Capital Windfall? A Majority of Banks Could See Reduced Capital Requirements under the Basel II Standardized Approach-Some, However, Will Need More Capital (2008)

[ILLUSTRATION OMITTED] Bankers could be forgiven if they had a few misconceptions about the Basel capital rules. Even calling them new seems odd considering they have been in development for almost a decade with various versions being proposed, then withdrawn or reworked. Many small and midsize banks also have been alarmed by the prospects of being at a competitive disadvantage to the largest banks that will use the full-scale Advanced approach of the Basel rules. But as the long-running Basel saga nears its climax, these smaller banks may in fact have reason to cheer, as we explain in this article. First, a little background for those who haven't kept up with the Basel progression. The two flavors of Basel II The Basel II Accord represents the efforts of global bank regulators to update bank capital regulation and better capture true risk exposure. Basel II identifies three core principles or of sound capital regulation. Pillar One establishes minimum capital requirements with more complex and risk-sensitive risk-weights than the current regime has, and also includes a capital requirement for operational risk. Pillar Two enhances the role of supervisory oversight in setting capital standards. U.S. banks are well-accustomed to supervisory oversight in all areas of operation, but Basel II extends this relationship and requires a formal demonstration of risk management and capital adequacy. Pillar Three requires heightened disclosures that allow the market to better judge capital adequacy. Together, the three pillars of Basel II represent regulators' best attempt at judging and managing bank capital in a world of increasing complexity. Two distinct flavors of Basel II are available in the U.S. The Advanced version, with its complex formulae and burdensome risk architecture demands, has garnered press and industry attention, but the vast majority of compliant U.S. institutions will ultimately adopt the simpler Standardized approach. The Advanced approach is mandatory for the largest dozen or so banks, while the Standardized approach is voluntary-banks and thrifts have the option of continuing to use the current rules (Basel I). Based on our analysis, adopting the Standardized rules could make sense for many institutions. On June 26, the four federal bank regulatory agencies released a Notice of Proposed Rulemaking (NPR) that anticipates the application of Standardized Basel II in the U.S. The proposed Standardized rule is detailed in the NPR; regulators will issue a final rule early next year, after digesting public comment on this interim document. NPR rules are subject to change, but they convey clear regulatory intent and are typically enshrined in the final rule with only minor modification. We estimate that half of the 7,500 banks and thrifts in the U.S. will see regulatory capital savings of at least 4.5% by adopting the Standardized approach, and a quarter will save at least 8.6%. However, 22% will not see any capital benefit. The remainder of this article identifies the characteristics that separate winners and losers under this regulation. Lower risk weights for many assets Pillar One of the proposed Standardized rule establishes a slightly revised means of calculating the Tier 1 and Total risk-based capital ratios. Table One compares the current and proposed Standardized risk-weights for a variety of exposures. The preponderance of assets held by most U.S. institutions--first and second lien mortgages, consumer loans, and small-ticket commercial and industrial and commercial real estate loans--have lower risk-weights under Standardized Basel II. Delinquent assets, short-maturity commitments, and ABCP (asset-backed commercial paper) liquidity facilities are among the few asset classes that require more regulatory capital under Basel II. For example, the 20% risk-weight currently drawn by FHA and VA mortgage loans are not risk-weighted under Standardized. …