FYI: An Update on Emerging Issues in Banking

Estimating the Capital Impact of Basel II in the United States

This FYI is a corrected version of the FYI of the same title originally issued December 

8, 2003. 

December 8, 2003 (revised August 5, 2004).1

This paper contains estimates of the capital impact of Basel II's advanced internalratings-based approach (A-IRB). We use 19 years of financial data from all FDICinsured commercial banks to develop a range of values for the key Basel II risk 

parameters that banks might be expected to use over time. This allows us to estimate 

average capital requirements under the A-IRB approach under a range of economic 

conditions. Our preliminary conclusions are:

• Contrary to descriptions of Basel II not significantly changing overall capital 

requirements, we expect large percentage reductions in risk-based capital 

requirements. 

• We believe that during most of a typical economic cycle, risk-based capital 

requirements for Basel II banks would be far below the levels needed for 

current Prompt Corrective Action (PCA) purposes. 

• Consequently, U.S. regulators will have to choose between ignoring the output 

of Basel II's formulas or significantly weakening the current PCA framework. 

• Extremely wide cyclical swings in capital requirements for wholesale lending 

are likely unless banks' risk inputs are actively managed by supervisors to an 

extent not currently contemplated. 

• Unless PCA is significantly weakened, the already wide disparity in core 

capital requirements between U.S. banks and other banks (Chart 1) will be 

widened. 

D

In addition, we have a less quantifiable public-policy concern about the wisdom of 

implementing the contemplated reductions in risk-based capital requirements for 1-4 

family mortgages. 
We discuss, at a purely conceptual level, options for changing the A-IRB framework to 

address our concerns. At their core, those changes would involve: i) implementing the 

concept of a "top down," minimum capital requirement within the international 

regulatory framework, and ii) identifying areas where the Accord could be made less 

prescriptive, in recognition of the added surety provided by that minimum requirement. 

We have a high degree of confidence that our conclusions are qualitatively correct, but 

recognize others may question specific aspects of our work. We have attempted to 

make the analysis in this paper sufficiently transparent that others may replicate and/or 

improve upon these estimates. In this regard, we intend to refine these estimates and 

regard this paper as the starting point of a work in progress. We look forward to a 

dialogue on these issues and are receptive to analyses that would shed light on the 

validity of our concerns. 

Methodology and Results

Previous Basel II capital impact studies have built their estimates from the bottom up, 

by surveying banks about the values of risk parameters used in their internal risk 

measurement systems. We construct our estimates from the top down, starting with 

historical losses to infer a plausible range of risk parameters, which we then input into 

the Basel II formulas. The approach is discussed in detail in the appendix. 

At its heart, our analysis is extremely simple. The Basel Committee's Quantitative 

Impact Study 3 (QIS-3) showed a 17 percent reduction for credit-risk capital at U.S. 

banks. This reduction occurred despite the participating banks' use of credit loss 

assumptions that were far more severe than historical experience. If more normal loss 

assumptions were input into the Basel II risk functions, capital requirements would be 

expected to be much less than the QIS-3 predicts. 

Our analysis appears to confirm this. Over time and on average, the A-IRB formulas 

would be expected to deliver much lower capital requirements than the current 

standards for the same pool of exposures. While we develop a range of capital

estimates as described below, we believe Chart 2 describes the qualitative features of 

the most likely capital outcome of Basel II. Specifically, A-IRB capital requirements are 

likely to be at or below the leverage standards set by U.S. Prompt Corrective Action 

standards for "well capitalized," and could often fall into a range currently deemed 

"undercapitalized" by PCA. Consequently, U.S. regulators would be forced to ignore 

much of the output of Basel II or weaken the PCA standards. Not as evident from 

Chart 2, but as described in a subsequent section, Basel II also creates the likelihood 

of significant cyclical swings in risk-based capital requirements for wholesale lending. 
D

Estimating the level of Basel II's A-IRB capital requirements

As described in more detail in the appendix, our starting point was the assumption that 

over time, average annual net charge off rates on broad loan categories should 

provide a good approximation to Basel II's 12-month expected loss measure that might 

be expected to prevail over the same period of time. For each broad loan category, we 

use historical loss rates as a percentage of on-balance sheet exposures to estimate an 

expected loss (EL). We assume a high and a low value for the weighted average loss 

given default on loans in each category. We then "reverse-engineer" a weighted 

average probability of default (PD) that, when multiplied by our assumed loss given 

default (LGD), would result in the estimated EL. The PD and LGD are fed into the 

appropriate A-IRB risk function to compute an "unexpected loss (UL)" capital charge 

(with an appropriate adjustment for the concavity of the risk function as described 

below). 

It is critical for the reader who wishes to comment upon our analysis to understand 

what we are measuring. The capital charges we compute should be regarded as 

overestimated capital charges for on-balance sheet credit exposures. Our approach 

attributes all credit loss during a year to the on-balance sheet loans at the start of that 

year. Therefore, if charge-offs during a year were taken on exposures that were not on 

the balance sheet at the beginning of that year (perhaps because those exposures 

existed only as undrawn lines or commitments at the beginning of the year, or because 

the charged-off loans had simply not yet been made at the beginning of the year), we 

would be overestimating the EL and hence the UL capital charge for the on-balance 

sheet loans. We do not know how quantitatively important this overestimation is. 

Tables 1 through 4, and the accompanying text, describe the analysis that went into 

the construction of Chart 2. These tables are based on a Call Report presentation of 

asset categories and the capital that might be required for them. To shed more light on 

the effects of capital requirements for off-balance sheet exposures, we subsequently 

estimate changes in capital requirements in a QIS format in Table 6. 

Table 1 summarizes the results of our estimates of A-IRB capital requirements by 

major type of lending, as a percentage of exposure. We did not conduct this analytical 

exercise for capital requirements for credit cards, because of the substantial policy 

uncertainty that still exists in that area. We consolidated small business lending into 

the wholesale category along with loans to banks, foreign governments, commercial 
and industrial loans, and loans secured by non-farm, non-residential real-estate. 

Table 1

A-IRB Capital Requirements Vary

Depending on LGD Assumptions

Using Low LGD Using High LGD 

Loan type cyclic 

low avg cyclic high

cyclic 

low avg cyclic high

Wholesale 2.77% 4.68% 6.41% 3.64% 6.59% 8.92% 

ADC 0.00% 4.54% 9.14% 0.00% 5.89% 11.97% 

1-4s 0.75% 1.17% 1.59% 0.91% 1.45% 2.02% 

O. consumer 2.91% 3.30% 3.47% 3.73% 4.53% 5.10% 

Source: FDIC

The cyclic highs and lows presented in Table 1 were computed by assuming that in 

every year, Basel II's EL for each broad loan category equaled the actual banking 

industry net charge-off rate for that loan category.2 This approach certainly 

exaggerates the degree of cyclic variability that would be expected under A-IRB. For 

example, no one would seriously argue that the capital requirement for acquisition, 

development and construction (ADC) lending would ever be zero. Even so, as 

described in the next section, it is not clear how some fairly substantial degree of 

variability in capital requirements would be avoided. 

The balance sheet weights, and the average values (over the 19-year period) of risk 

inputs used to construct these estimates are presented in Table 2. We used balance 

sheet weights for all insured commercial banks as of year-end 2002. This makes our 

results less sensitive to the details of exactly which set of banks ultimately adopt Basel 

II, but is subject to the criticism of understating the importance of credit cards and 

trading assets to Basel II's most likely adopters. Table 6, which gives a capital impact 

analysis in a QIS-3 format, is not subject to this criticism, and shows a very similar 

capital impact to the results displayed in Tables 1-4. 

The "spread adjustment" in Table 2 refers to the percentage reduction we need to 

make to our estimates to account for the concavity of the risk functions. Inputting a 

single weighted average PD and LGD into the Basel risk functions, as we have done, 

overstates the capital requirement a bank would face if it had a range of PDs and 

LGDs equating to our averages. Inspection of the distribution of a sampling of 

individual banks' PD and LGD bands in the QIS-3 data suggested the adjustments 

listed in Table 2. 

Table 2

Capital Impact Depends on the Level and Spread of Key Risk Inputs

Low LGD High LGD

Loan 

type Weight Avg EL PD LGD PD LGD Spread Adjustment

Wholesale 26% 0.99% 3.30% 30% 1.98% 50% 30% 

ADC 3% 0.88% 2.20% 40% 1.47% 60% 30%
1-4s 16% 0.15% 1.00% 15% 0.50% 30% 20%

O. 

consumer 

6% 0.90% 2.25% 40% 0.60% 60% 20%

Source: FDIC

For all other exposure categories we have simply made assumptions about the 

effective UL capital requirements under A-IRB as a percentage of exposure. Market 

risk capital requirements are included in our assumption about capital held for trading 

assets. The assumptions are listed below.

Table 3

Capital Requirements Assumed

for Other Balance Sheet Accounts 

Exposure 

type weight

Assumed 

UL

capital 

req

Cash and 

due 6% 1.60%

Fed funds 

and repos 4% 1.60%

MBS 10% 0.56%

Treasuries 1% 0.05%

Other 

securities 8% 1.60%

Credit cards 4% 8.00%

Trading 

assets 6% 4.00%

Other assets 10% 8.00%

Source: FDIC

Credit card lending received a substantial increase in capital requirements under the 

A-IRB approach described in the Basel Committee's Consultative Paper 3 (CP-3). 

Basel II's "standardized" banks, in contrast, saw a 25 percent reduction in capital 

requirements for credit card lending. Capital requirements for A-IRB credit card lending 

are under intensive review at this time, and the strong likelihood is that the 

requirements will be different-but we don't know how-than what was described in CP3. We regard our assumption of "no change" in requirements for advanced banks 

relative to the current rules as a placeholder to be used until current policy discussions 

are resolved. 

A range of overall UL capital requirements for credit risk (constructed by assetweighting the categories listed in Tables 1 and 3) and operational risk is presented in 

Table 4. Much more detail is provided in spreadsheets in the appendix. Operational 

risk capital is assumed to be 12 percent of the capital requirement for credit risk. This 
figure has been used by the Basel Committee as a rough indication of the potential 

magnitude of the operational risk charge, but in reality there is little basis for predicting 

its magnitude or its variation over time. 

Table 4

Under Most Scenarios, Basel II Lowers Risk-based Capital 

Requirements Substantially

Low LGD High LGD

Capital 

requirement

cyclic 

low avg high cyclic low avg high

All credit 

risk 2.77% 3.44% 3.99% 3.11% 4.10% 4.86% 

Operational 

risk 0.33% 0.41% 0.48% 0.37% 0.49% 0.58%

Subtotal 3.10% 3.85% 4.47% 3.48% 4.59% 5.44% 

Current RBC 5.05% 5.05% 5.05% 5.05% 5.05% 5.05%

% reduction 

in capital 39% 24% 11% 31% 9% -8%

Source: FDIC

The "current RBC" row refers to current weighted average risk based capital 

requirements-that is, a dollar amount equal to 6.75 percent of risk-weighted assetsexpressed as a percentage of on-balance sheet assets for the 50 largest banks in the 

U.S. The 6.75 percent figure is obtained by subtracting 1.25 percent of gross riskweighted assets from the basic requirement of 8 percent of risk weighted assets. Since 

we are estimating UL capital requirements under Basel II, we should subtract the 

portion of current capital requirements that can be met with loan loss reserves in order 

to get an "apples-to-apples" comparison. 

We believe that the estimates presented on the "low LGD" side of Table 4, or even 

lower numbers, are likely to be more reflective of the long run capital implications of AIRB. In reaching this judgment, we have considered the impact of a number of factors 

not explicitly reflected in the numerical analysis. Most of these factors suggest that our 

analysis overstates A-IRB capital requirements. First, similar to the caveats articulated 

by the Basel Committee in its May 5, 2003, report on the QIS results, our analysis 

does not reflect that banks will be able to categorize various small business loans as 

retail, nor does it fully recognize the new opportunities for recognition of collateral and 

risk mitigation banks will have under A-IRB. The results do not reflect the A-IRB's 

expanded use of models in setting capital for repos, liquidity facilities, and possibly 

other securitized, traded or marked-to-market assets. Finally, our estimates of average 

through-the-cycle EL rates may be on the high side, as they are computed using a 

high-loss period that included the failure of over 1500 U.S. commercial banks, a period 

that future supervisors implementing Basel II may regard as atypical. 

An important fact to consider when evaluating the QIS-3 estimates is that they were 

made in fall 2002, well into a U.S. corporate recession. To this extent, the QIS-3 

estimates of capital for corporate exposures are likely to overstate the capital that may 

be required in the future. QIS-3's estimated EL (including the EL on defaulted assets) 

for corporate drawn exposures-the largest single contributor to bank capital 

requirements in QIS-3-averaged 1.60 percent of the drawn amounts across the 
participating banks. This compares with a 1.00 percent average net charge-off rate on 

outstanding C&I loans over the 18 years we studied. This suggests the likelihood that 

over time, A-IRB capital for corporate exposures would be expected to come down 

significantly as compared to what was estimated by QIS-3.

Similarly, QIS-3's EL as a percentage of drawn residential exposures was 0.5 percent 

of the drawn balances, compared to a 0.15 percent historical average net charge-off 

rate. For other retail loans (not including credit cards), QIS-3 showed an EL of 1.8 

percent of drawn balances, compared to a 0.9 percent historical average charge-off 

rate for "other consumer loans." These figures provide further indirect support to our 

analysis, and suggest that QIS-3 materially overestimated the long-run average capital 

requirements that Basel II is likely to bring. 

We conclude from these arguments, in conjunction with the results presented in Table 

4, that average risk based capital requirements for traditional banking activities would 

hardly ever exceed the five percent leverage threshold for being "well capitalized" 

under current U.S. Prompt Corrective Action regulations, and could well be less than 

four percent of exposures during strong expansions. In short, existing Prompt 

Corrective Action standards are likely to come into conflict with the new risk-based 

requirements of Basel II's advanced approaches. 

Possible objections to our analysis

Several factors might, at least in principle, argue that there would be a smaller 

reduction in capital requirements than our estimates show. First is the effect of those 

parts of the Basel II framework that must currently be categorized as "moving parts." 

These include important parts of retail, securitization, credit risk mitigation, and 

recalibration to a UL-only framework. In this regard, most changes now under 

discussion are capital-reducing. Moreover, at least at this time, the type of recalibration 

being considered would not be expected to significantly increase capital relative to 

what the CP-3 formulas require. 

A second factor that should be considered is the possibility that supervisors would 

require "stressed LGDs." The U.S. Advance Notice of Proposed Rulemaking (ANPR) 

indicated banks should use stressed LGDs where appropriate. To the extent this is 

actually done, Basel II's ELs could systematically exceed actual losses year after year, 

and our estimated capital requirements would be too low. We regard the extent true 

stressed LGDs will actually be used as unclear. An equally likely possibility is that realworld pressures will cause Basel II's risk inputs to be underestimated. We believe the 

best starting point for an analysis is simply to assume that ELs measure what Basel II 

says they measure: expected 12-month credit loss.

Another factor that should be considered is that if A-IRB resulted in greater capital 

being required for significant off-balance sheet exposures than did the U.S. version of 

Basel I, our conclusions regarding the likely direction and magnitude of the capital 

impact might be mitigated. In the QIS-3, this did not appear to be the case except for 

credit card banks.

Table 5 shows that QIS banks with large off-balance sheet exposures relative to their 

asset size did not tend to face greater A-IRB capital requirements as a percentage of 

their on-balance sheet assets. The U.S. version of Basel I already forces the largest 

banks to hold significant risk weighted assets for off balance sheet exposures. A 

significant portion of this off-balance sheet exposure has extremely low credit risk, 

including exposures arising from collateralized or highly liquid transaction processing 

businesses and unused prime credit card lines. Therefore, under A-IRB, most capital 

requirements for off-balance sheet risk decrease substantially compared to the Basel I 

requirements. The result is that, as illustrated in Table 5, A-IRB capital requirements 

diminish markedly both as a percentage of exposure and as a percentage of onbalance sheet assets, the greater the volume of off-balance sheet activities. Apart, 

possibly, from credit card lending, we view it as unlikely that new exposures banks 

would be forced to capitalize-and that they are not already capitalizing under Basel Iwould increase enough to materially offset the effects of A-IRB's lower risk weights. 
Table 5 - Large Off-Balance Sheet 

Exposures do not Imply

Relatively Higher Capital 

Requirements 

Exposure to 

Assets

% of 

exposure

% of 

assets

>300% 1.52% 4.99%

200-300% 2.19% 5.45%

125-200% 3.81% 5.65%

<125% 6.69% 7.16%

Source: FDIC

Table 6 provides evidence from the QIS-3 in support of this contention. Table 6 is 

based on an approximating relationship described in the appendix. The basic idea is 

that the percentage change in the ratio of required risk-based capital to total assets 

equals the weighted average of the percent changes in each risk weighted asset 

category, but that some further assumptions are needed to account for the role of the 

loan-loss reserve in forming a "UL-to-UL" comparison of current and A-IRB capital 

requirements. Table 6 shows that the key driver of the overall change in the ratio of 

risk based capital to total assets is the change in the capital requirement for drawn 

credit exposure. The change in all other sources of risk-based capital, taken together, 

slightly increase the overall percentage decline in capital. Thus, the critical issue in 

terms of capital impact is, in fact, whether our estimates of capital for drawn credit are 

accurate. 

Table 6

A-IRB Capital Impact Approximated by Weighted Change in Components

Exposure Category

Current

RWA 

share

RWA est

% 

change

Contribution to 

Change in

overall RBC to 

Asset ratio

All Current RWA 100.00%

Drawn Credit Exposure, net of 

revolving 62.77% -47.62% -29.89%

Revolving 7.51% 0.00% 0.00%

Corp commitments 12.31% -29.84% -3.67%

Other commitments 1.64% 8.00% 0.13%

Trading book 7.35% 2.03% 0.15%

Equities 1.60% 228.32% 3.66%

Securitization
- originators 5.58% -11.31% -0.63%

- investors 1.18% -16.79% -0.20%

All other QIS 0.04% -94.59% -0.04%

Subtotals 99.99% -30.50%

Impact on Capital

Current RBC to Asset 

ratio(excluding provisions) 5.05%

AIRB Credit Capital 3.51%

Operational Risk Capital 0.42%

Total AIRB Risk Based 

Capital 3.93%

Source: FDIC

We estimated the percent change in capital requirements for drawn credit exposures 

net of revolving using our "low LGD" averages reported in Table 1. The balance sheet 

weighted average of our "low LGD-average" requirements for the wholesale lending, 

ADC lending, 1-4 family residential mortgages and other retail lending categories 

reported in Table 1 was 3.41 percent of exposures, equating to a 42.6 percent risk 

weight. For all commercial banks at year-end 2002, the average risk weight for all 

loans and leases, excluding credit cards and other revolving consumer credit (the 

excluded revolving credit does not include home equity loans), was 82 percent. The 

reduction in average risk weight from 82 percent to 42.6 percent equates to the 47.6 

percent decline in risk weighted assets reported in Table 6.3

There is not a perfect mapping between the capital requirements we estimated for our 

four drawn loan categories and the QIS-3 category we have labeled drawn credit 

exposure, for three reasons. First, an unknown percentage of the QIS credit exposure 

buckets comprised securities, repos and cash and due. We believe, however, that AIRB capital requirements for all of these items, with the exception of Treasury 

securities, declined substantially (for corporate, bank and sovereign repos, for 

example, the decline was greater than the 47.6 percent we report). Second, a portion 

of these credit exposures are in fact undrawn. We know of no reason to believe, 

however, that the decline in capital requirements for these undrawn amounts would be 

much different than for the drawn amounts. Finally, the drawn credit exposure 

category includes a miscellaneous assortment of lending categories for which we did 

not estimate a capital change and that are not separately estimated in QIS-3. 

For revolving consumer credit, we again assumed no change in requirements, 

consistent with the discussion earlier in this paper. The change in risk weighted assets 

for all other categories is taken directly from QIS-3. The end result, a 3.93 percent ratio 

of risk based capital to total assets, is very close to the 3.85 percent figure reported in 

Table 4 for the "Low LGD—average" scenario.

To summarize, we estimated capital requirements using historical call report data for 

the major drawn loan categories except for credit cards and other revolving consumer 

credit. We made point estimates of all other risk based capital requirements for the 

traditional call report categories, arguing that our estimates were sufficiently 

conservative to more than cover any additional capital from off-balance sheet 

activities. In Table 6, we checked the answer that we got for the "low LGD" scenario 
using the same low LGD assumptions for drawn credit, and using the QIS estimates 

for all other categories of exposure, and came to roughly the same answer. 

We believe that the overall conclusion that Basel II's A-IRB capital requirements would 

generally be well below current U.S. PCA requirements is difficult to challenge, and 

that the burden of proof is now on others to show where the A-IRB capital 

requirements would be sufficiently more stringent than we have estimated as to 

overturn our conclusions. 

Cyclical swings in capital requirements

Swings in capital requirements over the business cycle would be expected to be very 

pronounced if ELs accurately measure 12-month loss at a point in time. Chart 3 plots 

estimated UL capital requirements for wholesale lending under the two alternative 

LGD assumptions. UL capital requirements for wholesale lending range from as low as 

about 3.6 percent of exposure to as high as about 8.9 percent of exposure if a 

stressed LGD of 50 percent is assumed. These are average figures that understate 

the degree of bank-specific variation that would be expected to occur.

D

Using lower LGDs reduces swings in capital requirements but also reduces those 

requirements (in the limit when LGD is zero, there is no volatility—the capital 

requirement is zero throughout the cycle). For example, assuming a 30 percent 

through-the-cycle LGD for wholesale lending, UL capital ranges between about 2.8 

percent of exposure and about 6.4 percent of exposure. 

One way to avoid such volatility, at least in principal, would be for the supervisors to 

require inter-temporal smoothing of risk inputs. Chart 4 shows the results of a 

"smoothed EL" approach where we assume that expected loss rates are the average 

of seven years of actual loss rates, namely the current year, the previous four years, 

and the subsequent two years. The Chart shows that depending on the LGD 

assumptions, even such seven-year averaging of loss experience results in swings in 

wholesale capital requirements of several percentage points over the cycle.4
D

In the extreme, risk inputs could be smoothed so much that each loan segment would 

have EL rates that do not change over time. The result, in the context of this analysis, 

would be roughly steady capital requirements. Within the assumptions of our analysis, 

these would be expected to correspond to the "average" columns of Table 4. 

It is not clear, in any event, how inter-temporal smoothing of risk inputs sufficient to 

ameliorate large swings in capital requirements could be accomplished within the 

implementation scheme now envisioned. While banks are encouraged to use defaultweighted, or stressed, or conservative through-the-cycle LGDs, they are permitted to 

use point-in-time estimates of PD. With a steady LGD, point-in-time PDs would result 

in cyclic swings in EL, and hence UL capital requirements. 

More generally, substantial input smoothing appears inconsistent with the conceptual 

framework of the A-IRB. The A-IRB approach contains no mechanism for achieving 

targeted capital outcomes. Risk inputs are to be evaluated loan-by-loan and pool-bypool. Revisiting or changing a large number of risk inputs based on a bank's overall 

wholesale capital requirement is not envisioned. It is not clear how large-scale 

supervisory management of risk inputs to produce desired capital outcomes would 

square with the stated importance of banks' validation efforts. 

Another way to avoid swings in capital requirements would be through supervisory 

overrides of those requirements. Placing ex ante reliance on supervisory overrides of 

regulations to correct perceived flaws in those regulations would appear problematical, 

however. If regulatory capital outcomes are considered so unacceptable that 

supervisory overrides would often be needed, that suggests that the regulations 

should be changed. 

The foregoing discussion suggests that three questions need to be answered relative 

to the capital impact of the A-IRB. 

• Are the risk-based capital outcomes pictured in Charts 2, 3 and 4 acceptable? 

• If not, how will such outcomes be avoided under the CP-3 framework? 

• Finally, if there is no good answer to this second question, how should the 
framework be changed?

Mortgages

Another important issue is whether there are particular lending segments for which the 

reduction in capital is excessive. The reductions in capital for single-family residential 

mortgages appear to constitute a significant expansion of the safety-net support 

provided to this activity when conducted within national banking systems. A backward 

look at the credit risk performance of this sector may suggest such safety-net support 

will never need to be exercised, but this appears to be a heavy bet for bank regulators 

to place. It is noted that Standard & Poor's has expressed discomfort with the A-IRB 

retail capital framework in general.

International competitive issues

Finally, the proposed new risk-based capital rules would be expected to exacerbate 

the effects of cross-country differences in the regulation and supervision of bank 

capital. As seen in the beginning of the paper, Chart 1 shows that these cross-country 

differences are already considerable. The A-IRB approaches would appear to widen 

existing capital disparities, because minimum leverage ratio requirements will not 

permit U.S. banks to reduce their capital requirements by as much as banks in other 

countries. 

Options

Our assessment is that on average and through the cycle, CP-3 will deliver substantial 

reductions in risk based capital requirements. U.S. policy-makers will be confronted 

with a choice between ignoring the results of Basel II or substantially weakening the 

PCA requirements. Without a significant weakening of PCA, the disparity in effective 

capital requirements U.S. banks already face because of leverage capital 

requirements will be widened. We believe that without significant change to the CP-3 

framework, wide swings in capital requirements over the business cycle for wholesale 

lending activities are likely. 

To the extent readers are convinced that this analysis does present a compelling case 

for change of the CP-3 framework, we suggest there are three logical directions for 

change, two of which, we believe, merit further discussion. 

1. Change risk weight functions by raising and flattening them. Higher, flatter curves 

would reduce the potential for swings in requirements, make the capital outcomes 

closer to the Basel Committee's goals and may help reduce worldwide bank capital 

disparities. There would be much more risk sensitivity than under current rules, but 

somewhat less risk sensitivity than under CP-3. 

2. Abandon the U.S. leverage ratio and institute full-models-based risk-based capital 

requirements so low that they are lower than point-in-time economic capital 

requirements at the height of an economic expansion. This is the approach a 

significant banking industry trade group has recommended in its comment letter, but it 

is not an approach we can support. 

No one knows how to measure the hundred year flood plain for a large complex bank. 

Measuring the risk of extreme tail events in ever-changing bank loss distributions will 

always be an inexact science. Placing exclusive reliance on banks' statistical 

estimates of the likelihood of these tail events is not an acceptable way to protect the 

deposit insurance funds or, ultimately, the taxpayer. In this regard, a bank failure is 

costly to the broader economy, not just to the stakeholders in that bank. So even 

assuming a bank's models are accurate, the capital banks should hold from a social 

welfare perspective would normally be expected to exceed the capital that the banker 

calculates to meet his own needs. In the language of economics, minimum capital is 

needed to address the significant external costs of bank failures. 

It should also be noted that the A-IRB risk functions are simply statistical calculation 

engines that can produce economic capital estimates that have an unclear connection 

to mainstream economic theory. The idea that there is no free lunch—that risk-free 

profit opportunities are arbitraged away—is a fundamental precept of standard 
economics and finance. Yet the A-IRB risk functions are built on a conceptual 

framework that assumes an "unexpected loss" of zero for important categories of 

assets, including any exposure for which the bank estimates an LGD of zero, defaulted 

exposures, exposures purchased at a sufficient discount, and "partially charged off" 

exposures. The A-IRB approach in effect assumes that a bank's marginal investment 

in such assets provides a risk-free profit opportunity. 

Minimum capital requirements are sometimes criticized as "not risk sensitive." The 

discussion above shows that when one considers the risk of model error, the "no-freelunch" postulate, and the risk of damage to economic and financial systems that come 

from weak and failing banks, it is the lack of a minimum requirement that should more 

properly be criticized as "not risk sensitive." This brings us to option three. 

3. Explicitly include the concept of a capital floor as part of the international capital 

regulatory framework. With the added surety of a floor as part of the framework, it may 

be possible to make certain other aspects of the Accord less prescriptive. The result, 

conceivably, could be a framework that better meets the safety and soundness 

objectives of prudential capital regulation while being less costly for banks to 

implement. 

In many ways, we believe this third option could give the best of all worlds. At any 

event, we believe it is absolutely critical that our regulatory framework acknowledge 

the merits of both risk based capital and minimum capital (Chart 5). Modeled capital 

can be used as an input to regulatory capital, but should never be permitted to be the 

sole driver of regulatory capital. We look forward to discussions with all interested 

persons about the issues and options described in this paper. 

Chart 5

D

Appendix

The results of this paper are summarized in various tables and charts that display 

estimates of A-IRB unexpected loss (UL) capital requirements as a percentage of 

exposure. More specifically, let k denote the UL capital requirement per dollar of 

wholesale exposures implied by CP-3's wholesale risk function. The value of k 

depends on the risk inputs PD, LGD and M (probability of default, loss given default 

and maturity).

k(PD, LGD, M) = [KUL]/EAD

where EAD is exposure at default and KUL is CP-3’s UL capital requirement (i.e., the 

total requirement minus calculated expected loss (EL)).
Write CP-3’s wholesale correlation R as a function R(PD) of PD. For ease of notation 

let 

J(PD) = N[(1 – R(PD))^-0.5 * G(PD) + (R(PD) / (1 – R(PD)))^0.5 * G(0.999)]

where the expression on the right is reproduced from the CP-3 wholesale risk function 

(N( ) is the standard normal cumulative distribution function and G( ) is the inverse of 

the standard normal cumulative distribution function). Again for notational convenience 

let 

H(M, PD) = [1 + (M – 2.5)*b(PD)] / [1 – 1.5*b(PD)],

where b(PD) is CP-3’s maturity adjustment b, written as a function of PD.

With this notation, KUL becomes

KUL = EAD*LGD*J(PD)*H(M, PD) – EAD*LGD*PD

so that dividing by EAD, we have

k(PD, LGD, M) = LGD*[J(PD)*H(M, PD) – PD]. (1)

We develop estimates of weighted average wholesale PD and LGD described below, 

assume a value of M, insert these three numbers in equation (1), and report the 

results. To reiterate, the reported results are estimated capital requirements per dollar 

of exposure. We follow a similar procedure for CP-3's mortgage, other retail, and highvolatility commercial real estate risk functions. We do not analyze qualifying revolving 

exposures (QRE), which we view as subject to too much policy uncertainty to allow for 

an impact analysis. We likewise do not analyze small and medium sized enterprise 

exposures, but instead combine those exposures with wholesale exposures. 

The remainder of this section summarizes how we estimated the weighted average 

PDs and LGDs and the corresponding capital requirements. Essentially, whereas QIS3 builds its estimates from the bottom up, using risk inputs to construct EL and UL 

capital requirements, we work from the top down, starting with estimates of EL to 

construct plausible ranges of the risk inputs which we then use to estimate the UL 

capital requirement. 

1. We use data from quarterly financial reports of condition and income (Call Reports) 

for all FDIC-insured commercial banks, 1984-2002. 

2. We construct "unbiased EL rates" that are set by definition to annual net charge off 

rates for the four loan categories (wholesale; acquisition, development and 

construction; 1-4 family mortgage; other retail). Call this estimated EL rate L.

3. For each of these loan categories we produce two capital estimates, one assuming 

a high long run average LGD and the other assuming a low long run average LGD

4. For each loan category we set weighted average PDs equal to L/LGD, using the L 

and the high and low values of LGD from the previous two steps. Note that as defined 

in CP-3, EL is a dollar amount equal to EAD* PD*LGD. Expressed as a percentage 

rate, EL per dollar of exposure, or L, is simply PD*LGD. Since we don't know EAD, we 

empirically estimate L using net loss per dollar of on balance sheet exposures for the 

given loan category. Since total exposure is in principal at least equal to on balance 

sheet exposure, we are somewhat overstating the loss per dollar of drawn exposure, 

and our estimates of PD and LGD will be correspondingly overstated for the drawn 

category. Thus we have to some extent overstated the resulting UL capital 

requirements for drawn exposures. 

5. We assumed a 2.5 year average maturity for wholesale lending, the midpoint of the 

currently allowed CP-3 range of 1-5 years. 
6. For each year, each exposure type, and each LGD (high and low) we input the 

estimated weighted average PD and LGD (and where applicable, M) into equation (1), 

giving an estimate of UL capital requirement expressed as a percentage of exposure, 

by year and exposure type. This procedure overstates the capital requirement 

because of the concavity of the risk functions with respect to PD. We adjust for this 

using a sample of actual PD bands for QIS-3 banks.

7. For other asset categories we simply assume a range of required capital. 

8. We weighted all the resulting percentage capital requirements by the year-end 2002 

aggregate balance sheet weights for all insured commercial banks to compute 

average A-IRB capital requirements "by year" for credit risk as a percentage of 

exposure. It should be noted we view these estimates not as "what Basel II would 

have required over time," but as an indicative of the capital requirements a portfolio 

with current balance sheet weights might face under varying economic conditions. 

9. We added 12 percent of the resulting credit risk requirement to cover operational 

risk. The Basel Committee has suggested this 12 percent figure as an indicator of its 

intentions about the rough magnitude of the operational risk charge. In reality, 

however, there is little empirical basis for forecasting its magnitude.

Our basic proxy for EL rates described in step 2 assumes that ELs measure accurately 

what CP-3 says they are intended to measure-namely, twelve months of credit loss. 

To motivate the use of our specific EL proxy, note that industry-wide loss rates tend to 

move up and down in relatively small increments in line with economic conditions. A 

specific large, well-diversified bank might have a higher or lower expected loss rate 

than the industry as a whole, based on that bank's unique risk profile. Collectively, 

however, U.S. A-IRB banks should not have expected average loss rates that are 

much different from industry averages. There may be issues about the timing of 

charge-offs and recoveries that would cause the time path of a true economic measure 

of unbiased 12-month EL to be different than the time path of our estimates of 

unbiased EL. Such differences would not be expected to affect either the validity of our 

19-year average EL measures, or the validity of the notion that unbiased ELs are 

much lower in expansions and much higher in recessions. 

Notes to Table 6: 

Table 6 is based on an approximation. Let 

C0 = total risk based capital, current rules, minus allowable portion of allowance for 

loan and lease losses

C1 = total UL-only risk based capital, new rules, excluding op risk

R0 = total risk weighted assets, current rules

R1 = total risk weighted assets, new rules, excluding op risk

i = 1, ..., n, credit exposure categories

R0,i = risk weighted assets, category i, current rules

R1,i = risk weighted assets, category i, new rules

A = total on-balance sheet assets

wi = share in current risk weighted assets of exposure category i

pi = percent change in risk weighted assets of exposure category i 

Then 

[(C0/A) - (C1/A)]/(C0/A) = (C0 - C1)/C0

 ≈ 0.0675*(R0 - R1)/(0.0675*R0)

 = (R0 - R1)/R0

 = (∑i (R0,i - R1,i))/R0

 = ∑i (R0,i/R0)((R0,i - R1,i)/R0,i)

 = ∑i wipi

The approximation is in the second line of the chain of equalities above. We are 

assuming first that all of the allowable 1.25 percent of gross risk weighted assets is 
used to offset the 8 percent capital requirement on total risk weighted assets. Thus, we 

write C0 = .0675*R0 as our "UL-only" current capital requirement. Second and more 

significantly, we assume that in moving from CP-3/QIS-3 numbers that included an ELcomponent for the capital charge, to a UL-only capital requirement post-Madrid, that 

the relationship

 0.08 * (UL-only risk-weighted assets) ≈ 0.0675 * (EL + UL risk weighted assets)

is approximately satisfied. Roughly speaking, this means that a bank that exactly met 

its EL + UL capital requirement with a 1.25 percent reserve would continue to exactly

meet it UL-only capital requirement with no additional capital shortfall or credit. 

If so,

C1/A ≈ C0/A[1 - ∑iwipi].

Writing the capital ratios in percentage points, this relationship is the basis for the 

capital impact portion of Table 6: 

C1/A ≈ 5.05[1 - 0.3381] = 3.34 

The individual components of Table 6 were constructed as follows: 

Current RWA share was derived from relative aggregate shares from the QIS-3 results 

for U.S. banks: 

1. Drawn Loans: sum of QIS-3 categories for "drawn and off balance sheet" 

categories: corporate, retail residential, retail non-residential, SME corporate, 

specialized lending, sovereign, bank, SME retail, and purchased receivables; 

plus the sum of corporate, bank, and sovereign repos. Note: "Off balance 

sheet" in this context would typically refer to the undrawn portion of a line of 

credit that may well be drawn in the normal course of business. This is 

distinguished from the "commitments" categories below that typically refer to 

arrangements such as a letters of credit that are not expected to be exercised 

in the normal course of business. 

2. Revolving: QIS-3 categories for qualifying revolving loans. 

3. Corporate Commitments: sum of QIS-3 categories for "commitments": 

corporate, SME corporate, specialized lending, sovereign, bank 

4. Other Commitments: sum of QIS-3 categories for commitments: retail 

revolvers, retail residential, retail non-residential, SME retail. 

5. Trading book: sum of QIS-3 categories for trading book: trading book: 

derivatives, repos, specific risk, market risk, plus the sum of corporate 

derivatives, bank derivatives, SME corporate derivatives 

6. Equities: QIS-3 categories for equities 

7. "Securitization originator" uses the QIS-3 category of that name 

8. "Securitization investor" uses the QIS-3 category of that name 

9. All other QIS: Investment in related entities 

10. Note all other categories had de minimis amount of exposures reported 

RWA percentage change used the QIS-3 results for U.S. banks: with the exception of 

the following categories: drawn loans: corporate, retail residential, retail nonresidential, SME corporate, specialized lending, sovereign, bank, SME retail. This 

analysis used the weighted average capital charge estimated in the analysis for the, 

"Estimated Capital Charge IRB bank Optimistic LGD's" for: wholesale loans, ADC, 

residential mortgages, and other consumer retail loans over the time period reported 

compared to the 12-2002 reported weighed average capital charge for these loan 

categories from Schedule RCR of the Quarterly Reports of Condition and Income for 

the QIS-3 reporting banks.

The Current RWA share times the RWA percentage change generated the 

Contribution to the change in the overall RBC to asset ratio. 

This net reduction times the current RBC (excluding provisions) to asset ratio 
generated the estimated AIRB credit capital ratio. 

Operational risk is 12 percent of AIRB credit capital ratio. 

Total AIRB risk based capital is the sum of operational risk capital and AIRB credit 

capital to assets. 

Table 7 

Estimated Capital Charge IRB Bank Pessimistic LGDs

Por

tfol

io 

Sh

are 

A

vg

. 

20

02 

20

01 

20

00 

19

99 

19

98 

19

97 

19

96 

19

95 

19

94 

19

93 

19

92 

19

91 

19

90 

19

89 

19

88 

19

87 

19

86 

19

85 

19

84 

Cas

h 

and 

bal

due 

from 

depo

sitor

ies

6% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.6

0

% 

1.6

0

% 

1.6

0

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

Fed 

fund

s 

and 

repo

s

4% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.6

0

% 

1.6

0

% 

1.6

0

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

Secu

ritie

s

M

BS

10

% 

0.

56

% 

0.

56

% 

0.

56

% 

0.

56

% 

0.

56

% 

0.

56

% 

0.

56

% 

0.

56

% 

0.

56

% 

0.

56

% 

0.5

6

% 

0.5

6

% 

0.5

6

% 

0.

56

% 

0.

56

% 

0.

56

% 

0.

56

% 

0.

56

% 

0.

56

% 

0.

56

% 

Tr

eas

1% 

0.

05

% 

0.

05

% 

0.

05

% 

0.

05

% 

0.

05

% 

0.

05

% 

0.

05

% 

0.

05

% 

0.

05

% 

0.

05

% 

0.0

5

% 

0.0

5

% 

0.0

5

% 

0.

05

% 

0.

05

% 

0.

05

% 

0.

05

% 

0.

05

% 

0.

05

% 

0.

05

% 

Ot

her 8% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.6

0

% 

1.6

0

% 

1.6

0

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 
Who

lesal

e 

loan

s 

LG

D=5

0%

26

% 

6.

59

% 

7.

32

% 

7.

00

% 

5.

87

% 

5.

23

% 

4.

67

% 

3.

66

% 

3.

64

% 

4.

12

% 

4.

91

% 

6.7 9

% 

7.7 3

% 

8.6 0

% 

8.

92

% 

8.

52

% 

8.

04

% 

7.

51

% 

7.

77

% 

7.

55

% 

7.

39

% 

AD

C 

LG

D=6

0%

3% 

5.

89

% 

5.

12

% 

4.

56

% 

2.

80

% 

2.

41

% 

1.

24

% 

0.

00

% 

5.

31

% 

5.

68

% 

9.

05

% 

10.

96

% 

11.

97

% 

11.

57

% 

5. 9

% 

5. 9

% 

5. 9

% 

5. 9

% 

5. 9

% 

5. 9

% 

5. 9

% 

Cre

dit 

card

4% 

8.

00

% 

8.

00

% 

8.

00

% 

8.

00

% 

8.

00

% 

8.

00

% 

8.

00

% 

8.

00

% 

8.

00

% 

8.

00

% 

8.0 0

% 

8.0 0

% 

8.0 0

% 

8.

00

% 

8.

00

% 

8.

00

% 

8.

00

% 

8.

00

% 

8.

00

% 

8.

00

% 

Resi

dent

ial 

mtg. 

LG

D=3

0%

16

% 

1.

45

% 

1.

52

% 

2.

01

% 

1.

27

% 

1.

25

% 

0.

91

% 

1.

02

% 

1.

06

% 

1.

26

% 

1.

50

% 

1.8 2

% 

2.0 2

% 

1.7 8

% 

1.

45

% 

1.

45

% 

1.

45

% 

1.

45

% 

1.

45

% 

1.

45

% 

1.

45

% 

Othe

r 

cons

ume

r 

LG

D=6

0%

6% 

4.

53

% 

5.

10

% 

5.

01

% 

4.

93

% 

4.

80

% 

4.

80

% 

4.

80

% 

4.

62

% 

4.

18

% 

3.

75

% 

4.1 0

% 

4.6 5

% 

4.8 9

% 

4.

78

% 

4.

59

% 

4.

37

% 

4.

40

% 

4.

43

% 

4.

13

% 

3.

73

% 

Tra

ding 

book

6% 

4.

00

% 

4.

00

% 

4.

00

% 

4.

00

% 

4.

00

% 

4.

00

% 

4.

00

% 

4.

00

% 

4.

00

% 

4.

00

% 

4.0 0

% 

4.0 0

% 

4.0 0

% 

4.

00

% 

4.

00

% 

4.

00

% 

4.

00

% 

4.

00

% 

4.

00

% 

4.

00

% 

total 90

% 

Othe

r 

asset s

10

% 

8.

00

% 

8.

00

% 

8.

00

% 

8.

00

% 

8.

00

% 

8.

00

% 

8.

00

% 

8.

00

% 

8.

00

% 

8.

00

% 

8.0 0

% 

8.0 0

% 

8.0 0

% 

8.

00

% 

8.

00

% 

8.

00

% 

8.

00

% 

8.

00

% 

8.

00

% 

8.

00

% 
total 100

% 

Tota

l 

Cre

dit 

Capi

tal

4.

10

% 

4.

31

% 

4.

28

% 

3.

81

% 

3.

62

% 

3.

39

% 

3.

11

% 

3.

26

% 

3.

40

% 

3.

72

% 

4.3

3

% 

4.6

8

% 

4.8

6

% 

4.

72

% 

4.

60

% 

4.

47

% 

4.

33

% 

4.

40

% 

4.

33

% 

4.

26

% 

Tota

l 

Cre

dit 

plus 

12% 

op 

risk

4.

59

% 

4.

83

% 

4.

80

% 

4.

27

% 

4.

06

% 

3.

80

% 

3.

48

% 

3.

65

% 

3.

80

% 

4.

16

% 

4.8

5

% 

5.2

4

% 

5.2

4

% 

5.

44

% 

5.

29

% 

5.

16

% 

5.

00

% 

4.

85

% 

4.

93

% 

4.

84

% 

Note: UL capital charge is estimated from the CP-3 risk weight functions with EL subtracted from the capital 

charge. Wholesale and ADC loan estimates were reduced by 30% to reflect the concavity and maturity bias 

induced by the estimation method. Residential mortgage and other retail were reduced by 20% to reflect the 

concavity effect. 

Source: FDIC calculations based on Quarterly Reports of Condition and Income, all FDIC insured Call Report 

filers

Table 8

Estimated Capital Charge IRB Bank Optimistic LGDs 

Por

tfol

io 

Sha

re 

A

vg

. 

20

02 

20

01 

20

00 

19

99 

19

98 

19

97 

19

96 

19

95 

19

94 

19

93 

19

92 

19

91 

19

90 

19

89 

19

88 

19

87 

19

86 

19

85 

19

84 

Cash 

and 

bal 

due 

from 

depo

sitor

ies

6% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

Fed 

fund

s 

and 

repo

s

4% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 
Secu

rities M

BS

10

% 

0.

56

% 

0.

56

% 

0.

56

% 

0.

56

% 

0.

56

% 

0.

56

% 

0.

56

% 

0.

56

% 

0.

56

% 

0.

56

% 

0.

56

% 

0.

56

% 

0.

56

% 

0.

56

% 

0.

56

% 

0.

56

% 

0.

56

% 

0.

56

% 

0.

56

% 

0.

56

% 

Tr

eas

1% 

0.

05

% 

0.

05

% 

0.

05

% 

0.

05

% 

0.

05

% 

0.

05

% 

0.

05

% 

0.

05

% 

0.

05

% 

0.

05

% 

0.

05

% 

0.

05

% 

0.

05

% 

0.

05

% 

0.

05

% 

0.

05

% 

0.

05

% 

0.

05

% 

0.

05

% 

0.

05

% 

Ot

her 8% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

1.

60

% 

Who

lesal

e 

loan

s 

LGD

=30 %

26

% 

4.

68

% 

5.

08

% 

4.

85

% 

4.

15

% 

3.

77

% 

3.

43

% 

2.

78

% 

2.

77

% 

3.

08

% 

3.

58

% 

4.

71

% 

5.

40

% 

6.

13

% 

6.

41

% 

6.

07

% 

5.

66

% 

5.

23

% 

5.

43

% 

5.

26

% 

5.

13

% 

EL

0.

99

% 

1.

10

% 

0.

94

% 

0.

54

% 

0.

40

% 

0.

30

% 

0.

18

% 

0.

18

% 

0.

23

% 

0.

34

% 

0.

85

% 

1.

34

% 

1.

93

% 

2.

17

% 

1.

88

% 

1.

54

% 

1.

21

% 

1.

36

% 

1.

23

% 

1.

14

% 

ADC 

LGD

=40 %

3% 

4.

54

% 

4.

09

% 

3.

69

% 

2.

34

% 

2.

02

% 

1.

04

% 

0.

00

% 

4.

23

% 

4.

48

% 

6.

52

% 

8.

13

% 

9.

14

% 

8.

76

% 

4. 5

% 

4. 5

% 

4. 5

% 

4. 5

% 

4. 5

% 

4. 5

% 

4. 5

% 

EL

0.

88

% 

0.

17

% 

0.

14

% 

0.

05

% 

0.

04

% 

0.

01

% 

0.

00

% 

0.

19

% 

0.

22

% 

0.

87

% 

2.

42

% 

3.

41

% 

3.

03

% 

Cred

it 

card

4% 

8.

00

% 

8.

00

% 

8.

00

% 

8.

00

% 

8.

00

% 

8.

00

% 

8.

00

% 

8.

00

% 

8.

00

% 

8.

00

% 

8.

00

% 

8.

00

% 

8.

00

% 

8.

00

% 

8.

00

% 

8.

00

% 

8.

00

% 

8.

00

% 

8.

00

% 

8.

00

% 

Resi

denti

al 

mtg. 

LGD

=15 %

16

% 

1.

17

% 

1.

22

% 

1.

59

% 

1.

03

% 

1.

02

% 

0.

75

% 

0.

84

% 

0.

87

% 

1.

02

% 

1.

20

% 

1.

44

% 

1.

59

% 

1.

42

% 

1.

17

% 

1.

17

% 

1.

17

% 

1.

17

% 

1.

17

% 

1.

17

% 

1.

17

% 
EL

0.

15

%

0.

15

%

0.

23

%

0.

12

%

0.

12

%

0.

08

%

0.

09

%

0.

09

%

0.

12

%

0.

15

%

0.

20

%

0.

23

%

0.

19

%

Othe

r 

cons

ume

r 

LGD

=40

%

6%

3.

30

%

3.

47

%

3.

47

%

3.

46

%

3.

42

%

3.

42

%

3.

42

%

3.

36

%

3.

16

%

2.

92

%

3.

12

%

3.

37

%

3.

45

%

3.

41

%

3.

35

%

3.

25

%

3.

27

%

3.

28

%

3.

13

%

2.

91

%

EL

0.

90

%

1.

46

%

1.

29

%

1.

18

%

1.

04

%

1.

04

%

1.

04

%

0.

89

%

0.

66

%

0.

50

%

0.

63

%

0.

92

%

1.

13

%

1.

02

%

0.

87

%

0.

75

%

0.

76

%

0.

78

%

0.

64

%

0.

50

%

Trad

ing 

book

6%

4.

00

%

4.

00

%

4.

00

%

4.

00

%

4.

00

%

4.

00

%

4.

00

%

4.

00

%

4.

00

%

4.

00

%

4.

00

%

4.

00

%

4.

00

%

4.

00

%

4.

00

%

4.

00

%

4.

00

%

4.

00

%

4.

00

%

4.

00

%

total 90

%

Othe

r 

asset

s

10

%

8.

00

%

8.

00

%

8.

00

%

8.

00

%

8.

00

%

8.

00

%

8.

00

%

8.

00

%

8.

00

%

8.

00

%

8.

00

%

8.

00

%

8.

00

%

8.

00

%

8.

00

%

8.

00

%

8.

00

%

8.

00

%

8.

00

%

8.

00

%

total 100

%

Tota

l 

Cred

it 

Capi

tal

3.

44

%

3.

55

%

3.

54

%

3.

22

%

3.

11

%

2.

95

%

2.

77

%

2.

89

%

2.

99

%

3.

20

%

3.

59

%

3.

84

%

3.

99

%

3.

90

%

3.

80

%

3.

69

%

3.

58

%

3.

63

%

3.

58

%

3.

54

%

Tota

l 

Cred

it 

plus 

12% 

op 

risk

3.

85

%

3.

98

%

3.

96

%

3.

61

%

3.

49

%

3.

31

%

3.

10

%

3.

24

%

3.

35

%

3.

58

%

4.

02

%

4.

30

%

4.

47

%

4.

37

%

4.

26

%

4.

14

%

4.

01

%

4.

07

%

4.

01

%

3.

96

%

Note: UL capital charge is estimated from the CP-3 risk weight functions with EL subtracted from the capital charge. 

Wholesale and ADC loan estimates were reduced by 30% to reflect the concavity and maturity bias induced by the 

estimation method. Residential mortgage and other retail were reduced by 20% to reflect the concavity effect.
Source: FDIC calculations based on Quarterly Reports of Condition and Income, all FDIC insured Call Report filers.

1 This paper corrects a calculation error in the estimation of wholesale 

capital requirements reported in the original version of this paper, 

published on 12/8/2003. The author is grateful to Schyler Thiessen of 

Economists. Inc. for alerting him to the issue. The error, described in 

footnote 2 of this paper, does not affect the original paper's qualitative 

conclusions about the proposed capital framework that existed at the 

time the original paper was published. This version of the paper is 

intended solely to correct the original calculation error, and not to reflect 

the many changes made to the Advanced Internal Ratings-Based 

framework that have subsequently been made. The new framework is 

described in " International Convergence of Capital Measurement and 

Capital Standards," published in June, 2004 by the Basel Committee on 

Banking Supervision, with the support and agreement of the FDIC. 

2 The historical net charge-off rates for wholesale loans were calculated 

incorrectly in the 12/8/2003 paper as a result of a cell reference error in a 

spreadsheet that created a weighted average wholesale charge-off rate 

by combining the individual charge-off rates for C&I loans, non-farm nonresidential real estate loans, loans to banks and loans to foreign 

governments. The historical average net charge off rate for wholesale 

loans was reported as 0.52 percent when it should have been 0.99 

percent. 

3 Table 6 in the original paper reported a reduction in risk-weighted 

assets of 52.9 percent for credit-risk (excluding revolving retail). Given 

the incorrect wholesale estimated capital requirement from the original 

Table 1 of 3.69 percent of exposure, Table 6 should have reported a 

decline in RWA of over 55 percent. Instead, the 3.69 percent from Table 

1 was miscopied as 3.96 percent, resulting in a smaller percentage 

reduction appearing in the original Table 6, and inadvertently mitigating 

(at least in Table 6) some of the effects of our calculation error. 

4 For numerical tables of data in Charts 3 and 4, refer to end of 

document. 

About FYI

FYI is an electronic bulletin summarizing current information about the 

trends that are driving change in the banking industry, plus links to the 

wide array of other FDIC publications and data tools. 

Disclaimer

The views expressed in FYI are those of the authors and do not 

necessarily reflect official positions of the Federal Deposit Insurance 

Corporation. Some of the information used in the preparation of this 

publication was obtained from publicly available sources that are 

considered reliable. However, the use of this information does not 

constitute an endorsement of its accuracy by the Federal Deposit 

Insurance Corporation.

Last Updated 08/05/2003
Chart 1 

Core Capital Requirements for 

U.S. Banks Far Exceed International Averages 

Tier 1 Capital / Assets Ratio (%), 

World's 100 Largest Banks 

Singapore 6.77 

USA 6.34 

Korea 5.35 

Ireland 5.23 

Spain 5.07 

Australia 4.91 

Italy 4.68 

UK 4.49 

India 4.46 

Canada 4.32 

China 4.18 

Top 100 

Banks 4.12 

Denmark 3.94 

France 3.94 

Netherlands 3.72 

Sweden 3.63 

Belgium 3.22 

Japan 3.15 

Austria 3.13 

Germany 2.63 

Switzerland 2.18 

Source: FDIC calculations using Fitch Bankscope and The Banker July 2003 
Chart 2 

Basel II Capital - Still Investment Grade?

Year Estimated Basel II 

Capital Requirement

Actual 

Leverage 

Capital Ratio

2003 6.72% 

2002 3.85% 6.67% 

2001 3.98% 6.81% 

2000 3.96% 6.66% 

1999 3.61% 6.96% 

1998 3.49% 6.44% 

1997 3.10% 6.37% 

1996 3.24% 6.38% 

1995 3.35% 6.29% 

1994 3.58% 6.33% 

1993 4.02% 6.62% 

1992 4.30% 5.94% 

1991 4.47% 4.85% 

1990 4.37% 4.70% 

1989 4.26% 4.51% 

1988 4.14% 4.75% 

1987 4.01% 3.96% 

1986 4.07% 5.08% 

1985 4.01% 4.97% 

1984 3.96% 4.71% 

Source: Bank Call Reports; estimated requirements 

based on Quarterly Reports of Condition and 

Income, all FDIC insured Call Report filers 
Chart 3 Wholesale Capital Charges 

With "Unbiased" EL

Year EL LGD=30% LGD=50% 

2002 1.10% 5.08% 7.32% 

2001 0.94% 4.85% 7.00% 

2000 0.54% 4.15% 5.87% 

1999 0.40% 3.77% 5.23% 

1998 0.30% 3.43% 4.67% 

1997 0.18% 2.78% 3.66% 

1996 0.18% 2.77% 3.64% 

1995 0.23% 3.08% 4.12% 

1994 0.34% 3.58% 4.91% 

1993 0.85% 4.71% 6.79% 

1992 1.34% 5.40% 7.73% 

1991 1.93% 6.13% 8.60% 

1990 2.17% 6.41% 8.92% 

1989 1.88% 6.07% 8.52% 

1988 1.54% 5.66% 8.04% 

1987 1.21% 5.23% 7.51% 

1986 1.36% 5.43% 7.77% 

1985 1.23% 5.26% 7.55% 

1984 1.14% 5.13% 7.39% 

Chart 4 Wholesale Capital Charges With 

"Smoothed" EL

Year EL:Smoothed LGD=30% LGD=50% 

2000 0.52% 4.10% 5.79% 

1999 0.39% 3.76% 5.22% 

1998 0.31% 3.46% 4.72% 

1997 0.35% 3.62% 4.99% 

1996 0.49% 4.02% 5.66% 

1995 0.72% 4.50% 6.46% 

1994 1.00% 4.94% 7.13% 

1993 1.25% 5.28% 7.58% 

1992 1.43% 5.52% 7.88% 

1991 1.56% 5.68% 8.07% 

1990 1.63% 5.77% 8.18% 

1989 1.62% 5.75% 8.16% 

1988 1.50% 5.61% 7.99% 

Chart 5 -Modeled Capital Vs. Minimum Capital: Our Regulatory Framework Must Accommodate Both

This chart explains the fact that the ultimate level of capital held by a given institution should include an analysis of both 

quantitative and qualitative factors. That is, the validity of model-generated capital numbers must be assessed through the 

regulatory process, and modeled capital and minimum regulatory ratios must coexist.