regulatory minimums. 

Differences in the implementation costs of capital requirements also could 

have competitive effects. In principle, higher implementation costs could 

lead to a one-time increase in costs or ongoing costs associated with 

compliance. One-time costs would influence profitability directly, while 

ongoing costs also could influence the cost of lending for banks in the 

same way that higher capital costs could influence pricing and 

profitability. Significant implementation costs are likely to be easier to 

 23In previous work, officials at several banks told us that they weigh a number of factors 

when deciding how much capital to hold, including regulatory requirements, internal 

economic capital models, strategic needs, and market expectations, which are often 

exemplified by assessments from credit rating agencies such as Moody’s and Standard and 

Poor’s. Officials at one of these rating agencies agreed that banks manage capital to meet 

these demands. 

24In particular, there is very little “exogenous variation” (variation caused by regulation and 

not by banks themselves) in minimum capital requirements across banks, making it 

extremely difficult to estimate the impact of changes or differences in minimum capital 

requirements. 

25A decrease in required capital was met with a reduction in actual capital of only 20 

percent of the size of the decrease in required capital. However, it is not clear that these 

quantitative estimates would apply to banks competing in the United States. Because small

banks tend to hold a relatively large buffer of capital over minimum requirements, changes 

in those requirements may result in relatively little change in the amount of capital these 

banks hold. Isaac Alfon, Isabel Argimón and Patricia Bascuñana-Ambrós, “How do

individual capital requirements affect capital at UK banks and building societies.” 

Documentos de Trabajo No. 0515, Banco De España, 2005. 

Page 21 GAO-08-953 Risk-Based Capital
bear the larger the institution—the costs of implementing regulation are 

on average higher (as measured by cost per employee) for smaller firms.26

The possible effects of differences in regulatory capital requirements on 

implementation and capital costs also could influence incentives for 

consolidation by making acquisitions more or less advantageous for banks 

operating under different capital rules. Such advantages would imply that 

those banks under a given capital regime might be able to use the capital 

resources of banks under a different regime more effectively, making it 

profitable for the former banks to acquire the latter ones. Conversely, if 

implementation costs for a capital regime imposed on larger banks were 

high, this might discourage some banks from merging because they would 

become large enough to be required to adopt a capital regime with high 

implementation costs. 

The new U.S. capital rules address some competitive concerns of banks; 

however, other concerns remain. Regulators analyzed some competitive 

issues raised by banks during the development of the Basel II rules in the 

United States. In the final rule for the advanced approaches, the regulators

addressed concerns about differences between the NPR and the New 

Basel Accord that could have led to greater implementation costs. For 

example, in the final rule they harmonized the definition of wholesale loan 

default with the accord, thus responding to banks’ concerns that 

differences in the definition of wholesale loan default between the NPR 

and the accord could have led to increased costs of operating in multiple 

countries. However, core banks remain concerned that the leverage 

requirement will affect their ability to compete with both foreign- and 

some U.S.-based competitors. The coordination between U.S. and foreign 

regulators on implementation issues for core banks may address some 

competitive concerns of internationally active core banks. For non-core 

banks, the proposed standardized approach rule may address some 

concerns—for example, that core banks could hold less capital for similar 

assets. The proposed rule is more risk sensitive than Basel I, providing 

non-core banks with the possibility of lower regulatory capital minimums 

for certain assets or activities. Other factors, such as the leverage 

requirement, may reduce differences in capital for banks competing in the 

United States. 

New U.S. Capital Rules 

Have Reduced Some 

Competitive Concerns 

about Basel II 

 26W. Mark Crain, The Impact of Regulatory Costs on Small Firms, for the Small Business

Administration Office of Advocacy, September 2005. This study does not necessarily 

represent the views of the Office of Advocacy or the Small Business Administration. 

Page 22 GAO-08-953 Risk-Based Capital
As a result of the potential for large banks to hold less capital under Basel 

II, at least for certain assets, researchers, primarily at the Federal Reserve,

conducted studies of the potential impact of Basel II on specific markets 

and on aspects of the rule, including the impact on residential mortgages, 

credit cards, operational risk, and mergers and acquisitions. These studies 

were limited by the availability of data and by a lack of information on the 

impact regulatory capital has on bank behavior. Nonetheless, the studies 

identified that there could be competitive impacts in the residential 

mortgage market and helped to lead to the development of alternatives to

Basel I for non-core banks. 

U.S. Regulators 

Recognized Some 

Competitive Concerns 

during the Development of 

the Rules 

OCC and OTS provided the Office of Management and Budget (OMB) with 

regulatory impact analyses that included examination of the impact of the 

rules on domestic competition.27 In addressing competitive issues in this 

analysis, OCC relied primarily on the studies conducted at the Federal

Reserve. In its regulatory impact analysis, OTS incorporated OCC’s 

analysis adding appropriate material specifically related to the thrift 

industry. For example, OTS noted that because thrifts have high 

concentrations of assets in residential mortgages, the leverage 

requirement would be more likely to impose greater capital requirements 

on these firms than would the Basel II requirements and, as a result, would 

have a negative impact on the ability of thrifts to compete with other 

banking organizations. OTS also pointed out that interest rate risk for 

those mortgage-related assets that a bank is planning to hold rather than 

trade is particularly important to thrifts. However, the adequacy of capital 

held for these risks is being assessed in Pillar 2 rather than in Pillar 1, 

where the risks associated with changes in interest rates on mortgage 

related assets that are being actively traded are assessed. Since there is 

more regulatory flexibility in Pillar 2 than in Pillar 1, OTS expressed 

concern that thrifts could be disadvantaged if different regulatory agencies

did not implement Pillar 2 consistently. 

The regulators did less analysis regarding the international competitive 

impact of the new rules. At the time that the capital rules were being

developed, OMB provided little guidance on analyzing the international 

impact of U.S. rules and the agencies did not discuss international 

competition issues in their analyses. Alternatively, European Union 

guidance for regulatory impact analyses includes a more detailed 

 27As part of the Department of the Treasury, OCC and OTS are subject to Executive Order 

12866, as amended, which requires executive agencies to submit to OMB a regulatory

impact analysis when issuing rules or regulations that will likely exceed annual costs of 

$100 million or more to government entities or the private sector. 

Page 23 GAO-08-953 Risk-Based Capital
evaluation of impacts on international trade and investment, and OMB is 

considering including more explicit guidance on the analysis of the impact

on international trade and investment in the United States.28 During the 

development of Basel II, U.S. banks raised concerns about being 

disadvantaged internationally by certain aspects of the U.S. rules. 

U.S. Final Rule on the 

Advanced Approaches 

Addresses Some 

Competitive Concerns 

Raised by Banks, but the 

Leverage Ratio Continues 

to Be a Concern 

Although regulators have harmonized some aspects of the advanced

approaches final rule with the New Basel Accord, concerns remain about 

remaining differences in the final rule and other issues such as the 

leverage requirement that could have competitive effects. The final rule 

removed an important technical difference in the definition of default for 

wholesale products that existed between the U.S. NPR and the New Basel 

Accord. However, other differences were retained, such as the U.S. 

implementation schedule and the amount by which regulatory capital 

could decrease during a bank’s transition to the final rule. Core banks are 

specifically concerned that the leverage requirement will have negative 

effects on their ability to compete with CSEs and foreign-based banks. 

U.S. banking regulators harmonized certain aspects of the U.S. final rule 

on the advanced approaches with the New Basel Accord, reducing some 

concerns of core banks. For example, one of the major concerns of U.S. 

core banks was that the proposed rule included a different definition of 

default for wholesale products, which could lead to increased 

implementation costs through the need to maintain separate systems for 

data in the United States and in those foreign countries where U.S. core 

banks were required to adopt Basel II. The definition of default for 

wholesale products in the final rule now closely resembles the New Basel 

Accord’s definitions for these types of products, thus limiting the potential

for higher implementation costs for core banks. Other technical 

differences that have been diminished for core banks include how core 

banks have to estimate their losses after a borrower has defaulted on a 

loan. Table 3 outlines several key technical differences between the earlier 

proposed U.S. rules and the New Basel Accord and highlights where U.S. 

regulators diminished or retained differences in the final rule.

Final Rule Eliminated Some 

Technical Differences That 

Raised Concerns about 

Competitive Effects, but Other 

Differences Remain 

 28OMB and the Secretariat General of the European Commission, Review of the 

Application of EU and US Regulatory Impact Assessment Guidelines on the Analysis of

Impacts on International Trade and Investment: Joint Draft for Comment (Washington,

D.C./Brussels, Belgium: Nov. 8, 2007). 

Page 24 GAO-08-953 Risk-Based Capital
Table 3: Significant Technical Differences between the U.S. NPR on Advanced Approaches and the New Basel Accord, and

the Treatment of These Differences in the U.S. Final Rule on Advanced Approaches 

Significant 

technical 

differences 

U.S. NPR on the Advanced

Approaches New Basel Accord

U.S. Final Rule on Advanced

Approaches 

Wholesale 

definition of 

default 

Based on whether: 

• the bank places any exposure

to the borrower on non-accrual

status, 

• the bank incurs full or partial

charge offs on any exposure to

the borrower, or

• the bank incurs a credit-related

loss of 5 percent or more on 

the sale of any exposure to the 

borrower or transfer of any 

exposure to the borrower to the 

held-for-sale, available-forsale, trading account, or other 

reporting category. 

Based on whether: 

• the bank considers a borrower 

unlikely to pay in full without 

recourse to bank actions, or 

• a borrower’s payment on principal 

or interest is more than 90 days 

past due. 

• Includes non-accrual 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 non-accrual

status. 

Based on whether: 

• the bank considers that the 

borrower is unlikely to pay its credit 

obligations to the bank in full, 

without recourse by the bank to 

actions such as realizing collateral 

(if held), or 

• the borrower is past due more than 

90 days on any material credit 

obligation to the bank. 

• Includes nonaccrual and material 

credit-related loss on sale as 

elements indicating unlikeliness to 

pay. 

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 a borrower unlikely to pay in 

full without recourse to bank actions. 

• 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. 

• Banks can adopt the definition of 

default of host countries for foreign 

subsidiaries subject to prior 

approval of their primary federal 

supervisor 

Small- and 

medium-sized 

enterprise (SME) 

lending 

Does not include an adjustment 

that would result in a lower capital 

requirement for loans to SMEs

compared to other business loans 

under the framework. 

Includes such an adjustment. Does not include an adjustment that 

would result in a lower capital

requirement or loans to SMEs 

compared to other business loans. 

Page 25 GAO-08-953 Risk-Based Capital
Significant 

technical 

differences 

U.S. NPR on the Advanced

Approaches New Basel Accord

U.S. Final Rule on Advanced

Approaches 

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. 

Bank’s LGD estimate must be reliable 

and sufficiently reflective of economic 

downturn data and should have 

rigorous and well-documented policies 

and procedures for (1) identifying 

economic downturn conditions for 

each exposure subcategory, (2) 

identifying changes in material 

adverse relationships between the 

relevant drivers of default rates and 

loss rates given default, and (3) 

incorporating identified relationships 

into LGD estimates. 

Source: GAO.

One technical difference that remains between the U.S. final rule on 

advanced approaches and the New Basel Accord is the treatment of SME 

loans. U.S. regulators believe that an adjustment to lower the capital 

charge for such business loans is not substantiated by sufficient empirical 

evidence. In other words, this suggests that, all other things equal, SME 

loans have risks comparable to those posed by larger corporate loans. U.S.

regulators also noted that the SME treatment in the Accord might give rise 

to a domestic competitive inequity between core banks and banks subject

to other regulatory capital rules, such as Basel I. Officials at one rating 

agency with whom we spoke said that a lower capital requirement for 

SME loans in the New Basel Accord was not reflective of the risk for these 

exposures, and the rating agency did not treat these loans differently from 

other business loans in their own assessments of capital adequacy. In

addition, several experts with whom we spoke noted that this difference in

capital requirements for SME loans would likely not have any immediate 

or major impact on competition between U.S. and foreign banks. 

In addition to the technical differences discussed above, the final rule 

addressed one concern related to a prudential safeguard U.S. regulators 

introduced in the 2006 NPR, but some core banks remain concerned about

the implementation schedule. The NPR contained a benchmark—a 10 

percent reduction in aggregate minimum capital among core banks—that 

would have been viewed as a material reduction in capital requirements 

that warranted modification in the rule. Core banks had commented that 

this safeguard could affect them negatively because of the uncertainty 

surrounding its application. In the final rule, U.S. regulators eliminated the 

Page 26 GAO-08-953 Risk-Based Capital
benchmark. However, retention of the implementation schedule proposed 

in the 2006 NPR continues to raise concerns for some core banks because 

it will lead to a longer transition period in the United States than in other 

countries and delay any possible capital reductions. European banks and 

most Canadian banks on the advanced approaches most likely will exit 

their transitional periods by January 2010. In contrast, U.S. core banks 

cannot exit their transitional periods before April 2012 and could do so in 

2014 or later. Furthermore, European banks will be able to reduce capital 

to 90 percent of Basel I requirements in 2008 and to 80 percent of Basel I 

requirements in 2009 while Canadian banks will be able to apply for 

approval to reduce their capital by similar amounts under the same 

timeframes. Under the final rule, U.S. core banks will have three distinct 

transitional periods during which required risk-based capital may be 

reduced to only 95 percent, 90 percent, and 85 percent of Basel I 

requirements respectively.29 The different implementation schedules and 

maximum capital reductions may provide foreign competitors of U.S. core 

banks an earlier opportunity to make use of any decreases in capital costs 

associated with lower required capital for certain assets or activities. 

Therefore, by making the transition to Basel II lengthier for U.S. core 

banks, foreign competitors may be able to take better advantage of 

strategic opportunities, such as a mergers or acquisitions. Though several

core bank officials with whom we spoke remained concerned about the 

time difference, officials at one core bank explained that the current 

market environment may limit the competitive implications of that 

difference. 

Several core bank officials with whom we spoke mentioned that they 

would have wanted to have the option to select the standardized approach 

with some officials suggesting that the lack of a choice may lead to higher

implementation costs. In the United States, the final rule requires all core 

banks to adopt the advanced approaches for both credit and operational 

risk, but affords opportunities for the primary federal supervisor to 

exercise some flexibility when applying the final rule to core banks. The 

advanced approaches rule specifically allows for the exemption of 

subsidiary depository institutions from implementing the advanced

approaches, and, under the reservation of authority, the primary 

federal regulator can require a different risk weighted asset amount for 

one or more credit risk exposures, or for operational risk, if the regulators 

determine that the requirement under the advanced approaches is not 

commensurate with risk. However, some U.S. regulatory officials with 

 29See appendix III for a timeline of Basel II implementation in the United States. 

Page 27 GAO-08-953 Risk-Based Capital
whom we spoke noted the potential risk of a piecemeal approach and 

emphasized that they do not want banks to apply the advanced approach 

for credit risk to their least risky portfolios and to apply Basel I or the 

proposed standardized approach for their riskier portfolios. 

In contrast, some foreign banks have not been explicitly required to adopt 

the advanced approaches for credit and operational risk. For example, 

Canadian regulators told us that they have an expectation for their 

domestic banks with significant global operations to move to the advanced

approach for credit risk and that there is no such expectation for domestic 

banks to use the advanced approach for operational risk. Furthermore, all 

other banks in Canada can decide to adopt the advanced approaches with 

the condition that the bank must adopt the advanced approach for credit 

risk before adopting the advanced approach for operational risk. In 

addition, regulatory officials from the United Kingdom told us that all 

banks were required to adopt the standardized approach in 2007, but some 

banks applied for a waiver to allow them to adopt the advanced 

approaches for determining capital requirements for credit risk or for 

operational risk. Moreover, officials from one European bank told us that 

they entered their first transitional year in their country with 

approximately three-quarters of their portfolios on the advanced approach

for credit risk. 

Officials from some of the core banks with whom we spoke expressed 

concerns that they may be at a competitive disadvantage due to the 

retention of the U.S. leverage requirement, which applies to all depository 

institutions and U.S.-based bank holding companies. Foreign banks based 

in other industrialized countries are generally not subject to a leverage 

requirement.30 Some U.S.-based core banks are concerned about the 

impact of the leverage requirement for bank holding companies on their 

operations abroad. That is, in meeting the leverage requirement, a U.S. 

bank holding company must include the assets of its foreign operations, 

potentially increasing the amount of required regulatory capital in 

comparison with the regulatory capital requirements for foreign-based 

bank holding companies. For example, the additional capital needed to

meet the leverage requirement may exceed the additional capital required 

under the advanced approaches for certain corporate loans that are 

Retention of Leverage 

Requirement Has Raised 

Concerns of Core Banks about 

Competitive Effects 

 30Of the foreign countries we visited, only Canada has a leverage requirement that is similar in

some ways to the one in the United States. The Swiss National Bank is also considering the 

introduction of a leverage requirement. Some Basel Committee member countries have other 

supplementary capital measures, akin to the well-capitalized designation for U.S. depository

institutions, which are generally based on risk and assessed in Pillar 1 or Pillar 2.

Page 28 GAO-08-953 Risk-Based Capital
estimated by banks to be relatively low-risk, as demonstrated in figure 3.

Most core bank officials with whom we spoke also said that by 

maintaining the leverage requirement, U.S. regulators were preserving a 

regulatory capital requirement that was not aligned with the improved 

risk-management practices promulgated by the final rule on the advanced

approaches. Officials from one trade association said that because the 

leverage requirement does not require additional capital as risk increases, 

banks may have an incentive to increase their return on equity by holding

assets with higher risk and return, but no additional capital required by the 

leverage requirement. In contrast, regulatory officials have stated that riskbased and leverage requirements serve complementary functions in which 

the leverage requirement can be seen as offsetting potential weaknesses or 

supplementing the risk-based capital requirements. 

Page 29 GAO-08-953 Risk-Based Capital
Figure 3: Required Capital for Short-term Corporate Loans under the Advanced Approach and Bank Holding Company 

Leverage Requirement, by Probability of Default 

Required capital (percentage)

Annual probability of default

Leverage requirement (bank holding companies)

Advanced approach

Higher requirement

Sources: GAO analysis of the advanced approaches rule, Federal Reserve regulation, and data from the QIS-4 summary.

0

1

2

3

4

5

6

7

8

0.05% 0.15% 0.25% 0.35% 0.45% 0.55% 0.65% 0.75% 0.85% 0.95% 1.05% 1.15% 1.25% 1.35% 1.45% 1.55% 1.65% 1.75% 1.85% 1.95% 2.05%

Note: Estimates of the capital required under the advanced approaches in the figure assume an LGD 

of 35.8 percent (adjusted for downturn conditions using the supervisory formula from the advanced

approaches NPR, based on mean LGD for corporate, bank, and sovereign exposures from the fourth 

quantitative impact study (QIS-4 ) of 30.2 percent), and a maturity of 1 year. The leverage 

requirement of 3 percent for bank holding companies subject to the market risk amendment is 

measured in tier 1 capital, while the Basel II credit risk requirement is measured in total capital. The 

estimates of required capital under the advanced approach do not include any increase in the 

operational risk capital requirement that could come from holding additional assets.

In terms of potential competitive effects domestically, some core bank 

officials with whom we spoke expressed concerns that certain financial

firms, primarily the CSEs, offer similar wholesale products but lack similar 

regulatory capital requirements, while other core bank officials were no 

longer concerned. As noted previously, CSEs are required to compute and 

report to SEC capital adequacy measures consistent with the standards in 

the New Basel Accord, and SEC expects them to maintain certain capital

ratios, though they are not required to do so. SEC has said that it will make 

modifications in light of the final rule adopted by U.S. bank regulators and

subsequent interpretations. In addition, bank holding companies are 

subject to a leverage requirement, but CSEs do not have a similar 

Page 30 GAO-08-953 Risk-Based Capital
requirement. For example, in December 2007, the leverage ratio for core 

bank holding companies ranged from about 4.0 percent to about 6.8 

percent and for CSEs ranged from about 3 percent to 3.8 percent. 

International Coordination 

among Regulators Has 

Contributed to Reducing 

Competitive Concerns for 

Core Banks 

U.S. regulators and their foreign counterparts are coordinating in ways 

that contribute to reducing the potential for adverse competitive effects on

U.S. banks operating abroad. These efforts aim to resolve some issues that 

develop between regulators in a bank’s home country and those in other 

countries where the bank operates, usually referred to as home-host 

issues. Handling home-host issues is an essential element of the New Basel 

Accord framework because it allows for national discretion in a number of 

areas.31 Several foreign regulators with whom we spoke discussed how 

well U.S. regulators have been able to collaborate with their foreign 

counterparts on a variety of supervisory issues. Specific to Basel II 

implementation, U.S. regulators have been able to provide needed 

information to foreign bank supervisors that could limit the compliance 

costs of subsidiaries of U.S. banks operating abroad. For example, OCC 

examiners explained to us how they assisted a foreign regulator in better 

understanding some of the information a core bank was using in 

estimating credit risk for a certain loan portfolio. In another instance of 

collaboration, foreign regulators explained to us that they waived the 

requirement for a core bank to adopt the advanced approaches for its 

foreign-owned subsidiary until the core bank adopted the advanced

approaches in the United States. 

Over the years, the U.S. regulators have entered into various informationsharing agreements that facilitate cooperation with their foreign 

counterparts. These agreements are intended to expedite the meeting of 

requests posed by foreign regulators for supervisory information from U.S.

regulators. As of July 2008, OCC and Federal Reserve officials explained 

that they had some form of an information-sharing agreement with 25 and 

16 foreign jurisdictions respectively. Likewise, FDIC and OTS officials 

both described good working relationships with their foreign counterparts 

as they related to U.S. banks with international operations that they 

supervise. 

U.S. regulators have been and continue to be active members in the Basel 

Committee and its various subcommittees, including the Accord 

 31The Basel Committee has issued general principles for information sharing between home 

and host countries. See Basel Committee, Home-host Information Sharing for Effective

Basel II Implementation (Basel, Switzerland: June 2006). 

Page 31 GAO-08-953 Risk-Based Capital
Implementation Group. In addition, U.S. regulators participate in colleges 

of supervisors and other international bodies, such as the Joint Forum.32

Participation in such entities further provides U.S. regulators information 

on how U.S. banks may be treated by foreign regulators, thus allowing for 

more dialogue among regulators to preemptively address any home-host 

issues. The Accord Implementation Group’s purpose is to exchange views 

on approaches to implementation of Basel II, and thereby to promote 

consistency in the application of the New Basel Accord. Colleges of 

supervisors are meetings at which regulators from various countries 

discuss supervisory matters that relate to a specific bank that has global 

operations. Officials from the Federal Reserve stated that the colleges are

more often better for sharing information among regulators than for 

addressing a specific regulatory issue. Though regulators from various 

countries are sharing information, several core banks expressed concerns

to us that their foreign regulators have been implementing Basel II 

differently. 

Proposed Standardized 

Approach May Reduce 

Competitive Concerns of 

Non-core Banks, as May 

Other Factors 

As discussed earlier, because non-core banks compete with core banks in 

some markets, non-core banks were concerned that core banks would be 

able to hold less capital than non-core banks were holding under Basel I 

for the same assets. Part of this concern came from the April 2005 results 

of the fourth quantitative impact study (QIS-4), which estimated that Basel 

II could result in material reductions in aggregate minimum required riskbased capital among potential core banks.33 By holding less capital for 

certain products, such as residential mortgages, core banks might charge

less for these products than non-core banks. Two studies of the potential

impact of Basel II on the market for residential mortgages have disagreed 

as to the magnitude of any competitive impact—one suggested a 

potentially significant shift in income from mortgages toward banks on the 

advanced approaches, while the other argued that any competitive impact

 32Established in 1996 under the aegis of the Basel Committee, the International 

Organization of Securities Commissions, and the International Association of Insurance 

Supervisors, the Joint Forum on Financial Conglomerates (Joint Forum) deals with issues

common to the banking, securities, and insurance sectors, including the regulation of

financial conglomerates.

33A number of factors could have caused QIS-4 to either underestimate or overestimate 

minimum required capital. In addition, the sensitivity of the advanced approaches to 

economic conditions and the good economic environment during QIS-4 were important 

factors in explaining lower estimates of required capital. There are some limitations 

associated with the data from QIS-4. At the time, the regulators emphasized that the QIS-4 

was conducted on a “best efforts” basis with limited data and without the benefit of fully 

articulated final rules for U.S. implementation. 

Page 32 GAO-08-953 Risk-Based Capital
was unlikely.34 In addition, U.S. regulators have recognized that some 

banks were concerned about core banks being required to hold less capital 

overall, thus making it advantageous to acquire non-core banks. The 

proposed standardized approach rule should address some of the 

competitive concerns non-core banks expressed in the early 2000s, while

several other factors, including the leverage requirement, also may reduce

differences in capital between core and non-core banks. 

U.S. regulators have proposed the standardized approach in part to 

mitigate potential competitive differences between core and non-core 

banks.35 The U.S. version of the standardized approach features more risksensitive capital requirements than Basel I. In particular, it adds risk 

sensitivity for mortgages based on their loan-to-value (LTV) ratios and has 

lower capital requirements than Basel I for some lower-risk (lower LTV) 

mortgages (see fig. 4). 

Proposed Standardized 

Approach Provides a More 

Risk-sensitive Option for Noncore Banks

 34Note that neither study’s conclusions are based on an analysis of a standardized 

approach. Paul S. Calem and James F. Follain, “Regulatory Capital Arbitrage and the

Potential Competitive Impact of Basel II in the Market for Residential Mortgages,” Journal 

of Real Estate Finance and Economics, vol. 35 (2007), and Diana Hancock, Andreas

Lehnert, Wayne Passmore, and Shane M. Sherlund, An Analysis of the Potential 

Competitive Impacts of Basel II Capital Standards on U.S. Mortgage Rates and Mortgage

Securitization, Federal Reserve Board (April 2005). 

35The proposed standardized rule incorporates many features that U.S. regulators proposed 

in Basel IA, which also was proposed to limit potential competitive advantages core banks

may have had over non-core banks. For example, Basel IA included the increased risksensitivity in residential mortgages that is also in the proposed standardized approach. 

Page 33 GAO-08-953 Risk-Based Capital
Figure 4: Risk Sensitivity of Proposed Standardized Approach vs. Prudently 

Underwritten Residential Mortgages under Basel I, by LTV

Required capital (percentage)

Loan-to-value (LTV) ratio

Basel I

Proposed U.S. standardized approach

Source: GAO analysis of the standardized proposal.

0

2

4

6

8

10

12

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

Note: Estimates of required capital under the standardized approach in the figure do not include any 

increase in the operational risk capital requirement that could come from holding additional assets. 

Mortgage loans that are not prudently underwritten would receive a 100 percent risk weight under 

Basel I. Banks must demonstrate that mortgage loans with a LTV that exceeds 90 percent are 

prudently underwritten to receive the 50 percent Basel I risk weight. 

The proposed standardized approach rule is also similar to the 

standardized approach under the New Basel Accord in that, like the 

accord, it features increased risk sensitivity for some externally rated 

exposures, including corporate loans. This is in contrast to the single risk 

weight for corporate credits and most mortgages in Basel I. Figure 5 

demonstrates that the minimum required capital under the standardized 

approach for the credit risk associated with externally-rated corporate 

loans will be much more similar to that required under the advanced 

approaches than that required under Basel I. In addition, the standardized 

approach expands incentives for better risk management in that it allows 

banks to reduce capital in light of certain additional practices that could 

reduce risk, such as the use of collateral or third-party guarantees, and 

explicitly requires banks to set aside capital for operational risk. The 

added risk sensitivity of the standardized approach proposal should 

Page 34 GAO-08-953 Risk-Based Capital
reduce some differences in risk-based capital requirements, as compared 

with the advanced approaches, for adopting banks. 

Figure 5: Required Capital for Externally Rated Corporate Loans under Basel I, 

Proposed Standardized Approach, and Advanced Approach, by Rating

0

5

10

15

20

25

AAA Aa A Baa Ba B C

Required capital (percentage)

Sources: GAO analysis of the advanced approaches rule, standardized proposal, 

and data from Moody's Investors Service and the QIS-4 summary.

Moody’s rating

Standardized approach

Advanced approach

Basel I

Low

Medium

High

Note: Estimates required capital under the advanced approaches in the figure assume LGDs of 28.0 

percent, 35.8 percent, and 44.2 percent for low, medium, and high estimates, respectively (adjusted 

for downturn conditions using the supervisory formula from the advanced approaches NPR, based on

25th percentile, median, and 75th percentile LGDs for corporate, bank, and sovereign exposures from

QIS-4 of 21.7 percent, 30.2 percent and 39.4 percent, respectively), and a maturity of 3 years. Default 

probabilities, from Moody’s, are 0.03 percent for AAA, Aa, and A (the lower bound in the advanced 

approaches rule), 0.18 percent for Baa, 1.21 percent for Ba, 5.24 percent for B, and 19.48 percent for 

C. We include a range of estimates for the advanced approach for credit risk because it allows for 

greater granularity of risk assessments than the standardized approach and because banks may use 

a variety of methodologies and different underlying data for estimating risk parameters. The estimates 

of required capital under the advanced and standardized approaches do not include any increase in

the operational risk capital requirement that could come from holding additional assets. 

Once the standardized approach rule becomes final, non-core banks will 

have the option of choosing it or the advanced approaches, or remaining 

on Basel I. Presumably, non-core banks will take into consideration a wide 

range of issues when deciding what regulatory capital framework to adopt, 

Page 35 GAO-08-953 Risk-Based Capital
including potential competitive effects. For example, a growing non-core 

regional bank that competes principally with core banks in wholesale and

retail lending may find it beneficial to adopt the advanced approaches in 

order to model and receive lower risk-based capital requirements for 

certain lower-risk credits. Similarly, a smaller non-core bank that found 

itself increasingly competing with regional banks might opt for the 

additional risk-sensitivity of the standardized approach. However, one 

trade association representing some of the smallest non-core banks with 

whom we spoke said the standardized approach may not fully address the 

competitive concerns of these banks because the capital relief associated 

with holding some lower risk assets might be offset by additional capital 

required for operational risk. Officials at one large non-core bank told us 

that the bank was considering all of its options carefully and noted that 

there were a large number of factors to consider in deciding which riskbased capital rule to adopt. 

While the leverage requirement, particularly for bank holding companies,

remains a competitive concern for core banks, the leverage requirements 

that all depository institutions must meet may limit competitive 

differences resulting from banks in the United States operating under 

multiple risk-based capital rules. Because these banking institutions must 

meet both risk-based and leverage requirements, the leverage requirement 

may be the effective or binding requirement for lower-risk assets held on 

the balance sheet, or more generally for banks with a relatively low-risk 

portfolio. The additional capital needed to meet the leverage requirement 

likely will exceed both the additional advanced and standardized 

approaches risk-based capital requirements for certain lower-risk assets 

held on balance sheets, such as low LTV mortgages and highly rated 

corporate credits.36 Figure 6 compares the capital required by the 

advanced approaches with the capital required by the leverage

requirement for certain externally rated corporate loans. 

Other Factors, Such as the 

Leverage Requirement, May 

Reduce Competitive Effects of

Multiple U.S. Capital Rules 

 36Alternatively, banks could eliminate the leverage requirement and receive the lower, riskbased capital requirement by converting the asset to an off-balance sheet activity, such as 

by selling a guarantee on that asset in the event of default. To the extent risk-based capital

requirements decrease for some assets under the advanced approaches, the incentive for 

core banks to do so may increase. 

Page 36 GAO-08-953 Risk-Based Capital
Figure 6: Required Capital for Externally-rated Corporate Loans under the 

Advanced Approach and Depository Institution Leverage Requirement, by Rating

0

5

10

15

20

AAA Aa A Baa Ba B C

Required capital (percentage)

Sources: GAO analysis of the advanced approaches rule, and data from Moody's Investors Service and the QIS-4 summary.

Moody’s rating

Advanced approach

Leverage requirement (depository institutions)

Higher requirement

Note: Estimates of required capital under the advanced approaches in figure 6 assume a LGD of 35.8 

percent (adjusted for downturn conditions using the supervisory formula from the advanced 

approaches NPR, based on median LGD for corporate, bank, and sovereign exposures from QIS-4 of 

30.2 percent), and a maturity of 3 years. Default probabilities, from Moody’s, are 0.03 percent for 

AAA, Aa, and A (the lower bound in the advanced approaches rule); 0.18 percent for Baa; 1.21 

percent for Ba; 5.24 percent for B; and 19.48 percent for C. The leverage requirement of 4 percent for 

depository institutions is measured in tier 1 capital, while the Basel II credit risk requirement is 

measured in total capital. The estimates of required capital under the advanced approach do not 

include any increase in the operational risk capital requirement that could come from holding 

additional assets. 

Because U.S. banks hold capital for a number of reasons and are generally

expected to hold more than the minimum amount of capital required, 

banks under different risk-based capital rules may nevertheless hold 

similar capital for similar assets and activities—and therefore have similar 

capital costs—despite differences in minimum required capital. As already 

discussed, banks hold capital based on management views on the amount 

of capital the bank needs internally and market expectations, in addition

to regulatory requirements. Furthermore, regulators generally expect 

banks to hold capital above these minimum requirements, commensurate 

Page 37 GAO-08-953 Risk-Based Capital
with their risk exposure. For example, as part of Pillar 2, banks and 

regulators will assess risks not covered or not adequately quantified by 

Pillar 1 minimum requirements. 

Another factor that may reduce competitive effects resulting from 

differences in risk-based capital requirements is the ability of banks to 

originate loans and subsequently securitize and sell them to other entities.

Differences in required capital for credit risk across multiple risk-based 

regimes would likely have a competitive impact only to the extent that 

banks retain the credits they originate on their balance sheets or retain a 

significant portion of the credit risk off their balance sheets. Banks may 

securitize residential mortgages and other types of loans into other 

marketable investments in order to raise further funds to originate 

additional loans. This is also known as an originate-to-distribute model 

where revenues are derived from the sale of assets rather than an ongoing

stream of interest payments. However, the recent turmoil in the credit 

markets has reduced the volume of some securitizations and highlighted

weaknesses in underwriting standards associated with the originate-todistribute model. As a result, incentives for securitization could be 

influenced by changes in capital requirements and the market 

environment. 

The potential impact of the new regulatory capital rules on incentives for 

mergers and acquisitions remains uncertain because it is not clear how 

much capital requirements and other regulatory costs will change under 

the new capital rules. As noted earlier, differences in regulatory capital 

requirements could influence incentives for consolidation by making 

acquisitions more or less advantageous for banks operating under 

different capital rules, such as the multiple risk-based capital rules being 

introduced in the United States. However, several industry participants 

with whom we spoke said that mergers and acquisitions generally were 

driven by strategic concerns such as gaining access to a new market rather 

than capital concerns. In addition to the new capital rules, changes in 

credit markets may be affecting the benefits and costs of certain mergers. 

For example, one regional bank told us that the costs of implementing the 

advanced approaches is high especially for smaller banks and that the 

benefits of the advanced approaches were less certain in the current 

financial climate where credit quality has deteriorated. As a result, some 

industry participants said that regional banks may be forgoing mergers 

with each other to avoid being classified as core banks that would have to

adopt the advanced approaches. 

Potential Impact of New Rules 

on Mergers and Acquisitions Is 

Uncertain 

Page 38 GAO-08-953 Risk-Based Capital
Many factors have affected the pace of Basel II implementation in the 

United States, and while the gradual implementation is allowing regulators 

to consider changes in the rules and reassess banks’ risk-management 

systems, regulators have not yet addressed some areas of uncertainty that

could have competitive implications. The final rule provides regulators 

with considerable flexibility and leaves open questions about which banks 

will be exempted from the advanced approaches. Without such 

clarification, core banks may expend greater resources to prepare for 

implementation than otherwise would be necessary. In addition, 

opportunities for regulatory arbitrage exist if regulators use different 

standards for exemptions. Regulators also have not fully developed plans 

for a required study of the impacts of Basel II implementation. Lack of 

development or specificity in criteria, scope, methodology, and timing will 

affect the quality and extent of information that regulators would use to 

help address competitive and other effects and make future changes in the

rules. 

The financial market turmoil that began in the subprime housing market in

2007 accounts, in part, for banks’ delaying implementation of the Basel II 

advanced approaches. In part, because the economy had been

experiencing benign conditions, in 2005, U.S. regulators had estimated in 

QIS-4—a study of the potential impact of Basel II as then proposed—that 

minimum capital requirements for credit risk would fall once Basel II was 

fully implemented. And, according to the head of one of the regulatory 

agencies, many were impatient with a gradual approach to implementing 

Basel II at that time. Now that credit markets are experiencing turmoil, 

some bank officials and regulators told us that banks will implement Basel 

II more slowly. 

Bank Regulators Have 

Taken Limited 

Actions to Address 

Additional 

Competitive Effects 

of Basel II 

Implementation on 

U.S. Banking 

Organizations 

A Number of Factors Have 

Affected the Pace of Basel 

II Implementation, 

Including Market Turmoil 

As a result of the current financial turmoil, regulators have been

considering modifications in the advanced approaches to Basel II and are 

assessing banks’ risk management systems. The Basel Committee has been

reviewing certain aspects of the capital framework including the treatment

of securitizations, greater specification of scenario testing in Pillar 2, and 

the treatment of credit risk charges for trading assets.37 The Basel 

Committee is also considering principles for sound risk management and 

supervision related to liquidity risk and issued a consultative document on

 37Basel Committee, Proposed Revisions to the Basel II Market Risk Framework (Basel, 

Switzerland: July 2008). 

Page 39 GAO-08-953 Risk-Based Capital
this issue in June 2008.38 U.S. regulators have noted that the gradual 

implementation of Basel II in the United States is allowing them to better 

understand how the rules might need to be adapted or implemented in the 

changed financial climate. Regulators have also been speaking to bankers 

in a number of forums on the need to improve risk management practices

in relation to Basel II. 

Gradual implementation is also built into the advanced approaches. (See 

app. III for an illustration of the timeline for the development and 

implementation of the advanced approaches.) As noted earlier, the 

advanced approaches rule took effect on April 1, 2008. Core banks 

generally must adopt an implementation plan approved by the bank’s 

board of directors by October 1, 2008, but do not actually have to begin the 

four intermediate phases that lead to full implementation of Basel II until 

April 1, 2010. If banks begin then and each of the four intermediate phases

takes a year, they would then be ready to fully adopt Basel II by April 1, 

2014. At the time the rule took effect, banks could start their parallel run, 

the first of the four intermediate phases, at the beginning of any quarter 

ranging from the second quarter of 2008 to the second quarter of 2010. 

The 2007 decision to offer non-core banks an option to adopt the 

standardized approach also has affected the pace of implementation in the 

United States. As a result of comments received on NPRs related to Basel 

II in 2006, U.S. regulators decided to offer non-core U.S. banking 

institutions the option of a standardized approach. Regulators issued the 

NPR in July 2008 but are uncertain as to when they will issue a final rule. 

In addition, the new NPR again asks the question of whether core banks 

should be permitted to adopt the standardized approach rather than 

advanced approaches creating uncertainties that will be discussed later. 

Some Uncertainties about 

Basel II Implementation 

Remain to Be Addressed 

A primary goal of federal bank regulators is to promote the safety and 

soundness of the banking institutions they oversee. To fulfill this obligation,

bank regulators must have the authority and flexibility to take actions to

achieve this objective. The Federal Reserve and OCC have taken a number of

steps to help ensure that Basel II is implemented consistently across the 

banking organizations they supervise and regulators have issued some joint 

statements and guidance to address some of the remaining uncertainty for 

 38Basel Committee, Principles for Sound Liquidity Risk Management and Supervision

(Basel, Switzerland: June 2008). Liquidity risk is 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. 

Page 40 GAO-08-953 Risk-Based Capital
banks. Nonetheless, the flexibility afforded by the rule for the advanced

approaches could lead to inconsistent application of the rules, which could, in

turn, produce competitive differences among the banks or provide 

opportunities for regulatory arbitrage.

A certain amount of flexibility for primary bank supervisors and related 

uncertainty for banks is necessary for maintaining the safety and 

soundness of the banking system. Under the final rule for the advanced 

approaches, regulators can respond to new or unforeseen situations that 

pose risks to safety and soundness without having to first change the rule. 

The rule reserves the authority of primary federal bank regulators to 

require that banks hold an amount of capital greater than the minimums 

dictated by the rule. This authority is being maintained both in the 

application of Pillar 1, where regulators can require that a bank calculate 

required capital in ways that recognize the individual situation of that 

institution and in Pillar 2, which by its very nature promotes supervision 

that uniquely addresses the situations of specific banks, while following 

general principles. For example, under the advanced approaches, 

regulators can generally allow U.S.-based banks with foreign subsidiaries 

to use a different retail definition of default for subsidiaries in foreign 

countries unless the primary supervisor determines that the banking 

organization is using the differences in the definitions of default to engage 

in regulatory arbitrage. 

The Final Rule for the 

Advanced Approaches Allows 

Regulators to Exercise Some 

Regulatory Flexibility 

Given the provisions for primary federal regulators to exercise their 

judgment during the implementation of Basel II, the Federal Reserve and 

OCC, which oversee all but one of the banks that meet the asset size and 

foreign exposure criteria for core banks, have taken a number of steps to 

help ensure that Basel II is implemented consistently within and across the 

banking organizations they supervise. As we have noted in a previous 

report, the Federal Reserve has been aware that its decentralized structure 

could lead to inconsistent supervisory treatment of large banks it oversees

and had developed some procedures to limit these differences.39 These 

procedures include having a management group, which consists of 

officials from the Federal Reserve Board of Governors and Federal 

Reserve District Banks, provide additional review of supervisory plans and

findings for large, complex banks. They have been relying on this process 

to help ensure consistency in the application of Basel II. OCC also has 

been taking actions to help ensure that examiners will implement Basel II 

in an equitable manner across the banks it supervises. Heretofore, the 

 39See GAO-07-154. 

Page 41 GAO-08-953 Risk-Based Capital
OCC examination process permitted lead examiners to provide 

information to banks without obtaining specific input from headquarters 

staff; however, OCC has been requiring that information about Basel II be 

raised to higher levels and that some of the same personnel be involved in

Basel-related examinations across banks. These two agencies also have 

taken a number of actions to ensure consistent application of Basel II 

across the agencies. For example, Federal Reserve and OCC examiners 

have conducted joint examinations to look at how banks are implementing 

some processes related to the advanced approaches. 

The other two primary bank regulators—OTS and FDIC—which oversee 

fewer core banks, have also participated in activities related to ensuring 

consistency in the implementation of Basel II. OTS is the primary regulator 

for the only thrift that meets the definition of a core bank on its own and is 

thus interested in ensuring that its processes for that bank are consistent 

with those of the other regulators overseeing similar institutions. OTS and 

FDIC oversee a number of depository institutions that have been identified

as core banks because they are subsidiaries of U.S.-based banks that meet 

the asset size and foreign exposure criteria for core banks, and FDIC also 

oversees subsidiaries of foreign-based banks that may adopt the advanced 

approaches. Officials at both agencies said that they are active in Basel 

Committee activities and that they played a role in the Federal Reserve 

and OCC’s joint examination of credit risk. In addition, according to some 

of the regulators, all four primary regulators have participated in joint 

examinations of operational risk across some of the core banks. 

Regulators have taken actions to reduce uncertainty by jointly providing 

some clarifying information about certain aspects of the capital rules. For 

example, during the development of the advanced approaches rule the 

regulators issued proposed guidance and interagency statements that 

helped to clarify certain aspects of the rules and, beginning in July 2008, 

updated some of these to reflect the final rule. They updated the 

interagency statement on the qualification process that had first been 

issued in 2005, following the Basel Committee’s issuance of the New Basel 

Accord. They also issued updated supervisory guidance for Pillar 2 that 

had been proposed initially in February 2007 to provide banks with more 

detail on the NPR for the advanced approaches. Regulators and examiners 

at one agency said that, in their view, it is not necessary to update the 

guidance on Pillar 1 that had been issued under the NPR because of the 

time and care that went into crafting the extensive and detailed preamble 

that accompanied the advanced approaches rule. Nonetheless, officials at 

many of the core banks with whom we spoke said that the lack of 

additional or updated guidance, including the standards by which 

examiners will judge the banks’ compliance, had been a problem for them. 

Regulators Have Taken Some 

Actions to Reduce Uncertainty 

but Have Not Clarified Which 

Banks They Will Exempt from 

the Advanced Approaches 

Page 42 GAO-08-953 Risk-Based Capital
Regulators may provide additional joint information to banks and 

examiners based on the questions they have received from banks since the 

advanced approaches rule was issued. Regulators told us they are 

considering providing this information in a question and answer format on 

their Web sites. In addition, each of the regulators will be providing 

separate guidance for its examiners to determine whether the banks they 

oversee are complying with the rule. 

Regulators said they do not intend to issue any joint guidance for the 

proposed standardized approach rule while it is out for comment or when 

a final rule is issued beyond information provided in a preamble. However, 

to ensure that non-core banks are not disadvantaged by core banks 

moving onto the advanced approaches, regulators have said they are 

planning to issue the standardized approach rule before core banks move 

into the first transitional period for the advanced approaches. Timely 

issuance of the final rule and any clarifying information will help to ensure 

that non-core banks have adequate information on which to base decisions 

about which capital regime—advanced approaches, standardized 

approach, or Basel I—will be best for them. 

While some flexibility is necessary and regulators have taken some steps to 

ensure greater consistency in the implementation of the rules, there are

actions the regulators could take to further reduce banks’ uncertainty about

Basel II without necessarily jeopardizing the safety and soundness of the 

banking system. One area where uncertainty could be reduced is in clarifying

which core banking institutions would be exempt from the application of the 

advanced approaches rule. The rule allows for exempting any core bank—a 

bank that meets the size or foreign exposure criteria for core banks or a 

depository institution that is a core bank because it is a subsidiary of a core 

bank that meets those criteria. Although the rule outlines a mechanism for

certain banks to be exempted and provides some broad factors regulators will 

use in making these determinations (asset size, level of complexity, risk 

profile, or scope of operation), the regulators have not been specific in the 

current rule about whether they will grant these exemptions and under what

circumstances. The regulators have said that they will not grant many 

exemptions and did not specify these exemptions because they believe it is

important for them to retain supervisory flexibility as they move forward with

implementation of the final rule. As such, they said each decision is to be

made on a case-by-case basis. 

Throughout the development of the rules, regulators had introduced 

uncertainty about the extent to which foreign-based banks with 

subsidiaries that are U.S. bank holding companies will be subject to the 

advanced rules in the United States and the current rule continues to 

Page 43 GAO-08-953 Risk-Based Capital
provide the Federal Reserve, the regulator of bank holding companies, 

considerable flexibility in making these decisions. The Federal Reserve 

has not answered the question of which specific bank holding companies

that are subsidiaries of foreign-based banks and qualify as U.S. core banks-

—they have assets of $250 billion or greater—will be exempted from using 

the advanced approaches in the United States. When the advanced 

approaches NPR was issued in 2006, some foreign-based institutions with 

large bank holding companies in the United States but relatively small 

depository institutions were surprised to find that they would be treated as 

core banks in the United States. The final rule acknowledged the concerns

of those institutions and noted that the Federal Reserve may exempt them, 

but it does not make it clear that they will be exempt. Because the Federal 

Reserve, the regulator of bank holding companies, has not issued more 

specific criteria or guidance for reviewing requests for exemptions, these 

banks (at least one bank has requested an exemption) may have to devote

resources to complying with the U.S. final rule until they receive an 

answer on whether they will be exempted. On the other hand, while only 

one banking organization is affected, the rule specifically exempts bank 

holding companies with significant insurance underwriting operations that 

otherwise would meet the requirements to be a core bank. 

Similarly, the rule states that regulators will consider the same factors—

asset size, level of complexity, risk profile, and scope of operations—in 

making a determination as to whether depository institutions that are

subsidiaries of U.S. core banks can be exempted. As a result, institutions 

have little guidance concerning the likelihood that some of their depository

institutions will be exempt and will need to prepare for a full

implementation of the advanced approaches in each entity until they receive

a response from their regulator on whether they will be exempted. 

Moreover, because the factors are so broad, if different regulators use 

different specific criteria to exempt entities, they may set up the potential

for regulatory arbitrage. For example, a U.S. banking organization could 

hold higher-risk assets in subsidiary banks that are exempt and remain on 

Basel I and could hold lower-risk assets in subsidiary banks that are not 

exempt from the advanced approaches. And banks that do not currently

have a structure that would allow them to reduce capital in this way could 

change their structure accordingly by acquiring or changing bank charters. 

The overall result could be lower capital held in the bank or resources being

devoted to reducing capital that do not properly align capital with risk. 

However, officials from the Federal Reserve noted that regardless of the 

structure of the bank, at the holding company level, all material bank assets 

would be consolidated and subject to the advanced approaches rule. 

Page 44 GAO-08-953 Risk-Based Capital
This continuing uncertainty could make it difficult for banking organizations

to pursue the most cost-effective route to complying with Basel II and could 

create more risk for the banks at a time when risks are already high because

of the turmoil in financial markets. For example, some industry participants 

told us that those parts of Basel II that do not improve risk management

divert resources that banks otherwise would use to better manage risk. In 

addition, resources devoted to circumventing certain aspects of the rule

through regulatory arbitrage will divert the attention of bank officials from 

improving banks’ risk-management systems. 

Finally, the uncertainty over which banking institutions ultimately will have to

adopt the advanced approaches continues because the advanced approaches 

rule says all core banks will be required to adopt detailed implementation plans 

for the complex advanced approaches by October 1, 2008, and the proposed 

standardized approach rule, which will not be finalized by that time, contains a 

question about whether and to what extent core banks should be allowed to 

use the simpler proposed standardized approach. The advanced approaches 

rule generally requires core banks to comply with the advanced approaches 

and adopt an implementation plan no later than October 1, 2008. Under this 

rule, the Federal Reserve can exempt bank holding companies from meeting 

the requirements of the final rule for the advanced approaches and primary 

federal regulators can exempt depository institutions that meet the definition of 

a core bank from the advanced approaches requirements. Given the authority

of the primary federal regulator, once the standardized approach rule is 

finalized, those regulators would be able to require that exempt banking 

organizations adopt that approach. However, the proposed standardized 

approach rule, which will not be finalized by the time the core banks must 

adopt their implementation plans, asks whether core banks should be allowed 

to use the standardized approach instead of the advanced approaches. 

In the press release accompanying the proposed standardized approach rule,

the FDIC Chairman stated, “Given the turbulence in the credit markets, I take 

some comfort with the fixed risk weights established under the standardized

approach as they provide supervisors with some control over unconstrained

reductions in risk-based capital.” However, the interagency statement on U.S. 

implementation of the advanced approaches issued in July 2008, stressed the 

existing timelines for the advanced approaches. The continued discussion on

whether core banks should be exempt from the advanced approaches and

permitted to adopt the standardized approach indicates that the primary

federal regulators continue to have questions about whether the advanced

approaches are the best risk-based capital requirements for core banks. Thus, 

it is difficult to tell whether the regulators have found a solution to difficulties 

that resulted from the differing perspectives they brought to negotiations 

during the development of the advanced approaches. We recommended in 

Page 45 GAO-08-953 Risk-Based Capital
our February 2007 report on Basel II that regulators take actions to jointly 

specify the criteria they will use to judge the attainment of their goals for 

Basel II implementation and for determining its effectiveness for regulatory

capital-setting purposes. We noted that without clarification on the criteria to

evaluate or make changes in the Basel II rules, the implementation will

continue to generate questions about the adequacy of the framework. 

Plans for Studying the 

Competitive Impacts of the 

Final Rules Have Not Been 

Fully Developed 

The regulators have not fully developed plans for an interagency study that

is to assess implementation and provide the information to form the basis 

for allowing banks to fully transition to Basel II. Partly in response to 

recommendations we made in 2007, the final rule says that the regulators 

will issue annual reports during the transitional period and conduct a 

study of the advanced approaches after the second transitional period. 

According to the rule, the annual reports are to provide timely and 

relevant information on the implementation of the advanced approaches. 

The interagency study is to be conducted to determine if there are material

deficiencies in the advanced approaches and whether banks will be 

permitted to fully transition to Basel II. In its regulatory impact analysis, 

OCC said that the regulators will consider any egregious competitive 

effects associated with implementation of Basel II, whether domestic or 

international in context, to be a material deficiency. 

Among the items the rule specifies that the study will cover, several are 

important first steps in studying the competitive effects of the rule. These 

include 

• the level of minimum required regulatory capital under U.S. advanced 

approaches compared to the capital required by other international and 

domestic regulatory capital standards; 

• comparisons among peer core banks of minimum regulatory capital 

requirements; 

• the processes banks use to develop and assess risk parameters and 

advanced systems, and supervisory assessments of their accuracy and

reliability; and 

• changes in portfolio composition or business mix.40

 40Under the final rule, other issues that regulators will consider as part of the study are: the 

potential cyclical implications of the rule; comparison of regulatory capital requirements to

market-based measures of capital adequacy, such as risk premiums on subordinated debt;

examination of robustness of risk management processes related to capital adequacy; and 

analysis of interest rate and concentration risks. 

Page 46 GAO-08-953 Risk-Based Capital
Some of these steps are similar to the calculations the regulators 

performed as part of QIS-4. The advantage of the future study over QIS-4 is 

that it will be based on actual data provided by banks whose risk 

management and data systems have been reviewed by regulators as part of 

the approval process for banks to enter the first two transitional periods. 

In addition, one regulator noted that the study will also benefit from the 

stresses of the recent market turmoil. This study should allow the 

regulators to determine the extent to which total regulatory capital 

changes in the short run, the specific behavior in which banks engage to 

comply with some aspects of the rule, and how the rule affects the capital

of different banks. 

However, plans for the study do not address a number of factors including the 

establishment of shared overall goals and criteria for Basel II that will help 

delineate the study’s scope, methodology, and timing. For example, while 

OCC in its impact study said that the evaluation of competitive impacts will 

be an important part of the study, the rule does not specify how this will be

measured and the scope and methodology of the study are not clearly 

designed to achieve this objective. Because regulators design the study to

evaluate Basel II in light of clearly specified overall objectives or criteria for 

Basel II, it will be difficult to jointly determine the extent to which the rules

need to be modified or whether implementation of Basel II should proceed. If 

some regulators object to the full implementation of Basel II while others do

not, the rule specifies that a regulator can permit the banking organizations

for which it is the primary federal regulator to move forward with the 

advanced approaches if it first provides a public report explaining its

reasoning. However, such an outcome would not provide confidence in the 

current regulatory system and could allow for regulatory arbitrage.

Further, the scope of the study has not been well defined. While the study 

contemplates calculations of capital using the standardized approach, 

Basel I, and other international rules as well as the actual data on the 

banks following the advanced approaches, regulators have not said that 

they plan to collect comparable data on financial entities not adopting 

these approaches—specifically, those banking institutions that will adopt

the standardized approach or remain on Basel I. In addition, the regulators

have not explicitly included the CSEs in the study. The effectiveness of the 

study will be limited if the CSEs are not included because information on a 

major segment of competitors of core banks that has had significant 

experience with some aspects of the advanced approaches will have been 

excluded. The agreement signed on July 7, 2008, between the Federal 

Reserve and SEC regarding coordination and information sharing in areas

of common regulatory interest should facilitate the inclusion of the CSEs 

in any study of the advanced approaches. Finally, the regulators have 

Page 47 GAO-08-953 Risk-Based Capital
conducted little research on international differences that could have 

competitive effects in the past, and the study’s design does not explicitly

include research on international differences that could have competitive

effects. However, since U.S. regulators participate in the Capital 

Monitoring Group, Accord Implementation Group, and other similar 

groups, they will have some perspective on Basel II implementation in the 

other countries in that group including some European Union countries 

and Canada that they will be able to use for this purpose. OCC officials 

explained that the Capital Monitoring Group will collect and analyze 

information on the implementation of Basel II in other countries and 

suggested that this information will inform the U.S. study. In addition, 

some U.S. regulators noted that the study outlined in the rule will not 

preclude them from looking at a broad range of data. 

The methodology the study will use to evaluate competitive impacts 

initially is not fully developed, although from a methodological perspective 

Basel II affords an opportunity to consider the impacts of regulatory 

capital on bank behaviors and among groups of banks adopting different

requirements at different times. While the measurements and comparisons 

envisioned for the study are a necessary first step for evaluating 

competitive impacts among the core banks and between the core banks 

and other groups, they do not take full advantage of the opportunities to 

better understand the impact of regulatory capital on a range of bank 

behavior. Because banks in the United States and around the world are 

adopting a range of capital requirements at different times, Basel II affords 

a unique opportunity to consider whether event studies could contribute 

to a better understanding of the impact of regulatory capital on a variety of 

bank behaviors. While regulators at OCC noted that with banks on 

different capital regimes, academics and other researchers, including 

those at the regulatory agencies, will have data available to study the 

impact of regulatory capital on bank behavior, they said that they had not 

thoroughly considered the use of event studies as part of the study 

planned by the regulators. Because regulators have not clearly specified 

how they will evaluate the competitive impacts of Basel II, there is an 

increased likelihood that the kinds of data needed to complete an effective 

study will not be available. 

In addition, the advanced approaches rule does not specify a methodology for 

the study to analyze the extent to which the new rules provide opportunities for 

regulatory arbitrage that could limit the effectiveness of the rules in promoting 

improved risk management throughout the banking system. Several industry 

participants noted that having multiple capital requirements with different 

levels of risk sensitivity provides incentives for core banks to hold less risky 

assets and leave more risky assets in banks using the standardized approach or

Page 48 GAO-08-953 Risk-Based Capital
Basel I. Higher risk-based capital requirements for high-risk assets at core 

banks may increase their cost of holding these assets. Greater costs would 

reduce the supply of credit for these types of loans, and thus returns would 

increase. As a result, banks with less risk-sensitive capital requirements under 

Basel I or the standardized approach might find some higher risk credits more 

attractive at these higher rates of return. (As illustrated earlier in fig. 2, there 

may be different amounts of capital required for the same asset across the 

different risk-based rules.) Officials at one regulatory agency said that all of the 

regulators were aware of this potential outcome and planned to look at changes 

in the portfolios of core banks in the study. Further, for non-core banks, 

regulators at another agency said they would become aware of non-core banks 

increasing their holdings of high-risk assets through their normal oversight 

duties. However, the advanced approaches rule does not specify how the study 

would more fully explore this potentially important outcome of the new rules. 

If this arbitrage took place, the rules could require less capital overall in the 

banking system and would leave banks with the least well-developed risk 

management systems with the riskiest assets, thus exposing the U.S. banking 

system to greater systemic risk. 

Finally, the timing of the study is unclear. The rule specifies that the study 

will be published after the second transitional period, but core banks 

could begin the four intermediate phases required for full implementation 

in 2008, 2009, or 2010 and different banks (as well as different types of 

banks) could enter the second transitional period in different years. The 

phased implementation produces uncertainty about timing and could 

throw into question how many banks will be included in the study, and 

whether the results of the study will provide relevant information for all of 

the banks. For example, if the banks in the second transitional period in 

2011 are primarily retail banks, the results are not likely to be applicable 

for the custodial banks, or vice versa. As a result of this and other factors 

discussed, the use of the study for taking actions that would improve risk 

management or reduce competitive concerns may be limited. 

Some regulators told us that they have not yet focused on plans for the 

study, in part, because it is early in the Basel II implementation process 

and they and the banks they supervise have been dealing with the financial 

turmoil. In addition, some regulators said that the language and factors 

laid out in the final rule should be viewed as a starting point, and officials

at one regulatory agency said that the study will benefit from the data that 

will be available from the financial turmoil in the world’s credit markets. 

A global effort is underway to implement the New Basel Accord, which 

aims to improve the risk-management practices of banks, in part, by Conclusions 

Page 49 GAO-08-953 Risk-Based Capital
aligning the capital banks hold more closely with the risks they face. 

Capital’s role becomes more important in periods of economic uncertainty

because banks rely on capital to weather unexpected losses. Although the 

impact of regulatory capital on a bank’s ability to compete is not always 

obvious because banks often hold more than their minimum required 

capital, regulatory capital is one of many factors that affects competition. 

And, the adoption of Basel II in the United States has raised concerns 

about competitive effects it could have on banks of varying sizes and in 

various locations. In addition, regulators have made clear that in light of 

the current market turmoil further revisions will be made in Basel II. 

Uncertainty about how to implement Basel II, to whom the rules will 

apply, and the effects the rules will have may lead banks to devote 

resources to information gathering and implementation that could 

otherwise be dedicated to improving risk management or other purposes. 

In our 2007 report, we noted that the rulemaking process for Basel II could 

benefit from increased transparency to respond to broader questions and 

concerns about transitioning to Basel II in the United States. The 

regulators referred to the recommendation in the advanced approaches 

rule and, with that rule and the proposed standardized approach rule, they 

have provided greater clarity about some aspects of Basel II. We recognize 

that the time table for Basel II implementation in the United States has 

slowed since we issued our earlier report and that both the regulators and 

the banks have been dealing with the market turmoil that began in mid2007. This gradual implementation is allowing bank regulators to reassess 

banks’ risk-management systems and consider changes in the rules before

any banks begin their Basel II implementation. As part of this preparation 

period, regulators have taken and are planning some actions to reduce 

uncertainty, but could take further actions to address remaining 

uncertainties about the implementation of the rules and facilitate banks’ 

planning and preparation for their implementation of a new capital regime. 

Regulators have taken actions to reduce some of the uncertainty 

surrounding implementation of Basel II by providing information to aid 

examiners and banks in interpreting the rules. Regulators have updated

some publicly available information on the process they will use to qualify 

banks for the advanced approaches and examine them under Pillar 2. 

Regulators have also engaged in discussions among themselves 

concerning posting additional information in a question and answer format 

on their Web sites. The timely issuance of additional information on the 

advanced approaches and a final standardized approach rule, which is in

process, will enable banks to best prepare to meet the new risk-based 

capital requirements and will help to ensure regulatory consistency across 

the banks. As a result, we encourage the regulators to continue providing 

Page 50 GAO-08-953 Risk-Based Capital
joint information in a timely manner on both the advanced and 

standardized approaches. 

We recognize that regulators have taken steps to reduce some uncertainties

related to Basel II; however, the regulators could take additional steps to 

address uncertainties that are not related to their need for flexibility to

respond to innovation in the industry and to unintended consequences that 

the rules may have. For example, in the final rule, the regulators did not

specify which banks technically met the definition of core banks. Although,

the rule specifically says that certain banks may be exempted by their primary 

regulator from the advanced approaches requirements, it does not provide 

well-defined criteria for evaluating requests for exemptions. Because this

clarity has not been provided and specific criteria have not been laid out, 

regulators may not provide exemptions in a consistent manner. The issuance 

of more specific guidance on which banks will be exempt from applying the 

advanced approaches would provide clarity and enable banks to plan

accordingly. Also, the question in the NPR for the standardized approach

about whether core banks should be able to use the proposed standardized

approach indicates that the primary federal regulators continue to have

questions about whether the advanced approaches are the best risk-based

capital requirements for core banks. Regulatory differences on these issues 

can lead to increased costs for the banks, inefficiencies for their regulators, 

and may weaken the overall effectiveness of the regulatory system by

creating opportunities for banks to engage in regulatory arbitrage. 

In our 2007 report, we recommended that regulators issue public 

reports on the progress and results of implementation efforts and that 

this reporting should include an articulation of the criteria by which 

they would assess the success of Basel II. While the regulators have 

proposed a study of the core banks after the second transitional year 

of the implementation of the advanced approaches, they have not yet 

developed the criteria on which to base the study’s design and 

objectives. These are needed for a determination of whether Basel II 

is effective for regulatory capital-setting purposes and whether to 

ultimately allow banks to move past the third transitional period to 

full Basel II implementation. As delineated in the advanced 

approaches rule, the study will measure the changes in capital and 

portfolios held by the core banks and will look at the differences in 

required capital for these banks if they were under the standardized 

approach rule or Basel I—necessary steps for evaluating the 

competitive impact of Basel II—but it does not explicitly describe 

components needed to determine if there are material deficiencies in 

the rule or for regulators to reach agreement on whether banks should 

be permitted to fully implement the advanced approaches. However, 

Page 51 GAO-08-953 Risk-Based Capital
the gradual implementation of the advanced approaches in the United

States affords regulators time to jointly establish criteria for 

evaluating Basel II and to fully develop a study that flows from those 

criteria—including (1) a broad enough scope—inclusion of non-core 

banks, CSEs, and foreign-based banks—to capture competitive 

effects; (2) consideration of a number of methodologies; and (3) the 

resolution of the timing issue. Such actions would help the regulators 

make better-informed decisions on an interagency basis about 

whether changes to the rules were necessary and whether to permit 

banks to fully implement Basel II. Without these criteria, it will be 

difficult for regulators to make these judgments and provide 

consistent guidance for banks. 

We are making two recommendations to the heads of the FDIC, Federal 

Reserve, OCC, and OTS: 

To further limit any potential negative effects, where possible, regulators 

should move to minimize the uncertainty surrounding certain aspects of 

Basel II. Specifically, regulators should clarify how they will use certain 

regulatory flexibility under the advanced approaches rule, particularly 

with regard to how they will exercise exemptions for core banks from the

advanced approaches requirement and the extent to which core banks will 

be allowed to adopt the standardized approach.

To improve the understanding of potential competitive effects of the new 

capital framework, the regulators should take steps jointly to plan for the 

study to determine if major changes need to be made to the advanced 

approaches or whether banks will be able to fully implement the current 

rule. In their planning, they should consider such issues as the objectives, 

scope, methodology, and timing needs for the future evaluation of Basel II. 

The plan should include how the regulators will evaluate competitive 

differences between core and non-core banks in the United States, 

between core banks and CSEs, and between U.S.-based banks and banks 

based in other countries.

We provided the heads of the Federal Reserve, FDIC, OCC, OTS, SEC, and 

Department of the Treasury with a draft of this report for their review and 

comment. We received written comments from the banking regulators in a

joint letter. These comments are summarized below and reprinted in 

appendix IV. The banking regulators also provided technical comments 

that we incorporated in the report where appropriate. We did not receive 

comments from SEC or the Department of the Treasury. 

Recommendations for 

Executive Action 

Agency Comments 

and Our Evaluation 

Page 52 GAO-08-953 Risk-Based Capital
In their letter, the banking regulators strongly endorsed our opening 

statement that ensuring that banks maintain adequate capital is essential to 

the safety and soundness of the banking system and said that it is this 

overarching objective that will guide their efforts and has led them to include

additional prudential safeguards in their implementation of the Basel II rules.

In a somewhat related matter, the regulators said that the report emphasizes 

the cost to banks of holding capital but did not discuss how a bank’s strong

capital base confers competitive strength and create strategic opportunities.

While we describe some of the costs to banks of holding additional capital 

because this is an important channel through which the new capital rules

could affect the competitiveness of U.S. banking organizations, we also note

that more capital reassures creditors and reduces the cost of borrowing. In 

addition, as noted in the draft, banks hold capital for this and other reasons 

including the ability to take advantage of strategic opportunities such as 

acquiring other banking institutions. 

As we detailed in the draft, the banking regulators highlighted the actions

they have taken to address many of the concerns that bankers and others 

have raised about the potential competitive equity effects of the 

implementation of Basel II and said that they are in general agreement 

with our recommendations. Specifically, they said that they will work 

together to resolve, at the earliest possible time, the question posed for 

comment in the proposed standardized approach rule regarding whether 

and to what extent core banks should be able to use the standardized 

approach. With regard to clarifying how they will decide whether to grant 

requests from core banks to be exempt from the requirement to adopt the 

advanced approaches, the regulators said they will assess each exemption 

request in light of the specific facts and circumstances applicable to the 

institution seeking the exemption and that they have already commenced 

discussions to ensure a clear and consistent interpretation of these 

provisions is conveyed to U.S. banks. 

Regarding the need to jointly plan the required study, the regulators 

commented that they will work together to develop “plans for the required

study of the impact of the advanced approaches of Basel II.” Specifically, they

said that they will begin to develop more formal plans for the study once they 

had “a firmer picture of banks’ implementation plans” but noted the 

difficulties concerning drawing definitive conclusions about the effects of

changes in regulatory capital rules. They also said that they would consider 

including in their analysis the potential competitive effects with CSEs and

foreign banks as we recommended. While we are encouraged by the 

regulators’ recognition of the need for more formal plans and consideration of

the scope of the study to include CSEs and foreign banks, we noted a number

of additional factors that also should be considered, such as developing

Page 53 GAO-08-953 Risk-Based Capital
criteria that will help them determine whether there are material deficiencies

that can be attributed to the new rules and what changes, if any, could 

address those deficiencies. Finally, because Basel II affords an opportunity to

consider the impacts of regulatory capital on bank behaviors and among 

groups of banks adopting different requirements at different times, we noted 

in the draft that it is important that regulators consider a number of

methodologies for evaluating the new capital rules and potential competitive

effects to determine which are the most appropriate. 

As agreed with your offices, unless you publicly release its contents 

earlier, we plan no further distribution of this report until 30 days from its 

date of issue. At that time we will send copies of this report to interested 

congressional committees, the Chairman of the Board of Governors of the 

Federal Reserve System, Chairman of the Federal Deposit Insurance 

Corporation, the Comptroller of the Currency, the Director of the Office of

Thrift Supervision, the Chairman of the Securities and Exchange 

Commission, and the Secretary of the Treasury. We will also make copies 

available to others on request. In addition, the report will be available at 

no charge on GAO’s Web site at http://www.gao.gov. 

If you or your staff have any questions regarding this report, please 

contact me at (202) 512-8678 or williamso@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 V. 

Orice M. Williams 

Director, Financial Markets 

 and Community Investment

Page 54 GAO-08-953 Risk-Based Capital
Appendix I: Objectives, Scope, and 

Methodology 

Page 55 GAO-08-953 Risk-Based Capital

Appendix I: Objectives, Scope, and 

Methodology 

Our objectives in this report were to discuss (1) the nature of the 

competitive environment in which U.S. banking organizations compete, (2) 

the extent to which different capital requirements may have competitive 

impacts on U.S. banking organizations internationally and domestically, 

and (3) actions regulators could take to address competitive effects and 

other potential negative effects of the new capital rules during 

implementation. 

For all our objectives, we reviewed a variety of documents, including 

regulators’ statements; the international Basel II framework (entitled 

“International Convergence of Capital Measurement and Capital 

Standards: A Revised Framework”) and other documents from the Basel 

Committee, such as the 1988 Basel Capital Accord (Basel I); the Basel II, 

Basel 1A, and Standardized Approach Notices of Proposed Rulemaking 

(NPR) and the final rule on the advanced approaches; supervisory 

guidance; academic articles, and our previous reports on banking 

regulation. 1 We interviewed senior supervisory officials at the Board of 

Governors of the Federal Reserve System and Federal Reserve Banks of 

Boston, New York, and Richmond (Federal Reserve), Office of 

Management and Budget, Office of the Comptroller of the Currency 

(OCC), Federal Deposit Insurance Corporation (FDIC), Office of Thrift 

Supervision (OTS), Securities and Exchange Commission, and Department 

of the Treasury. We also interviewed officials from the Accord 

Implementation Group, several foreign banking regulatory agencies, 

domestic, international, and foreign trade associations, credit rating 

agencies, and several academics and consultants with banking expertise. 

In addition, we interviewed officials from all of the core banks and other

banks, both foreign and domestic, with operations in the United States. 

Finally, we attended several conferences held by regulators and trade 

associations that included discussions related to Basel II. 

To describe the competitive environment in which U.S. banks operate, we 

collected data from several sources to illustrate which types and sizes of 

banks are active in which kinds of products. We used data from the 

Federal Reserve’s Structure and Share Data for U.S. Banking Offices of 

Foreign Entities, and Consolidated Financial Statements for Bank Holding 

Companies (i.e., FR Y-9C). These data include the amount of assets in 

particular products that bank holding companies hold on and off of their 

balance sheets. For banks and thrifts that do not report assets in particular 

 1

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

(Basel IA NPR); 72 Fed. Reg. 69288 (Dec. 7, 2007) (final rule on advanced approaches); and 

73 Fed. Reg. 43982 (July 29, 2008) (proposed standardized rule). 
Appendix I: Objectives, Scope, and 

Methodology 

products at the consolidated level to their regulator, we used data on 

banks and thrifts in the Federal Financial Institutions Examination 

Council’s (FFIEC) Consolidated Reports of Condition and Income (FFIEC 

031 or Call Report) and OTS’s Thrift Financial Reports, respectively. We 

also used data from FFIEC’s Country Exposure Lending Survey. 

To compare activities across banks of different sizes, we used data at the 

consolidated level because banks generally compete on an enterprisewide 

basis. For bank holding companies, we used data provided by the Federal 

Reserve. Almost all bank holding companies that have assets greater than

$500 million report assets in particular product categories on a 

consolidated basis to the Federal Reserve using the Y-9C form; however, a 

large proportion of those with assets under $500 million about 80 percent 

of the bank holding companies and a few larger bank holding companies 

do not report consolidated assets on a product basis to the Federal 

Reserve. We included these bank holding companies that have few assets 

outside their chartered commercial banks in our analysis, by having staff 

at the Federal Reserve group the commercial banks by bank holding 

company and sum the assets reported in the Call Reports accordingly. 

Thrift holding companies do not report data on assets by product category 

to OTS on a consolidated basis. Because thrift holding companies are 

often engaged in a wide variety of activities outside of banking, we could 

not rely on the thrift financial report data on individual thrifts to 

approximate the holding company for some thrifts as we did in the case of 

some bank holding companies. However, we were able to have OTS staff 

provide thrift financial report data that we used to approximate the thrift 

holding companies for those thrift companies primarily in banking. We did 

this by having OTS staff group the thrifts by holding company for those 

where thrifts make up 95 percent of the assets of the holding company and 

where they make up 75 percent of the assets of the holding company. The 

allocation of assets across product lines was substantially the same for 

these two categories, which allowed us to conclude that the data gave us a 

good approximation of differences between thrift holding companies that 

are primarily in the business of banking and bank holding companies. We 

concluded that they do differ in that thrifts that are engaged primarily in 

the business of banking hold a much larger percentage of their assets in 

residential mortgages than do bank holding companies across all size 

categories. To assess the reliability of these data, we talked with 

knowledgeable agency officials about the data and tested the data to 

identify obvious problems with completeness or accuracy. We determined 

the data were sufficiently reliable for the purposes of this report.

Page 56 GAO-08-953 Risk-Based Capital
Appendix I: Objectives, Scope, and 

Methodology 

To determine the extent to which different capital requirements may 

impact how various U.S. banking organizations compete, we reviewed the 

available academic literature on the role capital plays in bank competition. 

We also estimated minimum required capital for some assets under the 

advanced and standardized approaches for credit risk, Basel I, and 

leverage requirements, based on available information and data from the 

U.S. federal banking regulators’ fourth quantitative impact study (QIS-4) 

and Moody’s Investors Service. There are some limitations associated with 

the data from QIS-4. At the time, the regulators emphasized that QIS-4 was 

conducted on a “best efforts” basis without the benefit of either a 

definitive set of proposals or meaningful supervisory review of the 

institutions’ systems. We assessed the reliability of the data we used and 

found that, despite limitations, they were sufficiently reliable for our 

purposes. 

We conducted this performance audit from May 2007 to September 2008 in

Amsterdam, The Netherlands; Brussels, Belgium; Boston, Massachusetts; 

Chicago, Illinois; and Charlotte, North Carolina; London, United Kingdom; 

New York, New York; Toronto, Canada; and Washington, D.C., in 

accordance with generally accepted government auditing standards. Those 

standards require that we plan and perform the audit to obtain sufficient, 

appropriate evidence to provide a reasonable basis for our findings and 

conclusions based on our audit objectives. We believe that the evidence 

obtained provides a reasonable basis for our findings and conclusions 

based on our audit objectives. 

Page 57 GAO-08-953 Risk-Based Capital
Appendix

Approaches 

 II: Three Pillars of the Advanced

Page 58 GAO-08-953 Risk-Based Capital

Appendix II: Three Pillars of the Advanced 

Approaches 

Pillar 1 of the advanced approaches rule 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 available to and required for core banks 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 regulators: 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 “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 process 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 1 in 1,000 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 
Appendix II: Three Pillars of the Advanced

Approaches 

Figure 7: Computation of Wholesale and Retail Capital Requirements under the Advanced Internal Ratings-based Approach 

for Credit Risk 

( )

( )

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 -(LGDxPD) x N-1(PD)+ RxN-1(0.999)

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

1-1.5xb

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

Estimated by banks

Defined by regulators

Source: GAO analysis of information from the advanced approaches rule.

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. 

To determine minimum required capital for operational risk, banks will 

use their own quantitative models of operational risk that incorporate 

elements required in the advanced approaches rule. To qualify to use the 

advanced measurement approaches (AMA) for operational risk, a bank 

must have operational risk management processes, data and assessment 

Operational Risk 

Page 59 GAO-08-953 Risk-Based Capital
Appendix II: Three Pillars of the Advanced

Approaches 

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.

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

In previous work, regulatory officials generally said that changes to the 

rules for determining capital adequacy for market risk were relatively 

modest and not a significant overhaul. The regulators have described the

objectives of the new market risk rule as including enhancing the 

sensitivity of required capital to risks not adequately captured in the 

current methodologies of the rule and enhancing the modeling 

requirements consistent with advances in risk management since the 

implementation of the MRA. In particular, the rule contains an incremental 

default risk capital requirement to reflect the growth in traded credit 

products, such as credit default swaps, that carry some default risk as well 

as market risk. 

Pillar 2: Supervisory 

Review 

The Pillar 2 framework for supervisory review is intended to ensure that 

banks have adequate capital to support all risks, including those not 

addressed in Pillar 1, and to encourage banks to develop and use better 

risk management practices. Banks adopting Basel II must have a rigorous 

Page 60 GAO-08-953 Risk-Based Capital
Appendix II: Three Pillars of the Advanced

Approaches 

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. 

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 will collect, on a 

confidential basis, more detailed data supporting the capital calculations. 

Federal regulators would use this additional data, among other purposes, 

to assess the reasonableness and accuracy of a bank’s minimum capital 

requirements and to understand the causes behind changes in a bank’s 

risk-based capital requirements. Federal regulators have developed 

detailed reporting schedules to collect both public and confidential 

disclosure information. 

Pillar 3: Market Discipline in 

the Form of Increased 

Disclosure

Page 61 GAO-08-953 Risk-Based Capital
Appendix III: Basel II Timeline

Page 62 GAO-08-953 Risk-Based Capital

Appendix III: Basel II Timeline 

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.

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

regulation. The prompt corrective action provisions of FDICIA 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 the 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 

(New Basel 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 consecutive paper for comment.

Bank regulators—OCC, OTS, Federal Reserve, and FDIC (hereafter 

“regulators”)—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: Regulators release advance NPR 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.

2005 April: Regulators 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. Regulators later state that such results would be 

unacceptable in an actual capital regime.

January: Regulators issue interagency statement on qualification 

process for advanced approaches based on New Basel Accord.

September: Regulators announce 1-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: Regulators issue Basel IA advance NPR. 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.
Appendix III: Basel II Timeline

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

2007

2008

2009

2010

2011

2012

2013

2014

Core banks will be ready to implement advanced 

approaches (2012-2014 April)

Full implementation (first date available for Basel II)

Core banks will enter third transitional 

floor period (85% floor) (2011-2013)

Core banks will enter second transitional floor period (90% floor) and 

study to assess material deficiencies will be conducted (2010-2012)

Second transitional floor period (80% floor)

Core banks will enter first transitional floor period (95% floor) (2009-2011)

First transitional floor period (90% floor)

Core banks must begin 4 quarters for parallel run

(2008-2010 April)

Parallel run begins

June: EU 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.

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

December: Regulators issue advanced approaches rule.

July: Regulators issue NPR for optional standardized approach containing 

question on whether core banks should be able to choose this approach. 

Regulators issue updated guidance for supervisory review.

October: Last date for core banks to adopt implementation plan signed by board 

of directors.

Source: GAO.

July: Regulators agree to issue advanced approaches rule more consistent with 

New Basel Accord and to issue an NPR for an optional standardized approach.

February: Regulators issue proposed guidance for advanced approaches

and supervisory review.

September: Regulators 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: Regulators release NPR for Basel IA.

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.

Floor

applies to

individual

institution’s

capital

reduction.

Floor

applies to

individual

institution’s

capital

reduction.

2006

Page 63 GAO-08-953 Risk-Based Capital
Appendix IV: Comments from Federal 

Banking Regulators 

Page 64 GAO-08-953 Risk-Based Capital

Appendix IV: Comments from Federal 

Banking Regulators 
Appendix IV: Comments from Federal 

Banking Regulators 

Page 65 GAO-08-953 Risk-Based Capital
Appendix IV: Comments from Federal 

Banking Regulators 

Page 66 GAO-08-953 Risk-Based Capital
Appendix V: 

St

GAO Contact and 

aff Acknowledgments

Page 67 GAO-08-953 Risk-Based Capital

Appendix V: GAO Contact and Staff 

Acknowledgments 

Orice M. Williams (202) 512-8678 or williamso@gao.gov

In addition to the contact named above, Barbara I. Keller (Assistant 

Director), Nancy Barry, Emily Chalmers, Michael Hoffman, Joe Hunter, 

Robert Lee, Marc Molino, Carl Ramirez, Barbara Roesmann, Paul 

Thompson, and Mijo Vodopic made key contributions to this report. 

GAO Contact 

Staff 

Acknowledgments 
Related GAO Products 

Page 68 GAO-08-953 Risk-Based Capital

Related GAO Products 

Financial Market Regulation: Agencies Engaged in Consolidated 

Supervision Can Strengthen Performance Measurement and 

Collaboration. GAO-07-154. Washington, D.C.: March 15, 2007.

Risk-Based Capital: Bank Regulators Need to Improve Transparency and 

Overcome Impediments to Finalizing the Proposed Basel II Framework. 

GAO-07-253. Washington, D.C.: February 15, 2007.

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. 

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