Risk-Based Capital: Bank Regulators Need to Improve Transparency and Overcome Impediments to Finalizing the Proposed Basel II Framework
Published: 2007-02-15T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Concerned about the potential impacts of the proposed risk-based capital rules, known as Basel II, Congress mandated that GAO study U.S. implementation efforts. This report examines (1) the transition to Basel II and the proposed changes in the United States, (2) the potential impact on the banking system and regulatory required capital, and (3) how banks and regulators are preparing for Basel II and the challenges they face. To meet these objectives, GAO analyzed documents related to Basel II and interviewed various regulators and officials from banks that will be required to follow the new rules.
section_title: What GAO Found
paragraphs: Rapid innovation in financial markets and advances in risk management have revealed limitations in the existing Basel I risk-based capital framework, especially for large, complex banks. U.S. banking regulators have proposed a revised regulatory capital framework that differs from the international Basel II accord in several ways, including (1) requiring adoption of the most advanced Basel II approaches and by only the largest and most internationally active banks; (2) proposing Basel IA, a simpler revision of Basel I, and retaining Basel I as options for all other banks; and (3) retaining the leverage requirement and prompt corrective action measures that exist under the current regulatory capital framework. While the new capital framework could improve banks' risk management and make regulatory capital more sensitive to underlying risks, its impact on minimum capital requirements and the actual amount of capital held by banks is uncertain. The approaches allowed under Basel II are not without risks, and realizing the benefits of these approaches while managing the related risks will depend on the adequacy of both internal and supervisory reviews. The move to Basel II has also raised competitiveness concerns between large and small U.S. banks domestically and large U.S. and foreign banks internationally. The impact of Basel II on the level of required capital is uncertain, but in response to quantitative impact study results showing large reductions in minimum required capital, U.S. regulators have proposed safeguards, such as transitional floors, that along with the existing leverage ratio would limit regulatory capital reductions during a multiyear transition period. Finally, the impact on actual capital held by banks is uncertain because banks hold capital above required minimums for both internal risk management purposes as well as to address the expectations of the market. Banks and regulators are preparing for Basel II without a final rule, but both face challenges. Bank officials said they were refining their risk management practices, but uncertainty about final requirements has made it difficult for them to proceed further. Banks also face challenges in aligning their existing systems and processes with some of the proposed requirements. While regulators plan to integrate Basel II into their current supervisory process, they face impediments. The banking regulators have differing regulatory perspectives, which has made reaching consensus on the proposed rule difficult. Banks and other stakeholders continue to face uncertainty. Among the issues that regulators have yet to resolve are how the rule will treat bank portfolios that do not meet data requirements, how they will calculate reductions in aggregate minimum regulatory capital and what they will do if the reduction exceeds a proposed 10 percent trigger, and what criteria they will use to determine the appropriate average level of required capital and cyclical variation. Increased transparency going forward could reduce ambiguity and respond to questions and concerns among banks and industry stakeholders about how the rules will be applied, their ultimate impact on capital, and the regulators' ability to oversee their implementation.

section_title: Letter
paragraphs: For nearly a decade, federal banking regulators have been considering  revisions to risk-based capital rules that could have far-reaching  consequences for the safety, soundness, and efficiency of the U.S. banking  system. The original risk-based capital rules, known as Basel I, were  adopted by the Basel Committee on Banking Supervision in 1988 and  implemented in the United States in 1989. The proposed changes, known  as Basel II, are based on an internationally adopted framework developed  by the Basel Committee. Basel II aims to align minimum capital  requirements with enhanced risk measurement techniques and to  encourage banks to develop a more disciplined approach to risk  management. In the United States, Basel II rules are intended to apply  primarily to the largest and most internationally active banking  organizations. U.S. regulators expect about 11 banking organizations (core  banks), which account for close to half of U.S. banking assets, to be  required to implement Basel II. As such, regulators must take care to  ensure that Basel II functions as intended to help preserve the safety and  soundness of the banking system and mitigate the risk of losses to the  federal deposit insurance fund.
However, in moving toward the proposed Basel II framework, a number of  serious concerns have been raised by regulatory officials, banks,  academics, and congressional and industry stakeholders. First,  considerable uncertainty remains about the appropriate level of minimum  required capital and the potential impact of the proposed rules on  minimum required risk-based capital levels. Second, the proposed rules  depend in part on the reliability of banks’ internal models, and some  observers have expressed concerns about using banks’ internal models for  establishing regulatory capital requirements. Third, the increased  complexity of regulatory capital calculations undertaken by banks  heightens the challenge of effective oversight by banking regulators.  Fourth, the U.S. proposed rules differ in some respects from those of other  countries, raising concerns about possible competitive effects of different  rules between domestic and foreign banking organizations. Concerns have  also been raised about domestic competitive inequities between banks  that adopt Basel II and those that do not.
In light of these concerns, Congress has held several oversight hearings  that have provided valuable information on regulatory objectives, actions,  and potential pitfalls throughout the ongoing rule-making process. As part  of this effort, Congress mandated that we review the implementation of  Basel II in the United States. To date, federal regulators have requested  public comment on a Basel II Advance Notice of Proposed Rulemaking  (ANPR) and Notice of Proposed Rulemaking (NPR). They also have  proposed additional changes, known as Basel IA, to establish simpler  revisions to the regulatory capital framework for banks not subject to  Basel II. However, regulators do not expect to issue final rules until later  in 2007. Because the rule-making process is not complete, this report can  address only certain aspects of the implementation process to date.  Specifically, this report examines the following:  1.  developments leading to the transition to Basel II,  2.  the proposed changes to the U.S. regulatory capital framework,  3.  the potential implications of Basel II’s quantitative approaches and  their potential impact on required capital,  4.  banks’ preparations and related challenges, and  5.  U.S. regulators’ preparations and related challenges.
To meet our objectives, we reviewed the Basel II international accord, the  U.S. proposed rules for Basel II and Basel IA, draft supervisory guidance,  and related materials. We interviewed officials at the federal bank  regulatory agencies to obtain their views. We also interviewed officials at  each of the banks that, under the proposed rule, would be required to  adopt Basel II; a sample of banks that may opt into Basel II (based in part  on size and primary regulator); a state bank regulator and an association  of state bank supervisors; two bank trade associations; and two credit  rating agencies. To understand how regulators oversee risk management  processes at core banks and how the regulators are planning to  incorporate Basel II into their examinations, we interviewed bank  examiners and reviewed examination reports. We also compared the  proposed capital requirements for different assets to demonstrate how  related capital requirements may change, depending on the business cycle  and the estimated level of risk of holding certain assets. We conducted our  work from April 2006 to January 2007 in accordance with generally  accepted government auditing standards. More information on our scope  and methodology appears in appendix I.
subsections: section_title: Background
paragraphs: The business of banking involves taking and managing a variety of risks.  Major risks facing banking institutions include those listed in table 1.
Changes in the banking industry and financial markets have increased the  complexity of banking risks. Banking assets have become more  concentrated among a small number of very large, complex banking  organizations that operate across a wide range of financial products and  geographic markets. Due to these organizations’ scale and roles in  payment and settlement systems and in derivatives markets, a significant  weakness in any one of these entities could have severe consequences for  the safety and soundness of the banking system and broader economy. As  a result, federal banking regulators have adopted a risk-focused approach  to supervision that emphasizes continuous monitoring and assessment of  how banking organizations manage and control risks. Faced with such  risks, banks must take protective measures to ensure that they remain  solvent. For example, banks are required to maintain an allowance for  loan and lease losses to absorb estimated credit losses. Banks must also  hold capital to absorb unexpected losses. Capital is generally defined as a  firm’s long-term source of funding, contributed largely by a firm’s equity  stockholders and its own returns in the form of retained earnings. In  addition to absorbing losses, capital performs several other important  functions: it promotes public confidence, helps restrict excessive asset  growth, and provides protection to depositors and the federal deposit  insurance fund.
Capital adequacy is fundamental to the safety and soundness of the  banking system, and a bank’s capital position can affect its  competitiveness in several ways. Strong capital enhances a bank’s access  to liquidity on favorable terms and ensures that it has the financial  flexibility to respond to market opportunities. However, holding capital  imposes costs on banks, because equity is a more costly form of financing  than debt. Capital adequacy regulation seeks to offset banks’ disincentives  to hold capital, which result in part from access to federal deposit  insurance. In addition, capital adequacy requirements for large banks are  especially important because of the systemic risks these banks can pose to  the banking system. Regulators require banks to maintain certain  minimum capital requirements and generally expect banks to hold capital  above these minimums, commensurate with their risk exposure. However,  requiring banks to hold more capital may reduce the availability of bank  credit and reduce returns on equity to shareholders. In addition, capital  requirements that are too high relative to a bank’s risk profile may create  an incentive for a bank to hold more high-risk assets, in order to earn a  market-determined return on capital. Banking regulators attempt to  balance safety and soundness concerns with the costs of holding higher  capital.
subsections: section_title: U.S. Regulators Responsible for Implementing Basel II
paragraphs: Four federal banking regulators supervise the nation’s banks and thrifts,  and each serves as primary federal regulator over certain types of  institutions:    OCC supervises national (i.e., federally chartered) banks. Many of the  nation’s largest banks are federally chartered.
The Federal Reserve supervises bank holding companies, including  financial holding companies, as well as state chartered banks that are  members of the Federal Reserve System (state member banks). Many of  the largest banking organizations are part of holding company  structures—companies that hold stock in one or more subsidiaries—and  the Federal Reserve supervises bank holding company activities.
FDIC serves as the deposit insurer for all banks and thrifts and has backup  supervisory authority for all banks it insures. It is also the primary federal  regulator of state chartered banks that are not members of the Federal  Reserve System (state nonmember banks).
OTS regulates all federally insured thrifts, regardless of charter type, and  their holding companies.
Under the dual federal and state banking system, state chartered banks are  supervised by state regulatory agencies in addition to a primary federal  regulator. In addition to these banking regulators, SEC supervises broker- dealers. In 2004, SEC established a voluntary, alternative net capital rule  for broker-dealers whose ultimate holding company consents to  groupwide supervision as a consolidated supervised entity. The rule  requires consolidated supervised entities to compute and report capital  adequacy measures consistent with Basel standards.
section_title: Existing Regulatory Capital Framework
paragraphs: The U.S. regulatory capital framework includes both risk-based and  leverage minimum capital requirements. Both banks and bank holding  companies are subject to minimum leverage standards, measured as a  ratio of tier 1 capital to total assets. The minimum leverage requirement is  between 3 and 4 percent, depending on the type of institution and a  regulatory assessment of the strength of its management and controls.  Leverage ratios are a commonly used financial measure of risk. Greater  financial leverage, as measured by higher proportions of debt relative to  equity (or lower proportions of capital relative to assets), increases the  riskiness of a firm. During the 1980s, regulators became concerned that  simple capital-to-assets leverage measures required too much capital for  less risky assets and not enough for riskier assets. Another concern was  that such measures did not require capital for growing portfolios of off- balance sheet items. In response to these concerns, regulators from the  United States and other countries adopted Basel I, an international  framework for risk-based capital that required minimum risk-based capital  ratios of 4 percent for tier 1 capital to risk-weighted assets and 8 percent  for total capital to risk-weighted assets. By 1992, U.S. regulators had fully  implemented Basel I; and in 1996, they and supervisors from other Basel  Committee member countries amended the framework to include explicit  capital requirements for market risk from trading activity. The use of a  leverage requirement was continued after the introduction of risk-based  capital requirements as a cushion against risks not explicitly covered in  the risk-based capital requirements. The greater level of capital required  by the risk-based or leverage capital calculation is the binding overall  minimum requirement on an institution.
Furthermore, the Federal Deposit Insurance Corporation Improvement  Act of 1991 created a new supervisory framework known as prompt  corrective action (PCA) that links supervisory actions closely to a bank’s  capital ratios. PCA, which applies only to banks, not bank holding  companies, has become a primary regulatory influence over bank capital  levels. PCA requires regulators to take increasingly stringent forms of  corrective action against banks as their leverage and risk-based capital  ratios decline. The purpose is to ensure that timely regulatory action is  taken to address problems at financially troubled banks in order to  prevent bank failure or minimize resulting losses. There is a strong  incentive for banks to qualify as “well-capitalized,” which is the highest  capital category and exceeds the minimum capital requirements, because  banks deemed less than well-capitalized have restrictions or conditions on  certain activities and may also be subject to mandatory or discretionary  supervisory actions. Regulatory officials noted that the PCA well- capitalized standards are the de facto minimum regulatory capital  requirements for banks and that virtually all banks maintain capital levels  that meet the well-capitalized criteria. As shown later in this report in  figure 4, the required capital ratios for the well-capitalized category are:  (1) a total risk-based capital ratio of 10 percent or greater, (2) a tier 1 risk- based capital ratio of 6 percent or greater, and (3) a leverage ratio of 5  percent or greater.
section_title: The Transition to Basel II Has Been Driven by Limitations of Basel I and Advances in Risk Management at Large Banking Organizations
paragraphs: Regulatory officials generally agree that while Basel I continues to be an  adequate capital framework for most banks, it has become increasingly  inadequate for supervising the capital adequacy of the nation’s largest,  most complex banking organizations. Many of these banks have developed  advanced risk measurement techniques that have created a growing gap  between the regulatory capital framework and banks’ internal economic  capital allocation methods. Regulators have sought to encourage the use  of such methods as an element of strong risk management and because  such methods may provide useful input to the supervisory process. Basel  II is intended to address the shortcomings of Basel I and further encourage  banks to develop and maintain a disciplined approach to risk management.
subsections: section_title: Basel I Is a Simple Framework with Broad Risk Categories That Is Inadequate for Large Banking Organizations
paragraphs: When established internationally in 1988, Basel I represented a major step  forward in linking capital to risks taken by banking organizations,  strengthening banks’ capital positions, and reducing competitive inequality  among international banks. Regulatory officials have noted that Basel I  continues to be an adequate capital framework for most banks, but its  limitations make it increasingly inadequate for the largest and most  internationally active banks. As implemented in the United States, Basel I  consists of five broad credit risk categories, or risk weights (table 2).  Banks must hold total capital equal to at least 8 percent of the total value  of their risk-weighted assets and tier 1 capital of at least 4 percent. All  assets are assigned a risk weight according to the credit risk of the obligor  and the nature of any qualifying collateral or guarantee, where relevant.  Off-balance sheet items, such as credit derivatives and loan commitments,  are converted into credit equivalent amounts and also assigned risk  weights. The risk categories are broadly intended to assign higher risk  weights to—and require banks to hold more capital for—higher risk  assets.
However, Basel I’s risk-weighting approach does not measure an asset’s  level of risk with a high degree of accuracy, and the few broad categories  available do not adequately distinguish among assets within a category  that have varying levels of risk. For example, although commercial loans  can vary widely in their levels of credit risk, Basel I assigns the same 100  percent risk weight to all these loans. Such limitations create incentives  for banks to engage in regulatory capital arbitrage—behavior in which  banks structure their activities to take advantage of limitations in the  regulatory capital framework. By doing so, banks may be able to increase  their risk exposure without making a commensurate increase in their  capital requirements. For example, because Basel I does not recognize  differences in credit quality among assets in the same category, banks may  have incentives to take on high-risk, low-quality assets within each broad  risk category. As a result, the Basel I regulatory capital measures may not  accurately reflect banks’ risk profiles, which erodes the principle of risk- based capital adequacy that the Basel Accord was designed to promote.
In addition, Basel I recognizes the important role of credit risk mitigation  activities only to a limited extent. By reducing the credit risk of banks’  exposures, techniques such as the use of collateral, guarantees, and credit  derivatives play a significant role in sound risk management. However,  many of these techniques are not recognized for regulatory capital  purposes. For example, the U.S. Basel I framework recognizes collateral  and guarantees in only a limited range of cases. It does not recognize  many other forms of collateral and guarantees, such as investment grade  corporate debt securities as collateral or guarantees by externally rated  corporate entities. In addition, the Basel Committee acknowledged that  Basel I may have discouraged the development of specific forms of credit  risk mitigation by placing restrictions on both the type of hedges  acceptable for achieving capital reduction and the amount of capital relief.  As a result, regulators have indicated that Basel II should provide for a  better recognition of credit risk mitigation techniques than Basel I.
Furthermore, Basel I does not address all major risks faced by banking  organizations, resulting in required capital that may not fully address the  entirety of banks’ risk profiles. Basel I originally focused on credit risk, a  major source of risk for most banks, and was amended in 1996 to include  market risk from trading activity. However, banks face many other  significant risks—including interest rate, operational, liquidity,  reputational, and strategic risks—which could cause unexpected losses  for which banks should hold capital. For example, many banks have  assumed increased operational risk profiles in recent years, and at some  banks operational risk is the dominant risk. Because minimum required  capital under Basel I does not depend directly on these other types of  risks, U.S. regulators use the supervisory review process to ensure that  each bank holds capital above these minimums, at a level that is  commensurate with its entire risk profile. In recognition of Basel I’s  limited risk focus, Basel II aims for a more comprehensive approach by  adding an explicit capital charge for operational risk and by using  supervisory review (already a part of U.S. regulators’ practices) to address  all other risks.
section_title: Basel I Does Not Reflect Financial Innovations and Risk Management Practices at Large Banking Organizations
paragraphs: The rapid rate of innovation in financial markets and the growing  complexity of financial transactions have reduced the relevance of the  Basel I risk framework, especially for large banking organizations. Banks  are developing new types of financial transactions that do not fit well into  the risk weights and credit conversion factors in the current standards.  For example, there has been significant growth in securitization activity,  which banks engaged in partly as regulatory arbitrage opportunities. In  order to respond to emerging risks associated with the growth in  derivatives, securitization, and other off-balance sheet transactions,  federal regulators have amended the risk-based capital framework  numerous times since implementing Basel I in 1992. Some of these  revisions have been international efforts, while others are specific to the  United States. For example, in 1996, the United States and other Basel  Committee members adopted the Market Risk Amendment, which requires  capital for market risk exposures arising from banks’ trading activities.  By contrast, federal regulators amended the U.S. framework in 2001 to  better address risk for asset securitizations. These changes, while  consistent with early proposals of Basel II, were not adopted by other  countries at the time. The finalized international Basel II accord, which  other countries are now adopting, incorporates many of these changes.
Despite these amendments to the current framework, the simple risk- weighting approach of Basel I has not kept pace with more advanced risk  measurement approaches at large banking organizations. By the late  1990s, some large banking organizations had begun developing economic  capital models, which use quantitative methods to estimate the amount of  capital required to support various elements of an organization’s risks.  Banks use economic capital models as tools to inform their management  activities, including measuring risk-adjusted performance, setting pricing  and limits on loans and other products, and allocating capital among  various business lines and risks. Economic capital models measure risks  by estimating the probability of potential losses over a specified period  and up to a defined confidence level using historical loss data. This  method has the potential for more meaningful risk measurement than the  current regulatory framework, which differentiates risk only to a limited  extent, mostly based on asset type rather than on an asset’s underlying  risk characteristics. Recognizing the potential of such advanced risk  measurement techniques to inform the regulatory capital framework,  Basel II introduces “advanced approaches” that share a conceptual  framework that is similar to banks’ economic capital models. With these  advanced approaches, regulators aim not only to increase the risk  sensitivity of regulatory measures of risk but also to encourage the  advancement of banks’ internal risk management practices.
Although the advanced approaches of Basel II aim to more closely align  regulatory and economic capital, the two differ in significant ways,  including in their fundamental purpose, scope, and consideration of  certain assumptions. Given these differences, regulatory and economic  capital are not intended to be equivalent. Instead, regulators expect that  the systems and processes that a bank uses for regulatory capital purposes  should be consistent with those used for internal risk management  purposes. Regulatory and economic capital approaches both share a  similar objective: to relate potential losses to a bank’s capital in order to  ensure it can continue to operate. However, economic capital is defined by  bank management for internal business purposes, without regard for the  external risks the bank’s performance poses on the banking system or  broader economy. By contrast, regulatory capital requirements must set  standards for solvency that support the safety and soundness of the  overall banking system. In addition, while the precise definition and  measurement of economic capital can differ across banks, regulatory  capital is designed to apply consistent standards and definitions to all  banks. Economic capital also typically includes a benefit from portfolio  diversification, while the calculation of credit risk in Basel II fails to reflect  differences in diversification benefits across banks and over time. Also,  certain key assumptions may differ, such as the time horizon, confidence  level or solvency standard, and data definitions. For example, the  probability of default can be measured at a point in time (for economic  capital) or as a long-run average measured through the economic cycle  (for Basel II). Moreover, economic capital models may explicitly measure  a broader range of risks, while regulatory capital as proposed in Basel II  will explicitly measure only credit, operational, and where relevant,  market risks.
section_title: Federal Regulators Are Proposing a Regulatory Capital Framework that Differs from the International Basel II Accord in Several Respects
paragraphs: While Basel II is an international framework based on shared regulatory  objectives, it is subject to national implementation. In the United States,  federal regulators have proposed a series of changes that would result in  multiple risk-based capital regimes—Basel II, Basel IA, and Basel I— largely based on the banking organization’s size and complexity. U.S.  regulators proposed requiring only the Basel II advanced approaches for  credit and operational risk for a small number of large and/or  internationally active banking organizations, but regulators are currently  seeking comment on allowing simpler risk measurement approaches for  these organizations. The U.S.-proposed changes to implement Basel II  differ from the international Basel II accord in several ways: the U.S.  proposal has a more limited scope, contains additional prudential  safeguards, retains key aspects of the existing regulatory capital  framework, and contains certain technical differences.
subsections: section_title: Basel II Is an International Framework Based on Shared Regulatory Objectives but Subject to National Implementation
paragraphs: The Basel II international accord seeks to establish a more risk-sensitive  regulatory capital framework that is sufficiently consistent internationally  but that also takes into account individual countries’ existing regulatory  and accounting systems. The international accord allows for a limited  degree of national discretion in the application of the approaches for  calculating minimum capital requirements, in order to adapt the standards  to different conditions of national markets. Since the international accord  was issued in 2004, individual countries have been implementing national  rules based on the principles and detailed framework that it sets forth, and  each country—including the United States—has used some measure of  national discretion within its jurisdiction. The Basel Committee noted that  as a result, regulators from different countries will need to make  substantial efforts to ensure sufficient consistency in the application of the  framework across jurisdictions. Furthermore, the Basel Committee  emphasized that the international accord sets forth only minimum  requirements, which countries may choose to supplement with added  measures to address such concerns as potential uncertainties about the  accuracy of the capital rule’s risk measurement approaches. As detailed  later in this report, the U.S.-proposed rules include such supplemental  measures, including certain requirements that already exist in the current  U.S. regulatory capital framework.
Basel II aims for a more comprehensive approach to addressing risks,  based on three pillars: (1) minimum capital requirements, (2) supervisory  review, and (3) market discipline in the form of increased public  disclosure. As shown in figure 1, Pillar 1 establishes several approaches  (of increasing complexity) to measuring risk. The advanced approach for  credit risk (known as the advanced internal ratings-based approach, or A- IRB) uses risk parameters determined by a bank’s internal systems for  calculating minimum regulatory capital. The A-IRB will increase both the  risk sensitivity and the complexity of such calculations. Under the  advanced approach for operational risk (known as the advanced  measurement approaches or AMA), a bank is to use its internal  operational risk management systems and processes to assess its need for  capital to cover operational risk. This method provides banks with  substantial flexibility and does not prescribe specific methodologies or  assumptions, although it does specify several qualitative and quantitative  standards. Pillar 2 explicitly recognizes the role of supervisory review,  which includes assessment of capital adequacy relative to a bank’s overall  risk profile and early supervisory intervention that are already part of U.S.  regulatory practice. Pillar 3 establishes disclosure requirements that aim to  inform market participants about banks’ capital adequacy in a consistent  framework that enhances comparability. Appendix III describes the Basel  II framework in further detail.
Federal banking regulators have proposed adopting the international  accord and integrating it into the existing U.S. regulatory capital  framework, but the four agencies have faced a number of impediments to  explicitly defining their objectives and balancing among several often  competing priorities. The international accord identifies several broad  objectives, and reaching agreement on these goals has been an important  part of building consensus among U.S. regulators on how to proceed with  Basel II. The international accord’s objectives are:    Safety and soundness. To further strengthen the soundness and stability  of the international banking system;   Consistency and competitive equity. To maintain sufficient  consistency that capital adequacy regulation will not be a significant  source of competitive inequality among internationally active banks;   Focus on risk management. To promote the adoption of stronger risk  management practices by the banking industry; and   Capital levels. To broadly maintain the aggregate level of minimum  capital requirements, while also providing incentives to adopt the more  advanced risk-sensitive approaches of the revised framework.
However, in satisfying these goals, federal regulators have struggled to  balance incentives (in the form of permissible capital reductions) for  banks that adopt the advanced risk measurement approaches with the  objective of broadly maintaining the aggregate level of minimum required  capital. At the same time, regulators seek to ensure that any incentives for  these banks do not adversely affect the ability of other banks to compete  domestically. In addition, regulators have sought to balance efforts to  protect safety and soundness under Basel II with efforts to maintain  sufficient consistency with the international framework. In particular,  regulators must ensure that the revised U.S. regulatory capital framework  does not create excessive international competitive inequities for U.S.  banking organizations. Unless these issues are resolved, they are likely to  generate ongoing questions about the appropriateness of Basel II as a  regulatory capital framework.
section_title: U.S. Regulators Propose to Apply Basel II Only to Large and/or Internationally Active Banks and Are Considering Which Risk Measurement Approaches to Make Available
paragraphs: As currently proposed in the United States, Basel II would be required only  for the nation’s largest and/or most internationally active banking  organizations. In addition, while banks in other countries may choose  from options that include both standardized and advanced approaches  available in the international accord, the current U.S. proposal permits  only the advanced approaches for credit risk (A-IRB) and operational risk  (AMA). In the proposed rule, U.S. regulators stated that they proposed to  implement only the advanced Basel II approaches, which use the most  sophisticated and risk-sensitive measurement techniques, in order to  promote further improvements in the risk measurement and management  practices of large and internationally active banks. Although other  countries may offer banks the choice of using any of the approaches in the  international accord, U.S. regulators noted that most foreign banks  comparable in size and complexity to U.S. core banks are adopting some  form of the advanced approaches. Regulators estimate that, according to  currently proposed criteria, 11 organizations would be required to comply  with Basel II. Together, these banks (known as core banks) hold about  $4.9 trillion in assets, or about 42 percent of total banking assets in the  United States (fig. 2). Other banks that are not required to adopt the Basel  II rule may opt into it with the approval of their primary federal regulator,  and regulators estimate that about 10 additional banks are considering  doing so.
Beginning in mid-2006, several core banks and industry groups have called  for the U.S.-proposed rules to offer all banks the option of adopting  alternative risk measurement approaches, including a standardized  approach for credit risk such as the one available in the international  accord. A standardized approach for credit risk, which is simpler and less  costly to implement than the Basel II advanced approach (A-IRB),  increases risk sensitivity compared to Basel I by expanding the number of  risk weight categories and more fully recognizing credit risk mitigation.  However, it is not as risk sensitive as the Basel II A-IRB approach, which  relies in part on banks’ internal models to estimate inputs into capital  calculations. Bank officials stated that the A-IRB approach, as proposed in  the United States, would yield little opportunity for banks to realize the  benefits of a more risk-sensitive capital framework. Officials from a few  core banks acknowledged that a standardized approach for credit risk  might not adequately address the risks facing large, complex banks.
However, other bank officials said that they would prefer having the  option of using a standardized approach for credit risk, especially if the  U.S.-proposed rule for the advanced approach continued to exhibit certain  differences from the international accord.
Some federal and state regulators have also noted the potential advantages  of allowing a standardized approach for credit risk. For example, FDIC  officials have noted that because the standardized approach establishes a  floor for each risk exposure, it does not provide the same potential for  dramatic reductions in capital requirements and would not pose the same  competitive inequity concerns as the advanced approach. But FDIC  officials also recognized that others have argued that only the advanced  approaches would provide an adequate incentive for strengthening risk  measurement systems at the largest banks. An association of state bank  regulators also called for consideration of the standardized approach in  the international accord, stating that it would be more risk sensitive than  the current framework and simpler to implement and supervise than the  advanced approach. An academic familiar with bank regulation also  expressed support for a standardized approach as an interim solution to  allow the regulators time to further assess the feasibility of the internal  ratings based approach.
In response to these developments, regulators have requested public  comments on whether U.S. banks subject to the advanced approaches  should be permitted to use other credit and operational risk approaches  similar to those provided in the international accord. However, regulators  have not specified how, if at all, they might propose to apply such  approaches, citing the need first to review comments received during the  comment period of the rule-making process, which has been extended to  March 26, 2007. Regulators have also noted that to date, banks have not  sufficiently clarified their views on what form a standardized approach for  credit risk should take. Given that the Basel II NPR only asks a question  about a standardized approach and offers no specifics, the banking  regulators indicated that pursuant to the rule-making requirements of the  Administrative Procedure Act they would likely issue a new, targeted NPR  if they were to include the approach as an option for credit risk. This new  proposal would require a definition of the standardized approach in the  United States, its application criteria, and how long banks could opt to use  it. Failure to provide a subsequent NPR if this option were included in the  final rule could result in new questions, issues, and potential unintended  consequences that the regulators may not have considered.
section_title: U.S. Regulators Have Revised Time Frames for Implementation and Proposed Prudential Safeguards
paragraphs: Concerns in the U.S. about the potential adverse impact of Basel II on  regulatory capital requirements have led federal regulators to revise the  time frame for implementation and propose additional prudential  safeguards. Appendix II shows key events in the transition to Basel II and  proposed implementation time frames in the United States and abroad. In  April 2005, U.S. federal regulators announced that a quantitative impact  study (QIS-4) had estimated that Basel II could cause material reductions  in aggregate minimum required risk-based capital and significant  variations in results across institutions and portfolio types. As a result,  they delayed the time frame for issuing the Basel II NPR in order to further  analyze the results of the study. In February 2006, regulators announced  that QIS-4 had estimated reductions in minimum total risk-based capital  requirements of 15.5 percent (mean) and 26.3 percent (median), as well as  reductions in minimum tier 1 risk-based capital requirements of 22 percent  (mean) and 31 percent (median), relative to the current Basel I-based  framework. The study also estimated significant reductions in minimum  required capital for almost every portfolio category. In addition, the study  showed that similar loan products at different banks may have resulted in  very different risk-based capital requirements. However, as discussed later  in this report, regulators were unable to conclude whether the study’s  estimates were an understatement or overstatement of the overall level of  minimum risk-based capital that would be required in a fully implemented  Basel II. Nevertheless, the regulators stated that the results observed in  QIS-4 would be unacceptable in an actual capital regime.
While regulators decided to proceed with issuing a proposed rule, delays  in both the rule-making process and the implementation time frame have  created challenges. Regulators stated that a final rule, supplemented with  certain prudential safeguards, would allow them to more reliably observe  the impact of Basel II. Such a controlled environment would prevent  unintended capital reductions and would allow banks to submit compliant  data based on a final rule that would provide greater certainty than data  submitted under a preliminary impact study. For example, regulators  delayed the start of the first available “parallel run” until January 2008, a  year later than the international accord, creating challenges for banks that  operate in multiple countries. Regulators also added a third transition  period to the original two transition periods and established floors on  capital reductions for individual institutions during the transition period  that are more conservative than those proposed in the international  accord.
Regulators must resolve a number of open questions before issuing the  final rule for Basel II. They have expressed a goal of doing so by June 30,  2007, at least 6 months prior to the start of the first available parallel run.  The regulators have defined more specific objectives in the U.S.-proposed  rule that include the following:    Viewing a 10 percent decline in aggregate risk-based capital requirements  compared to risk-based capital requirements under the existing rules as a  material reduction warranting modifications to the Basel II-based  framework;   Establishing comparable capital requirements for similar portfolios;    Domestically, working to mitigate differences in risk-based capital  requirements between institutions that participate in Basel II and those  that do not; and   Retaining the leverage ratio and prompt corrective action requirements.
Table 3 summarizes some of the key differences between the U.S.- proposed rules for Basel II and the international accord.
section_title: U.S. Regulators Proposed Basel IA and Plan to Retain Basel I for All Other Banks
paragraphs: Regulators have proposed revising and retaining key aspects of Basel I,  which would result in multiple risk-based capital regimes—Basel II, Basel  IA, and Basel I. The regime that each bank uses will be largely based on its  size and complexity. Federal regulators had initially limited the scope of  Basel II to a small number of large and/or internationally active  institutions and had planned to retain Basel I unchanged for all other  institutions, in order to reduce the regulatory burden for these banks. In  response to concerns voiced by small banks about potential competitive  inequities between them and banks adopting Basel II, regulators proposed  Basel IA. Regulatory and bank officials acknowledge that Basel IA may  help mitigate potential competitive inequities, although the extent of this  impact is still to be seen. Basel IA is a risk-weighting approach that  provides greater risk sensitivity than the current Basel I framework and is  less risk sensitive and less complex than the Basel II advanced  approaches. The Basel IA proposal discusses various modifications that  would increase the number of risk-weight categories relative to Basel I;  permit greater use of external credit ratings, if available, as an indicator of  credit risk; expand the range of eligible collateral and guarantors used to  mitigate credit risk; and use loan-to-value (LTV) ratios to determine risk  weights for most residential mortgages. Specifically, Basel IA proposes  six risk-weight categories based on LTV ratios that would replace Basel I’s  single risk category for most mortgages. As a result, minimum capital  requirements for mortgages under Basel IA would be more sensitive to  risk than they would be under Basel I. As shown in figure 3, Basel I would  generally require the same amount of capital regardless of the risk level  (LTV ratio) of the mortgage, but Basel IA would generally increase  required capital for higher risk loans and decrease required capital for  lower risk loans. Nevertheless, Basel IA would not be as sensitive to credit  risk as the Basel II A-IRB approach, nor would it rely on banks’ internal  models to determine minimum capital requirements. Under the Basel II A- IRB approach, risk parameter estimates take into account a wider variety  of information, such as probability of default, loss given default, and  exposure at default.
Federal regulators have recently requested comment on whether Basel IA  might be an appropriate option for banks subject to Basel II as an  alternative to the advanced approaches. As discussed earlier, in the  September 2006 Basel II NPR regulators requested comment on whether,  and for what length of time, a standardized approach for credit risk similar  to the approach in the international accord should be provided as an  option for core banks. Subsequently, in the Basel IA NPR released in  December 2006, the regulators requested comment on whether the Basel  IA proposal or the standardized approach in the international Basel II  accord would be an appropriate credit risk measurement approach for  Basel II banking organizations and whether operational risk should be  addressed using one of the three Basel II approaches. In many respects,  the Basel IA proposal is similar to the Basel II standardized approach for  credit risk. Both approaches create several additional risk categories and  for the most part do not rely on banks’ internal models for calculating risk- based capital. Unlike Basel IA, the standardized approach has only a single  risk-weight category for most mortgage loans. Compared with the  advanced approach, the standardized approach offers less risk sensitivity  but also less complexity, and it does not provide capital incentives for  large banks to further improve their risk management practices.  Regulators also asked in the Basel IA proposal how, if Basel IA is an  option for Basel II banking organizations, they can be encouraged to  enhance their risk management practices or financial disclosures if  provided options other than the advanced approaches. Lack of sufficient  resolution on these significant questions may lead to continued  uncertainty about the proposed changes to the U.S. regulatory capital  framework.
Given the large number of U.S. banks of different sizes, including  thousands of small banks, regulators also plan to retain Basel I. Any bank  not required to adopt Basel II would have the option of either adopting  Basel IA, upon notifying its primary regulator, or remaining under Basel I.  Regulatory officials have noted that Basel I would still be an adequate  capital regime for most banks but that it is becoming increasingly  inadequate for the largest and most complex banks. Regulators have  stated that some small banks tend to hold capital well in excess of current  regulatory minimums. Regulators indicated, based on comment letters  received, that due to the compliance burden associated with moving to  Basel IA, some small banks that are highly capitalized may choose to  remain under Basel I.
section_title: U.S. Regulators Plan to Retain the Leverage Requirement and Apply Existing Prompt Corrective Action Measures
paragraphs: While the U.S.-proposed Basel II and Basel IA rules address revisions to  risk-based regulatory capital, regulators also plan to retain the existing  leverage requirements and prompt corrective action (PCA) measures.  Federal regulators have committed to retaining a minimum leverage  requirement for all banks, regardless of whether they use Basel II, IA, or I  to calculate their risk-based required capital. The leverage requirement, a  simple ratio of tier 1 capital to on-balance sheet assets, is a U.S.-specific  measure, while risk-based requirements are generally defined based on the  international Basel accords. U.S. regulators stated that risk-based and  leverage requirements generally serve complementary functions, in which  the leverage ratio can be viewed as offsetting potential weaknesses of the  risk-based ratios, while the risk-based ratios offset weaknesses of the  leverage ratio. Risk-based requirements are intended to be more sensitive  to assets of varying levels of risk and to address risks of off-balance sheet  activities. However, the complexity of risk-based capital calculations will  increase significantly under the advanced approaches of Basel II as these  calculations depend on banks’ estimates of risks and supervisory formulas  that are based on certain assumptions. By contrast, a leverage ratio is easy  to calculate and verify. Regulatory officials also noted that the leverage  requirement can be considered to cover areas that risk-based requirements  do not currently address, such as interest rate risk, concentration risk, and  “model risk” (i.e., risk that the model assumptions or underlying data  could be unreliable). While U.S. regulators support the use of a leverage  requirement, some have noted that the leverage ratio, as currently  formulated, may impede the risk sensitivity of the proposed changes to  risk-based requirements.
In addition, under the PCA framework in the United States, banks tend to  hold both risk-based and leverage capital at significantly higher levels than  the international regulatory minimums. As figure 4 shows, the PCA  thresholds for “well-capitalized” status exceed the international Basel  minimums, which are considered under PCA as “adequately capitalized.”  According to banking regulators, failure to maintain well-capitalized status  can have significant consequences, such as higher deposit insurance  premiums. As a result, most U.S. banks maintain regulatory capital at  levels that achieve well-capitalized status. In connection with the U.S.- proposed Basel II framework, PCA will play a significant role in ensuring  that Basel II banks maintain sufficient capital.
section_title: The U.S. Proposal Differs in Other Ways from the International Accord
paragraphs: The Basel II NPR contains several other deviations from the international  accord that have resulted in uncertainty and concerns about international  consistency. For example, the proposed definitions of default for  wholesale and retail exposures in the United States differ from those used  in other jurisdictions. Differences in such fundamental definitions could  have significant effects on the implementation costs of banks operating in  multiple jurisdictions, possibly requiring banks to develop multiple data  systems and processes. Furthermore, in contrast to the international  accord, the U.S. proposal does not include an adjustment that would result  in required capital for loans to small- and medium-sized businesses being  lower than would be required for other business loans under the  framework. Regulators noted that some misunderstanding may exist  among banks on aspects of the proposed rule, such as the estimation of  loss given default (LGD), a key risk input, under economic downturn  conditions. The regulators proposed a supervisory formula for banks that  do not qualify for use of their own LGD estimates, but it was not intended  as a requirement for those banks that do qualify for use of their own LGD  estimates. A number of other differences exist, and regulatory officials  noted the need to take a comprehensive view of these differences, that in  some areas the proposed U.S. requirements are less conservative than the  international accord, and in other areas the requirements are more  conservative. Notwithstanding these differences, other international  differences in regulatory and accounting standards also have significant  consequences for the comparability of capital ratios and the associated  costs of implementing Basel II.
In addition, SEC has established a holding company supervision regime for  certain securities firms that requires computation of groupwide capital  adequacy measures and is separate from the federal banking regulators’  proposed Basel II rule, raising some concerns about competitiveness  between large commercial and investment banks subject to different  capital rules. SEC’s voluntary, alternative net capital rule, approved in  2004, allows certain broker-dealers to use internally developed  mathematical models to calculate market and derivatives-related credit  risk. In order for a broker-dealer to apply the rule, its ultimate holding  company (collectively, the “consolidated supervised entity”) must  calculate and report capital adequacy measures that are broadly consistent  with Basel standards and consent to groupwide supervision by SEC. SEC  issued the rule in part as a response to a requirement by the European  Union that non-European Union financial institutions be subject to  consolidated supervision at the groupwide level in order to conduct  business in Europe without establishing a separate European holding  company. Five investment bank holding companies have elected to be  treated as consolidated supervised entities. While the rule does not  prescribe the use of the Basel II advanced approach for credit risk,  consolidated supervised entities have with one exception elected to apply  this approach. According to SEC officials, because the timetable imposed  by the European requirements necessitated the adoption of holding  company capital requirements by consolidated supervised entities prior to  issuance by U.S. banking regulators of guidance on Basel II, SEC has used  the 2004 international Basel II accord as its guide for Basel II  implementation. SEC officials stated that they would review the changes  in the banking regulators’ final rule and that they planned to implement  Basel II for investment banks in a way that was generally consistent with  the Federal Reserve’s interpretation of Basel II as applied to financial  holding companies.
section_title: Basel II Is Expected to Improve Risk Management and Enhance Capital Allocation, While Proposed Safeguards Would Help to Prevent Large Capital Reductions during a Temporary Transition Period
paragraphs: The longer-term impact of Basel II on minimum regulatory capital  requirements and the safety and soundness of the banking system is  largely unknown, but its implementation could have a variety of  consequences for the banking system. First, bank and regulatory officials  generally agree that the movement toward Basel II has prompted the  largest U.S. banking organizations to make improvements in their risk  measurement and risk management systems. Second, the advanced Basel  II risk modeling approaches have the potential to better align capital with  risk, such that banks would face minimum capital requirements more  sensitive to their underlying risks. However, the advanced approaches are  not themselves without risks and realizing the benefits of these  approaches will depend in part on the sufficiency of credit default and  operational loss event data used as inputs to the regulatory and bank  models that determine required capital. Third, while initial estimates of the  potential impact of Basel II showed large drops in minimum required  capital, the impact of Basel II on minimum required capital is uncertain,  and U.S. regulators have proposed safeguards to prevent the large  reductions in required capital during a transition. Fourth, possible changes  in regulatory capital requirements have also raised some banks’ concerns  about competition between large and small banks domestically, and  between large banks headquartered in the United States and foreign  banking organizations. Finally, Basel II’s impact on the amount of capital  banks’ actually hold is also uncertain because regulatory requirements are  just one of several factors that banks weigh in deciding how much capital  to hold. In light of the uncertainty concerning the potential impact of Basel  II, these issues will require further and ongoing examination as the  banking regulators continue to finalize the Basel II rule and proceed with  the parallel run and transition period.
subsections: section_title: Basel II Preparations Have Contributed to Improved Risk Management at Participating Banks
paragraphs: Bank and regulatory officials generally agree that, due to the systems  required for the use of the advanced approaches, Basel II has already  prompted some large banks to improve their risk measurement and  management systems. For example, officials at one bank said that the  more detailed categorizing of risks under the advanced approaches would  offer information about a portfolio that banks could use to identify and  plan for potential problems. Other officials said that Basel II would  improve their collection and use of data so that they could aggregate and  better understand information about their risk profile across all their  portfolios. Some officials noted that Basel II would help to formalize  processes for identifying and addressing operational risk. In preparation  for Basel II implementation, many banks have improved data collection  and invested resources in quantifying and modeling operational risk.
Although they felt it still had many gaps, officials from several core banks  said that Basel II also brought regulatory requirements closer to the ways  in which they have been addressing economic risk internally. Many of  these officials believe that the transition to Basel II should help the banks  continue to more quickly improve their risk management practices.
Officials from some banks that were considering adopting Basel II cited  several factors that made the new framework attractive. Officials from  some banks acknowledged that over the long run Basel II would make the  regulatory capital framework more risk sensitive and improve bank’s risk  management and internal controls, resulting in stronger banks. Officials  from one bank stated that over the long term, Basel II would equip them  with the tools to better differentiate and price risks and allocate capital,  placing the bank in a stronger position to compete with larger banks.  Officials from a few banks said that as a result of acquisitions or business  growth, their institutions would grow and become more complex,  requiring more sophisticated risk measurement and management tools.  These officials also shared the view that Basel II would further improve  their collection and use of data and other information. Officials from one  bank believed that such information would allow banks to make better  decisions during emergency situations. Finally, officials at some banks  said that their foreign parent companies were required to implement the  new framework, facilitating their adoption of Basel II in the United States.
Regulatory officials also believed that the systems required for the  advanced approaches would allow banks to better understand and  measure risk, and they suggested that the improvements in risk  management at these banks was one of the primary benefits of Basel II.  For example, Federal Reserve officials noted that the proposed rule  mandates that the largest U.S. banks adopt the advanced approaches of  Basel II because these approaches would strongly encourage improved  risk measurement and management practices. Regulatory officials stated  that the requirement to model operational risk has created significant  interest in the discipline and has motivated some banks to collect  operational loss data. Another positive risk management effect of Basel II  preparation, according to some regulatory officials, is improved data  collection that will be useful for internal economic capital purposes as  well as for calculating regulatory capital.
section_title: Basel II Models Could Improve the Risk Sensitivity of Capital Requirements but Also Have Limitations
paragraphs: The bank and regulatory models associated with the Basel II advanced  approaches have the advantage of making capital requirements more  sensitive to some underlying risks, but also have a number of limitations.  This improved risk sensitivity could improve the safety and soundness of  the banking system. However, the use of bank models that influence  capital requirements requires increased reliance on risk assessments  provided by bank officials, though these assessments are subject to both  internal and supervisory review. The A-IRB approach incorporates  historical estimates of credit losses to determine required capital but is  based on simplifying assumptions provided by regulators about the  sources of credit risk. Its effectiveness will depend on the quality and  sufficiency of data on credit losses. With sufficient controls on the  modeling process, and relevant historical data, the A-IRB approach should  generate capital requirements more reflective of actual credit risk than the  broader risk categories of Basel I. The AMA approach offers a number of  channels for risk sensitivity, though the operational risk capital  requirements are sensitive to the potentially varied statistical assumptions  and data banks would use to estimate the magnitude of severe operational  loss events. Finally, while banks’ models have been used for internal  purposes, they are relatively unproven for regulatory capital purposes. The  use of these models also raises concerns about their ability to estimate  losses from low-frequency catastrophic events, which also increases the  importance of supervisory review as well as regulators’ attention to the  appropriate level of risk-based capital.
subsections: section_title: More Risk-Sensitive Capital Requirements Could Improve Safety and Soundness
paragraphs: For a given amount of capital, more risk-sensitive capital requirements  could improve the safety and soundness of the banking system through a  number of channels—each of which more closely aligns required capital  with associated risks—and provide a required level of capital more likely  to absorb unexpected losses. First, holding assets with higher risk under  Basel II would require banks to hold more capital relative to lower risk  assets. For example, while Basel I requires the same amount of capital for  many high-risk and low-risk mortgages, those mortgage loans on average  expected to have greater credit losses under Basel II would require more  capital than would be required for other mortgage loans. Second, banks  with higher risk credit portfolios or greater exposure to operational risk  would be required to hold relatively more capital than banks with lower  risk profiles. For example, a bank with a speculative bond portfolio, or one  with a business line more susceptible to fraud, could face relatively higher  capital requirements in those areas. Third, because credit quality varies  over the business cycle, banks could be required to hold more capital for  some assets as economic conditions are expected to deteriorate. As a  result, banks would have a relatively larger capital requirement when  credit losses from default are more likely. Finally, although more risk- sensitive capital requirements can help enhance safety and soundness, the  level of regulatory capital must also be sufficient to account for broader  risks to the economy and safety and soundness of the banking system,  which will require ongoing regulatory scrutiny.
section_title: A-IRB Approach for Credit Risk Has Strengths and Weaknesses
paragraphs: Assuming sufficient controls on the quantification and modeling process,  and relevant historical data, the A-IRB approach should generate capital  requirements more reflective of actual credit risk than the broad Basel I  risk categories; however, the formulas provided by regulators for  calculating capital requirements for credit risk have both strengths and  weaknesses. The A-IRB formulas generate a capital requirement that  depends on risk characteristics of the asset, estimated by the bank, such  as the probability of default (PD) and LGD, thus making required capital  more sensitive to the underlying risk of the asset. This improved risk  sensitivity would help ensure that banks are required to hold relatively  more capital against riskier assets more likely to generate unanticipated  credit losses and hold less required capital against less risky assets.  However, the appropriateness of the capital requirements generated by the  A-IRB approach depends on the accuracy of parameter estimates, such as  PD and LGD, which depend in part on the quality and comprehensiveness  of the historical data that underlie the estimates. For portfolios with data  that cover short time horizons or incomplete economic cycles, the capital  required under the A-IRB approach will not necessarily accurately reflect  the risk of credit losses from the asset because the more limited history  may not be representative. However, for portfolios with data covering  longer time horizons that include adverse economic conditions, the A-IRB  approach is anticipated to generate a capital requirement better aligned  with the underlying risk of the asset than the broad risk categories of  Basel I.
The authors of a Basel Committee working paper have noted significant  challenges related to estimation of loss severity and exposure at default in  particular, and highlight the importance of building consistent data sets at  banks. For new or innovative financial products, bank officials described  a number of strategies for estimating risk parameters, including simulating  how the borrower would behave under a variety of economic conditions,  comparing the product to similar products for which the banks already  had data, using expert judgment, and making conservative adjustments to  estimates. Officials at several banks told us these sorts of products were  typically not material portions of their credit portfolio, and therefore  would not materially affect their capital requirements under Basel II. None  of the bank officials with whom we spoke had received formal feedback or  guidance from regulators clarifying the treatment of portfolios that did not  have a historical track record, though one official explained that similar  strategies to those described above had already been endorsed by  regulators for market risk calculations.
For large corporate borrowers, bonds or loans with lower external ratings  would generally be assigned a higher probability of default, resulting in  relatively higher required capital. In addition, estimates of LGD for small  business loans, for example, will be sensitive to collateral that the  borrower provides, with greater collateral reducing the losses to the  lender if the borrower defaults, and hence required capital. However, the  A-IRB formulas are based on certain simplifying assumptions that provide  only limited recognition of diversification and concentration in credit risk,  among other limitations. Other criticisms include inappropriate values for  the regulator-provided asset correlations with the overall economy, and  the assumption that credit risk at a given bank is driven by a single,  economy-wide risk-factor with simplified statistical properties. More  generally, some researchers believe that the A-IRB approach does not  reflect best practices in banking but instead reflects a negotiated  compromise that attempts to balance competing goals, including improved  risk sensitivity and simplicity. In essence, the A-IRB approach is an  attempt to convert historical data on credit defaults into worst-case  scenario credit losses, assuming that this scenario can be captured by  statistical assumptions about the distribution of losses. These severe  scenarios are inherently difficult to estimate, because of their rarity, but  their magnitude will determine the level of resources banks will need to  weather similar events. Regulators acknowledge the assumptions of the A- IRB approach represent simplifications of very complex real-world  phenomena, meant to approximate such severe scenarios.
section_title: AMA for Operational Risk Also Has Strengths and Weaknesses
paragraphs: The Basel II NPR is less prescriptive on the calculation of capital  requirements for operational risk, the AMA. Nevertheless, banks must  incorporate a number of elements, and regulators have prescribed a level  of confidence for bank models that is equivalent to requiring a capital level  for operational risk that would have a one in one thousand chance of being  exceeded by operational losses in a given year, provided the underlying  assumptions were correct. The elements that banks must incorporate are  internal operational loss event data, external operational loss event data,  results of scenario analyses, and assessments of the bank’s business  environment and internal controls. One rationale for the flexibility  afforded under the AMA approach is that operational risk modeling is a  new and evolving discipline.
According to some regulatory officials, Basel II banks are all currently  exploring the loss distribution approach (LDA) to estimating their  exposure to operational risk. Under one possible way to implement a LDA,  a bank would use internal and external operational loss data to separately  estimate the range of possible frequencies and magnitudes of operational  losses. The bank would then combine this information with expert- designed scenarios to better anticipate very infrequent, yet very severe  operational loss events. Finally, the bank is required to incorporate  information regarding the strength of its internal controls, and risks of its  particular business environment into its estimates of potential losses.  Banks may also be able to use insurance or other risk mitigants aimed at  covering operational losses to reduce their operational risk required  capital by up to 20 percent. This approach offers a number of channels for  risk sensitivity and also provides incentives to mitigate operational risk.  First, internal operational loss data are by nature specific to individual  banks, so they are expected to reflect the types of losses that have  historically affected the bank. Second, because the AMA requires that  banks incorporate an assessment of the strength of internal controls,  expert-designed scenarios could reflect where internal controls, or lack of  them, are likely to mitigate or exacerbate potential operational losses.  Third, because banks would, to a limited extent, be able to reduce their  capital requirements by insuring against some operational losses, the AMA  could provide additional incentives for banks to purchase such insurance  or other risk mitigants.
There are several methodological challenges with respect to quantifying  operational risk. For example, the operational risk capital charge will be  strongly influenced by infrequent but very large operational losses.  Because of their rarity, the magnitude and likelihood of these losses is  difficult to estimate. Some banks have joined industry groups to share data  or have purchased data from external sources to supplement internal data.  Nevertheless, the estimated operational risk exposure will be sensitive to  the potentially varied statistical assumptions and data sources chosen by  the bank. The lack of data on severe operational losses also increases  reliance on scenario analysis. While scenario analysis can be useful in  offering a forward-looking perspective not captured by internal data, the  Basel Committee has noted that the rigor applied to scenario development  varies greatly from bank to bank.
section_title: Using Bank Models for Regulatory Capital Purposes Increases Importance of Validation and Supervisory Review of Bank Models
paragraphs: Required capital levels under Basel II will depend in part on a bank’s own  assessment of the risks to which it is exposed, and these assessments are  to be subject to both independent internal scrutiny and supervisory  review. The use of these assessments has the advantage of making  regulatory capital more sensitive to risks but also requires bank  supervisors to increase their reliance on the risk assessments of bank  officials. As discussed previously, models similar in some ways to the ones  that would be used for Basel II have been used by banks for internal risk  management purposes but, with the exception of market risk, have not  been used to calculate minimum regulatory capital requirements. To  address this issue, regulators have put several safeguards in place to  provide greater confidence in bank estimates, especially the requirement  that the models that the bank would use to implement Basel II must be  validated on an ongoing basis. That is, these models must have an  independent internal evaluation for conceptual soundness and real-world  performance, among other areas. The model validations can also be  reviewed by bank examiners and quantitative specialists at the discretion  of the regulators, and the integrity of the process surrounding model  validation is also subject to regulatory review. The adequacy of the  supervisory review process will be particularly important to ensure  prudent estimates of risk, and hence, required capital.
section_title: Changes in Capital Requirements Could Affect Competition among Banks
paragraphs: Possible changes in regulatory capital requirements have raised concerns  about competition between large and small banks domestically; between  large banks headquartered in the United States and foreign banks; and  commercial and investment banks in the United States, though the effect  of Basel II on bank competition remains uncertain. The competitive  landscape for banks headquartered in the United States will change in  2007 as some foreign banks implement Basel II, which has raised concerns  among core banks. For example, some core banks are concerned that the  leverage ratio, to which foreign banks based in industrialized countries are  generally not subject, may impose higher capital requirements than Basel  II for banks with relatively low-risk credit portfolios. U.S. banks competing  in foreign jurisdictions would be subject to foreign regulatory  requirements, as well as a 3 percent leverage ratio at the holding company  level. U.S. banks have also expressed concern about other aspects of the  U.S. Basel II rules that could impose higher costs than foreign Basel II  rules.
Controversial initial estimates of the capital levels that would be required  under the A-IRB approach suggested that credit risk capital required for  many broad asset classes could fall relative to Basel I. In particular, OCC  has noted that because of the low credit risk associated with collateralized  mortgage lending, that Basel II may lead to substantial reductions in  credit-risk capital for residential mortgages. Because mortgage lending is  an area where the largest U.S. banks compete with smaller banks, some  regulators and smaller banks were concerned that those banks not subject  to Basel II would be at a disadvantage. Regulators proposed Basel IA in  part to mitigate potential competitive disparities between large and small  banks, and the proposal features some additional risk sensitivity for  mortgages and lower capital requirements than Basel I for some lower risk  mortgages. OCC has noted that another potential avenue for competitive  effects between smaller banks and Basel II banks is small business  lending. One study of lending to small and medium enterprises found only  relatively minor competitive effects between community banks and Basel  II banks, because community banks and large banks make different kinds  of small business loans. However, there were potentially significant  adverse competitive effects on large banks that do not adopt Basel II in the  United States. While this study is a comparison of the A-IRB approach  and Basel I, regulators state in the Basel IA NPR that they are exploring  options for an additional, lower risk-category for certain small business  loans (the equivalent to a 25 percent reduction in capital requirements for  those loans). Even with Basel IA as an option, FDIC officials have  highlighted concerns about potential competitive disadvantages for banks  that do not adopt Basel II based on lower estimated capital requirements  in the QIS-4 as compared with the Basel IA ANPR. Retaining the leverage  ratio for all U.S. banks will likely be important to addressing some of these  competitiveness concerns.
Finally, banking organization officials have also raised the concern that  they will face disadvantages relative to domestic competitors that will not  be subject to the U.S. version of Basel II, such as some large investment  banks regulated by SEC at the holding company level (consolidated  supervised entities), which are permitted to use the international Basel II  framework. SEC officials with whom we spoke generally did not believe  that the differences between the NPR and SEC’s rule would raise material  competitiveness issues, mostly because investment banks did not  currently engage in significant middle market and retail lending. The  officials said they would review the changes to the banking regulators’  final rule and planned to implement Basel II for investment banks in a way  that was generally consistent with the Federal Reserve’s interpretation of  Basel II, as applied to financial holding companies, and would consider  changes that went beyond the Basel agreement. SEC officials stated they  did not anticipate the need to propose another rule to incorporate any  such changes.
section_title: The Impact of Basel II on the Level of Bank Capital Is Uncertain, but Proposed Safeguards Would Limit Capital Reductions during a Transition Period
paragraphs: While initial estimates of the impact of Basel II showed large drops in  minimum required capital, a considerable amount of uncertainty remains  about the potential impact of Basel II on the level of regulatory capital  requirements and the degree of variability in these requirements over the  business cycle in the long term. The banking regulators have committed to  broadly maintain the level of risk-based capital requirements and proposed  safeguards that would limit capital reductions during a transition period.
subsections: section_title: Quantitative Impact Study Raised Concerns about Large Drops in Required Capital
paragraphs: The QIS-4 showed, on average, large drops in minimum required risk- based capital for participating banks, and there are a number of factors  affecting capital requirements that could make the potential impact of  Basel II, as currently proposed, vary in either direction from the QIS-4  results. First, the Basel Committee has instituted a “scaling factor” that  was not included in the QIS-4 results, currently 1.06, equivalent to a 6  percent increase, which would raise capital requirements for credit risk  relative to QIS-4. The U.S. regulators, who have included this increase in  the NPR, view 1.06 as a placeholder, and have stated that they will revisit  the scaling factor along with other calibration issues identified during the  parallel run and transitional floor periods. U.S. regulators have also  committed to broadly maintain the overall level of risk-based capital  requirements (i.e., capital neutrality) with some incentives for the  advanced approaches in the NPR, though they have not defined precisely  how they plan to achieve this goal. Large reductions in minimum required  capital could reduce safety and soundness because banks would generally  hold too little capital in the absence of capital regulation. Second, the  regulators have noted a number of factors that could have biased the QIS-4  estimates in either direction. For example, the limited use of downturn  LGDs, meant to capture economic losses from default in a stressed or  recessionary economic environment, might have caused required capital  to be understated during QIS-4, while the lack of incorporation of credit  risk mitigation may have overstated required capital. Officials at some  banks noted more recently that, based on their estimates, they did not  expect large deviations from their QIS-4 results—with respect to the level  of total minimum capital requirements—given similar economic  conditions. Finally, the greater sensitivity of the A-IRB approach to  economic conditions and the good economic environment during QIS-4  was an important factor in explaining lower estimates of required capital,  and less favorable economic conditions could produce greater required  capital.
The QIS-4 results featured variations in capital requirements across  portfolios and also identical assets. Regulators offered several possible  explanations for this variation, but some regulatory officials believed that  the variation raised questions about the reliability of bank models for  determining regulatory capital. One result of the QIS-4 was a variation in  capital requirements for the same broad class of assets. However,  portfolios for a given type of exposure can vary significantly from bank to  bank. For example, one bank may specialize in prime credit card  borrowers, while another may specialize in less credit worthy credit card  borrowers. The former would therefore be required to hold less capital for  its credit card risks under a risk-sensitive system such as Basel II. FDIC  officials have expressed particular concern regarding variation in capital  requirements for identical assets across banks based on a test constructed  by regulators as part of the QIS-4. In a functioning capital regime, this  variation would imply different capital treatment across banks for the  same degree of risk, which, if significant, would run counter to both the  goals of capital adequacy and competitive equity. The regulators  emphasized that the QIS-4 was conducted on a “best efforts” basis without  the benefit of either a definitive set of proposals or meaningful supervisory  review of the institutions’ systems. Nevertheless, QIS-4 raised a number  of questions that have significantly changed the way U.S. regulators are  planning to implement Basel II.
section_title: The Parallel Run, Transitional Floors and Leverage Ratio Would Help Prevent Large Declines in Required Capital during a Transition Period
paragraphs: As proposed in the United States, Basel II would initially have a less  significant impact on minimum required capital because the parallel run  and transitional floors would prevent large reductions in capital  requirements during a transition. The parallel run would allow regulators  to observe how Basel II would affect minimum capital requirements; and  regulators would see how the banks’ models perform, as banks would  calculate required capital under both Basel I and Basel II, while meeting  the Basel I requirement. The NPR notes that regulators plan to share  information related to banks’ reported risk-based capital ratios with each  other for calibration and other analytical purposes. Banks would be  qualified to transition to Basel II only after four consecutive calendar  quarters during which the bank complies with all of the qualification  requirements to the satisfaction of its primary federal supervisor. During  at least three transitional years, permissible risk-based capital reductions  at a qualified bank would rise by 5 percent per year relative to minimum  capital requirements calculated using Basel I. Regulators have also stated  that banks under Basel II would continue to be subject to the leverage  ratio—a capital requirement that is calculated as a percentage of assets,  independent of risk—which could also prevent significant reductions in  required capital.
As mentioned previously, regulatory officials have suggested a number of  advantages to the leverage ratio—a common financial measure of risk— although as it is currently formulated, it also has some drawbacks. The  advantages of the leverage ratio include that it is easy to calculate and that  it can compensate for the limitations of the risk-based minimum  requirements, including coverage of only market, credit, and operational  risk, and the possibility that risks could be quantified incorrectly.  However, the leverage ratio could be the higher capital requirement for  some banks at some times, especially those with low risk profiles. This  would dampen some of the risk sensitivity of Basel II for low-risk banks  and assets, possibly leading to disincentives for banks to hold low-risk  portfolios. Furthermore, some banks were concerned that the leverage  ratio requirement, along with certain safeguards, defied the purpose of  moving to a conceptually more risk-sensitive capital allocation framework.  These banks believed that the leverage requirement and some safeguards  could prevent banks’ regulatory capital levels from reflecting actual risk  levels. As a result, the banks would not benefit from the capital reductions  associated with taking on less risk, or managing it more effectively. As  seen in figure 5, the leverage capital requirement for the lowest risk  externally rated corporate exposures could exceed the Basel II credit risk  requirement, making the leverage ratio the relevant requirement. Both  figures 5 and 6 compare the minimum leverage ratio requirement (a tier 1  capital requirement) with the Basel II credit risk capital requirement (a  total capital requirement that must be met with at least half tier 1 capital,  but can also include tier 2 capital). If the figures compared only tier 1  capital, the Basel II credit risk capital requirements would be half as high,  which would mean that the leverage ratio would exceed the Basel II tier 1  capital Basel requirement for a broader range of assets, and thus be the  relevant constraint.
OTS has noted that because of the low credit risk associated with  residential mortgage-related assets, relative to other assets held by banks,  the risk-insensitive leverage ratio may be more binding for mandatory and  opt-in thrifts, thus the proposed rule may cause these institutions to incur  much the same implementation costs as banks with riskier assets, but with  reduced benefits. Similar to the lowest risk externally rated corporate  exposures, as seen in figure 6, the leverage capital requirement for many  lower risk mortgages, such as those with a lower probability of default,  could exceed the Basel II credit risk requirement. Also, the U.S. leverage  requirement does not include off-balance sheet exposures, which include  many securitizations and derivatives, resulting in an incomplete picture of  capital adequacy. As a result, the retention of the leverage ratio under  Basel II may still provide a regulatory disincentive to hold low-risk assets  on the balance sheet.
To supplement the results from QIS-4, some banks simulated their  portfolios under alternative economic conditions and estimated that  capital requirements for consumer and business credit exposures could  vary from 20 to 35 percent over the business cycle under Basel II, because   defaults and losses are higher in poor economic times. More generally,  some bank officials said that Basel II is more sensitive than Basel I to the  risk level of their exposures and the health of the economy in which they  were operating. However, federal regulatory officials with whom we spoke  were uncertain about how much capital requirements would or should  vary over the business cycle. FDIC officials with whom we spoke said they  believed it was undesirable for bank capital requirements to fall  substantially during expansions and rise substantially during recessions,  when bank capital may be most difficult to obtain. Because capital  requirements could vary over the business cycle, average (i.e., through the  cycle) capital could be higher or lower than Basel I, depending on how  Basel II is calibrated. In particular, if Basel II were calibrated to be capital  neutral with Basel I during good economic conditions, average capital  requirements could actually rise relative to Basel I.
While minimum capital requirements are expected to vary over the  business cycle, actual capital held by banks could be more stable if banks  take into account more stressed economic scenarios through holding  capital above regulatory minimums. Requiring banks to hold more capital  when borrowers are more likely to default could help ensure that banks  have adequate capital when economic conditions begin to deteriorate.  However, some experts have raised concerns that this could exacerbate  already deteriorating economic conditions by discouraging banks from  lending. Regulatory officials were uncertain of whether minimum required  capital would adjust in advance of changes in economic conditions.  However, the Basel II NPR contains a stress-testing requirement in which  banks must simulate their portfolios in order to understand how economic  cycles, especially downturn conditions, affect risk-based capital  requirements. Adequate stress testing, as in calculating risk parameters,  will depend on banks gathering data from historical recessions that could  reflect future economic downturns, or adjusting existing data to reflect  more severe economic conditions. As part of Pillar 2, according to the  NPR, regulators expect that banks will manage their regulatory capital  position so that they remain at least adequately capitalized during all  phases of the economic cycle. OCC has noted that the stress-testing  requirements will help ensure that institutions anticipate cyclicality in  capital requirements, reducing the potential impact of changes in capital  requirements. In other words, bank capital would be relatively stable over  the business cycle, while the buffer between required capital and actual  capital held would fluctuate through the cycle. Several bank officials have  suggested that this scenario is consistent with banks’ desire to avoid  raising additional capital during a downturn.
section_title: Impact of Basel II on Total Capital Held Is Uncertain Because Banks Hold Capital for a Variety of Reasons
paragraphs: Basel II’s impact on the capital actually held by banking organizations is  also uncertain, because banks hold capital for a variety of reasons,  including market forces such as meeting the expectations of  counterparties and credit rating agencies. Officials at several banks told us  that they weighed a number of factors when deciding how much capital to  hold, including both minimum and Pillar 2 regulatory requirements;  internal economic capital models; senior management decisions; and  market expectations, which are often exemplified by assessments from  credit rating agencies such as Moody’s and Standard and Poor’s. The  Basel Committee has identified important obligations for banks as part of  Pillar 2 supervision, specifically a process for assessing their overall  capital adequacy in relation to their risk profile and a strategy for  maintaining their capital levels. This process requires banks to  demonstrate that their internal capital targets are well founded and  consistent with their overall risk profile and current operating  environment. Banks are to assess all material risks, including both those  risks covered by Pillar 1 minimum requirements as well as other risks that  are not addressed, such as concentration, interest rate, and liquidity risks.  One rating agency expected that banks would hold a larger capital cushion  than they currently do over regulatory requirements under Basel II  because of the uncertainty about the new requirements. Further, a foreign  bank supervisor suggested that the effect of Basel II on actual capital  would be less than the change in minimum required capital, due in part to  the expectations of counterparties and rating agencies.
section_title: Core Banks Are Incorporating Basel II into Ongoing Efforts to Improve Risk Management, but Challenges Remain
paragraphs: Officials at most core banks with whom we spoke reported that their  banks had been working to improve the way they managed and assessed  credit, market, and other types of risks, including the allocation of capital  to cover these risks for some years. According to these officials, the banks  were largely integrating their preparations for Basel II into their current  risk management efforts. Some officials saw Basel II as a continuation of  the banking industry’s evolving risk management practices and risk-based  capital allocation practices that regulators had encouraged. To help meet  the regulatory requirements proposed for Basel II’s advanced approaches,  many core bank officials reported that their banks were investing in  information technology and establishing processes to manage and quantify  credit and operational risk. To varying extents, many officials said that the  banks had hired additional staff or were providing different levels of  training for current employees. Most officials said that their banks had  incurred or would incur significant monetary costs and were allocating  substantial resources to implement Basel II. Many officials also reported  that their banks faced challenges in implementing Basel II, including  operating without a final rule, obtaining data that meet the minimum  requirements for the A-IRB for all asset portfolios and data on operational  losses, and difficulty aligning their existing systems and processes with the  proposed rules. Officials at many core banks viewed Basel II as an  improvement over Basel I, and some banks considering adopting Basel II  believed that the new regulatory capital framework would help improve  their risk management practices.
subsections: section_title: Core Banks Are Working to Integrate Basel II into Existing Efforts to Improve Risk Management and Capital Allocation Practices
paragraphs: Officials at many core banks with whom we spoke pointed out that their  banks had been improving the way they managed and assessed credit,  market, and other types of risks for some time, including allocating capital  to cover these risks. Some officials noted that regulators had encouraged  these efforts and added that many of the steps the banks had taken  foreshadowed proposed Basel II requirements, in part because of  regulatory guidance. For example, a number of core banks noted that the  Federal Reserve’s Supervisory Letter 99-18 (SR 99-18) emphasized the  need for banking organizations to make greater efforts to ensure that their  capital reflected their underlying risk positions. The guidance also  encouraged the use of credit-risk rating systems in measuring and  managing credit risk. One official compared the processes that the  guidance encouraged for determining whether or not banks were  adequately capitalized to the role of supervisory oversight under Pillar 2 of  Basel II. Officials at another bank explained that the bank had already set  up an internal risk rating system that was similar to what the officials  believe will be required under the A-IRB. Officials at other banks noted  that they were complying with OCC’s supervisory guidance in Bulletin  2000-16 for validating computer-based financial models, a process similar  to that which is proposed under Basel II.
Officials at many core banks said that their efforts to comply with the  proposed Basel II rules took place within an existing corporate structure  that allocated risk management, review, and reporting responsibilities  among different divisions and business units. For example, officials from  one bank said that their business units follow a common set of  implementation tools and information regarding these projects, which is  consolidated to facilitate managerial oversight. Some banks are  establishing risk governance policies or processes to help in developing  assessments of their risks and are monitoring and reporting these risks.  Officials from one bank noted that policies and processes for determining  risk parameters were being used to assess capital needs. Other banks have  established or are enhancing internal controls for systems related to Basel  II, including data systems.
section_title: Core Banks Are Investing in Information Technology, Such as Data Collection, to Quantify and Manage Risks
paragraphs: Officials at many core banks reported that their banks were investing in  information technology and establishing processes to manage and quantify  credit and operational risk, including collecting data on credit defaults and  operational losses, in order to meet the regulatory requirements proposed  for the advanced approaches. To varying extents, core banks are making  efforts to collect, aggregate, and store data and detailed information  associated with credit defaults that can be used to determine risk  parameters. For example, officials at several banks explained that they  were collecting more comprehensive and detailed information on their  credit defaults or were gathering such information more consistently.  Many banks are automating or upgrading their data collection systems,  including building data repositories that aggregate default information in a  centralized database.
In preparation for Basel II, some bank officials also reported that their  banks were creating or refining systems to classify and assign internal  ratings showing the risk levels of their credit exposures. Many banks are  also making efforts, to varying extents, to establish an ongoing,  independent process to track, review, and validate the accuracy of the risk  ratings. Many banks are working on statistical models that will generate  risk parameters that can be used to determine the level of regulatory  capital needed to cover their exposures to credit risk, according to bank  officials. For this effort, some banks are using existing models that are  also used to determine internal economic capital. Many are establishing  processes to review and validate the accuracy of their regulatory and  economic capital model inputs using quantitative methods and expert  judgment.
Similarly, officials at many core banks reported that their banks had built  or were in the process of building systems and databases to collect and  store data on operational losses. Officials at some banks noted that their  banks were compiling key risk indicators for potential operational losses  or said that their banks had engaged in benchmarking exercises for  operational risk with federal regulators. Several officials also reported that  their banks were in the process of codifying and enhancing their internal  controls for operational risk, including developing and documenting  relevant policies. Other banks are conducting independent reviews of the  operational risk-control processes that their business lines are required to  follow. As with credit risk, many officials said that their banks were  building or further developing their models to assess capital needs for  potential operational losses, including by applying scenario analyses.
section_title: Core Banks Reported That They Were Training Employees and Hiring Additional Staff to Implement Basel II
paragraphs: To varying extents, officials at many core banks stated that as part of their  preparations for Basel II they had hired or would hire additional staff and  were providing different levels of training for their staff to implement  Basel II. For example, one bank intends to hire more than 100 new staff  who would largely be devoted to building systems to address credit,  operational and market risk, including modifying the bank’s capital models  for operational risk. Some officials noted that they were reallocating  human resources within their organizations or drawing on the expertise of  existing staff who were already familiar with the Basel II requirements.  Some banks have devoted or plan to devote more resources to modeling  efforts, such as hiring consultants and validating models.
Bank officials also described training programs and standardized training  procedures that were tailored to projects related to Basel II or to staff  audiences, including (1) providing courses and online information on the  Basel II requirements and (2) educating senior management about the new  systems required under the advanced approaches. Banks have also  invested in or identified the need to focus training in specific areas, such  as how to assign credit-risk ratings to their borrowers, or validate their  rating systems. Other specific training topics reported by bank officials  included calculating capital for wholesale credit exposures, transferring  information from databases into risk models, and effective regulatory  reporting. In addition, banks have invested in training for operational  risk—for example, by promoting awareness for and treating operational  risk in a consistent manner. Some officials also noted that the training  required to implement Basel II was similar to the training they had  developed for their own risk management or economic capital efforts.  Officials from several banks expect to provide additional training as they  continue to implement Basel II or when they better understand what will  be required in the final rule.
section_title: Core Banks Reported Having Incurred Significant Monetary Costs in Implementing Basel II
paragraphs: Officials at many core banks said that they had or would incur significant  monetary costs, and were allocating substantial resources to implement  Basel II. Some banks had developed plans or performed analyses to see  what areas of their implementation efforts required improvement, so that  they could determine the skill sets, staffing levels, systems, and technology  needed to comply with the proposed rules. Many bank officials expected  to make significant investments in building their credit-risk infrastructure,  including developing models to measure risk. Specifically, some officials  noted that they were making greater investments to collect data and build  data warehouses. Officials at several banks added that they expected to  incur ongoing costs as a result of implementing Basel II. For example, one  bank official explained that they had performed a number of analyses to  estimate certain risk parameters and needed to check regularly that the  numbers generated from the analyses were reasonable.
Depending on the final rule, bank officials expect to incur additional costs.  The uncertainty about the final rule has contributed to the expense of  preparing for Basel II, according to the officials, because some banks have  been unable to make timely decisions or have had to adjust their systems  to conform to different stages of the proposed rules for Basel II specified  in the ANPR, and later in the draft NPR. However, officials at many core  banks stated that they might have incurred some of these costs regardless  of Basel II in their efforts to improve their risk management practices and  economic capital systems. For example, officials at one bank stated that  upgrading the bank’s technological infrastructure would also help the  bank meet Basel II requirements. Some officials were concerned that the  expenditures and efforts they had made to prepare for Basel II were far  greater than the improvements they expected Basel II to bring to their risk  management practices. But others noted that separating the direct costs of  Basel II from other expenses was difficult, because the banks had ongoing  risk management needs and laws to comply with, such as the Sarbanes- Oxley Act of 2002. Ultimately, banks’ efforts to meet Basel II  requirements have compressed such expenditures into a shorter time  frame.
section_title: Core Banks Face Challenges, Including the Lack of a Final Rule and Difficulties in Obtaining Data and Aligning Existing Systems with the Proposed Rules
paragraphs: Officials at many core banks reported that their banks faced challenges in  implementing Basel II. Key among these challenges is the uncertainty  created by the lack of a final rule. Some officials, for example, stated that  they had prepared for the implementation of Basel II knowing that the  requirements of the rule could change, potentially increasing costs.  Officials at a few banks noted that they might be unable to move forward  with certain implementation efforts, such as hiring or providing specific  training for their staff, without a final rule. If the final rule requires that  banks make significant changes to their current efforts, several officials  said that they might be unprepared for the parallel run that is scheduled to  start in January 2008. Other officials stated that without the final rule,  regulators were unable to provide banks with formal regulatory guidance  or definitive evaluations of their readiness to meet Basel II requirements,  thus making it difficult for banks to obtain clarification on parts of the  proposed rules. However, several officials found the preliminary feedback  they had received from regulators to be helpful.
Further, officials from many core banks said that they were having  difficulty obtaining data that met the minimum requirements of the A-IRB  for all asset portfolios and data on operational losses. For example, some  banks have not historically collected all of the data required for Basel II.  While bank officials generally said they believed their banks would meet  the data requirements by the start of the parallel run in 2008, many said  that they did not have enough historical data on loan defaults for credit  risk. In some cases, officials said that they did not have enough data on  credit defaults for immaterial portfolios or portfolios with low-risk, high- quality exposures. In other cases, the officials said that they needed to  collect additional information specified in the regulatory criteria. For  example, officials at a few banks described having to integrate and  reconcile different types of financial and risk data before they could apply  the information to their modeling efforts. Some banks lacked historical  data covering more than one economic cycle and noted that it was difficult  to capture default information reflecting what could occur during a  significantly stressed economic environment. Officials at a few banks  noted that it either took more effort or was a challenge to collect data  from different legacy systems. Similarly, many officials said that their  banks had limited internal data on operational losses, including instances  of severe loss. For both credit and operational risk, banks are  supplementing insufficient internal data with external data obtained  through rating companies or data consortiums. However, several officials  noted that it was difficult to assess the reliability of external data or to  draw analogies from external information that adequately represented the  risks of a bank’s portfolio.
Core bank officials also said that they were having difficulty aligning their  existing models with the proposed specifications for the A-IRB approach.  For example, some bank officials were concerned that the proposed  safeguards, such as certain limits that constrain how banks could calculate  risk parameters used to determine capital for credit risk, differed from  banks’ internal practices or would lead to higher capital requirements. In  calculating capital for credit risk, some banks use probabilities and  definitions of default for their internal economic capital that are different  from the regulatory capital specifications. Officials from several banks  noted that they were collecting separate information for both types of  calculations or maintaining separate models for calculating economic and  regulatory capital. Some officials also noted that because the U.S.  requirements for Basel II differed from those of other countries—for  example, the definitions of default and the implementation time frames— they were having difficulty using the systems and models used for the U.S.  requirements to meet the capital requirements of other countries. Others  noted that it would be difficult to comply with different Basel II rules  across countries, and some banks were preparing to implement the  standardized approach for credit risk in other countries because of the  delay in finalizing the rules for the advanced approaches in the United  States.
section_title: U.S. Regulators Are Integrating Preparations for Basel II into Their Current Supervisory Process but Face a Number of Impediments
paragraphs: While U.S. regulators have been integrating preparations for Basel II into  their current supervisory processes and building on their experience  overseeing risk management practices of the banks, a number of issues  remain to be resolved as regulators finalize the rule. All the regulators  have some experience overseeing models-based risk management at core  banks. In addition, they plan to integrate Basel II supervisory requirements  into their existing oversight processes and reviews and are taking steps to  prepare for the process of qualifying banks to use the advanced  approaches by reviewing banks’ preliminary qualification plans.  Regulators are also hiring and training staff and coordinating with U.S. and  foreign regulators. However, regulators face a number of impediments in  their efforts to agree on a final rule for the transition to Basel II.  Regulators’ different perspectives have made reaching agreement on the  NPR difficult, as will likely be the case for the final rule. Moreover, the  process could benefit from greater transparency going forward, including  how regulators will assess the Basel II results during the transition years  and report on any modifications to the rule during that period. It is also  important for regulators to resolve some of the uncertainty and increase  the transparency of their thinking by including in the final rule more  specific information about certain outstanding issues, such as how  regulators will treat portfolios that lack adequate data to meet regulatory  requirements for the advanced approaches, how regulators will calculate  reductions in aggregate minimum regulatory capital and what would  happen if the reduction exceeds a proposed 10-percent trigger, and how  worthwhile public disclosure will be under Pillar 3. If these issues are not  addressed, the ongoing ambiguity and lack of transparency could result in  continued uncertainty about the appropriateness of Basel II as a  regulatory capital framework.
subsections: section_title: Regulators Have Been Building on Experience Overseeing Risk Management
paragraphs: To varying degrees, banking regulators have overseen some aspects of  banking organizations’ internal models-based risk management since the  mid-1990s, including economic capital and market risk models similar to  those that will be a part of Basel II. Although this oversight has been for  risk management and—with the exception of certain market risk models— not for capital-setting purposes, regulators believe this experience will  help them oversee banks in a Basel II environment. Regulators have also  developed regulatory practices that will continue after the Basel II rule is  finalized. These practices include, among others, creating standards to use  in calculating banks’ risk-based capital ratios and reviewing banks’  internal controls to determine if they are sufficient for sound risk  management.
In 1996, regulators amended Basel I to incorporate market risks in the  Basel I calculations of required capital. The Market Risk Rule, which is  overseen by the Federal Reserve, OCC, and FDIC for a small number of  institutions, requires banks to use their own internal models to measure  risk. Specifically, it requires banks to measure banks’ daily value-at-risk  (VAR) for covered positions—that is, banks must maintain capital to cover  the risks associated with potential fluctuations in future market prices. A  bank’s internal model may use any generally accepted technique to  measure VAR, but the regulation requires that the model be sophisticated  and accurate enough for the nature and size of the covered positions. To  adapt banks’ internal models for regulatory purposes, banking regulators  developed minimum qualitative and quantitative requirements for all  banks subject to the market risk rule. Banks use these standards in  calculating their VAR estimate for determining their risk-based capital  ratio.
The Federal Reserve, OCC, and FDIC also review banks that are subject to  the market risk capital requirements for evidence of sound risk  management, such as an institution’s risk control unit that reports directly  to senior management and is independent of the business trading units.  The Market Risk Rule requires banks to conduct periodic backtesting—for  example, by comparing daily VAR estimates generated by internal models  against actual daily trading results to determine how effectively the VAR  measure has identified the boundaries of losses. Banks must use the  backtesting results to adjust the multiplication factor used to determine  the bank required capital. Federal Reserve officials said that the VAR  models have performed well, and noted that no banks have had model  backtest results that have required multiplication factors higher than the  minimum prescribed in the Market Risk Rule. The officials said that such  performance was due, in large part, to the continual improvement of the  banks’ VAR methodologies and other requirements of the Market Risk  Amendment, including the use of stress testing. Federal Reserve officials  said that regulators actively monitor the rigor and adequacy of banks’  internal VAR models in light of new and emerging products.
As part of their risk management reviews, the Federal Reserve and OCC  have also overseen some aspects of core banks’ economic capital models  since the 1990s. Although that oversight has focused on risk management  and not setting regulatory capital levels, Federal Reserve and OCC officials  said that the experience had helped prepare them for oversight of Basel II  regulatory capital models, as economic capital models and Basel II  regulatory capital models were similar. For example, as discussed earlier,  both measure risks by estimating the probability of potential losses over a  specified time period and up to a defined confidence level, using historical  loss data. According to these regulators, banks are generally using existing  economic capital systems as a starting point to create their Basel II  regulatory systems. Federal Reserve officials noted that because Basel II  would establish common system requirements for regulatory capital  purposes, in areas where banks have varying requirements for their  internal modeling systems, such as how they define default, regulators will  have greater comparability across systems. Further, some regulatory  officials noted that overseeing models to set regulatory capital levels  would involve increased regulatory scrutiny for model validation as well  as greater market discipline, because banks would be required to publicly  disclose aggregated information underlying the calculation of their risk- weighted assets.
The Federal Reserve and OCC also have existing supervisory guidance  that describes the regulatory approaches for some aspects of their  oversight of internal models, oversight that the regulators say has helped  prepare them for oversight of models in a Basel II environment. Federal  Reserve Supervisory Letter 99-18 (SR 99-18), issued on July 1, 1999, directs  supervisors and examiners to evaluate banks’ internal capital management  processes to judge whether these processes meaningfully tie the  identification, monitoring, and evaluation of risk to the determination of  the institution’s capital needs. In addition, SR 99-18 requires examiners to  consider the results of sensitivity analyses and stress testing conducted by  the institution and the way these results relate to their capital plans.  According to the letter, banks must be able to demonstrate that their  capital levels are adequate to support their risk exposure, and examiners  are to review the banks’ analyses. Finally, SR 99-18 directs examiners to  assess the degree to which an institution has in place, or is making  progress toward implementing, a sound internal process to assess capital  adequacy, including any risk modeling techniques used. Federal Reserve  officials noted that, although challenges continue to exist, banks in general  have made considerable strides in evaluating their internal capital  adequacy and enhancing governance and controls around the process that  produces such estimates. In some cases, work on the internal assessment  of capital adequacy has highlighted the need for institutions to focus on  fundamental risk management issues, such as risk identification, risk  measurement, and internal controls.
Likewise, OCC Bulletin 2000-16 (2000-16) (May 30, 2000) articulates  procedures for model validation: independent review of the models’  logical and conceptual soundness, comparisons with other models, and  comparison of model predictions and subsequent real-world events. OCC  officials and examiners for two large U.S. banking organizations said they  used 2000-16 to assess banks’ processes for validating their economic  capital models. One examiner, for example, noted that a review using  2000-16 led to requiring a bank to improve its documentation surrounding  models it had created. According to another official, it also helped to  promote greater understanding and awareness of the need for model  validation to become an integral part of bank risk measurement and  management systems. It further promoted greater consistency in  supervisory assessments of bank model validation practices.
OTS and FDIC officials said they also have some experience working with  models. OTS, the primary federal regulator of the remaining core Basel II  institution, has policy staff and examination experience in interest rate  risk modeling and validation processes. OTS created and maintains a Net  Portfolio Value model, which allows users to create customized interest  rate risk stress scenarios and incorporate emerging interest rate exposures  and techniques, among other things. OTS officials said this oversight had  helped OTS policy and examiner staff gain experience in overseeing the  use of models and validation processes. OTS officials also said that they  have some recent experience reviewing economic capital models and  validation for risk management purposes, though OTS’s experience in this  area has not been as extensive as the Federal Reserve’s or OCC’s.  Although OTS has not analyzed market risk models, it will do so should  the September 2006 amendments to the Market Risk Rule be adopted as  proposed. FDIC, as noted earlier, will be involved in the Basel II  implementation process as the deposit insurer for all of the Basel II banks,  and FDIC officials said they could be the primary federal regulator for  insured subsidiaries of core Basel II banks or possible opt-in banks. FDIC  officials said that, in addition to its oversight of banks subject to the  Market Risk Amendment, its examiners also have some experience  working with a variety of credit risk and valuation models.
section_title: Regulators Plan to Integrate Basel II into Their Existing Supervisory Processes
paragraphs: The regulators plan to incorporate Basel II’s additional supervisory  requirements into their existing oversight processes and supervisory  reviews. Regulatory officials said that because they currently oversee risk  modeling and capital adequacy activities, Basel II oversight is largely an  evolution of existing supervisory strategies. The primary federal  regulators’ current supervisory processes for core banks were generally  similar—risk-focused approaches that emphasize continuous monitoring  and assessment of how banking organizations manage and control risks.  Consistent with their current approaches, a team of examiners from the  relevant primary regulator will continue to be in charge of the supervision  of Basel II banks (core and opt-in banks), and teams from the Federal  Reserve will continue to oversee all of the Basel II bank holding  companies. Bank-specific examination teams are supported by other  regulatory staff on specific technical issues, such as core credit, credit  quantification, models and methodologies, and operational risk. As part of  their examination process, examiners will continue to assess the banks’  risks, identifying the business activities that pose the greatest risk, and  validate the use and effectiveness of the bank’s risk management  practices. Risks may include credit risks, both commercial and retail (such  as a bank’s credit rating system), risks involving the bank’s information  technology system (such as data warehousing issues), or corporate  governance risks (such as a bank’s ability to provide adequate audit  coverage). Officials from two regulators noted that these risk factors are  all part of banks’ risk management processes and would have to be  reviewed even in the absence of Basel II.
Based on their risk assessment, examiners develop and execute  supervisory plans that set out the timetable and work schedule for the  examiners for the year. The supervisory plans typically would include  oversight of several aspects of risk management that will continue under  Basel II. For example, examiners from two regulators noted they assess  how banks validate their models, by reviewing how banks verify their own  modeling processes (e.g., independent validation, sound governance, and  internal controls), peer benchmarking studies, and comparisons to rating  agencies. These examiners said they may also compare some models, test  specific assumptions, and assess data and internal audit systems and  procedures such as stress testing, use of scorecards (devices used to  determine an obligor’s default probability by associating it with a risk  rating for the obligor) and internal ratings for loans. Finally, these  examiners noted they review banks’ businesses or products, such as equity  derivatives, and conduct targeted exams that assess specific areas—for  instance, collateral or asset management for credit, market and  operational risk.
section_title: Regulators Are Taking Steps toward Eventual Qualification of Banks to Use the Advanced Approaches
paragraphs: Regulatory officials told us that they were taking steps toward eventual  qualification of banks to use the advanced approaches once the final rule  was in place but that this qualification work was preliminary because the  rule was not final. A bank will be qualified when its primary federal  regulator approves it and, after consulting with other relevant regulators,  determines whether the bank’s Basel II systems satisfy the supervisory  expectations for these approaches. The NPR states that regulators will  evaluate banks on their advanced internal ratings based systems for rating  risk and estimating risk exposure; regulators will consider a bank’s  estimates of key risk characteristics, such as probability of default and  loss given default (a process called quantification), ongoing model  validation, data management and maintenance, and oversight and control  mechanisms. As part of this evaluation, regulators said the examination  teams for each bank would develop a qualification strategy designed to  help the team better understand the design of the bank’s Basel II systems,  drawing on existing supervisory tools and assessing compliance with the  forthcoming U.S. rule and supervisory guidance. Regulatory officials said  that the qualification process would be a series of targeted reviews  tailored to each institution and determined by the results of specialized  reviews and the bank’s own independent testing. Regulatory officials also  emphasized that qualification would be an ongoing process and that the  final rule would require banking organizations to meet the qualification  requirements on a continuous basis, subject to supervisory review. In  addition, regulators plan to:    Continue conducting discovery reviews of banks’ Basel II systems and  processes that will cover areas such as data collection and warehousing,  wholesale and retail credit models, and the definition of default. Like  examinations, these reviews assess risks and look at parts of a bank’s risk  management programs; but unlike examinations, they cannot include tests  for compliance with Basel II requirements until a final rule is in place.  Federal Reserve and OCC examiners told us that the goals of discovery  reviews conducted before the rule was finalized are to understand the  conceptual underpinnings of a bank’s Basel II systems and evaluate the  processes and models from a prudent risk management standpoint. These  examiners said that discovery reviews could not result in formal  evaluations of banks’ Basel II progress because there was no final rule yet.  But they noted that they would speak with banks whose approaches  differed from what was currently proposed in Basel II. Similarly, some  regulatory officials and examiners told us that not having a final rule made  it difficult to gauge the progress that banks were making and prevented  them from determining what else banks might need to do to be Basel II  compliant.
Conduct reviews of each bank’s Basel II implementation plans and the  progress made in meeting them, called gap analyses, to identify additional  work that the banks need to do. The NPR requires banks’ implementation  plans to detail the necessary elements of rolling out advanced approaches  in both credit and operational risk. But without a final rule, regulators and  banks have been working with informal implementation plans and gap  analyses using previous regulatory guidance. Regulatory officials said the  preliminary implementation plans were an essential feature of the  qualification process, as they linked existing regulatory guidance with  specific implementation activities and provided an initial basis for the  development of supervisory plans related to the qualification process. For  example, one examiner’s review of a bank’s gap analysis found that the  bank needed to more fully define how it planned to estimate key risk  characteristics. The examiner noted that the bank was proceeding to  update its implementation plans across the other components of its  commercial internal ratings-based portfolio. As a result of these efforts,  regulators have developed gap analysis templates to guide examiners.
Communicate with banks about Basel II issues. Regulatory officials  emphasized that they were speaking with bank officials about the  development of the bank’s Basel II systems, including methodologies and  processes. These discussions will continue until after the final rule is  issued, and according to regulators, facilitate discovery and qualification  work.
Regulatory officials emphasized that, without a final rule, their work on  qualification was preliminary, although they said it did provide useful  information about the status of banks’ implementation efforts. For  example, regulators observed that all core banks had draft implementation  plans and have Basel II project management offices. But regulatory  officials said that core banks varied in their degree of preparation to date,  specifically, in the quality of their data and risk management systems. OCC  officials said that some banks are more likely than others to make use of  the potential 3-year implementation period between becoming a core bank  and the first transitional floor period to fully develop their data and risk  management systems.
section_title: Hiring and Training Supervisory Staff Is an Important Part of Regulators’ Basel II Preparations, but Retaining Staff Is a Key Challenge
paragraphs: U.S. banking regulators have been preparing for Basel II by hiring  additional supervisory staff, including examiners, with the necessary  quantitative skills and by providing training specific to Basel II. Officials  told us that although the skills needed to oversee Basel II implementation  were similar to the skills needed for all risk management oversight,  additional quantitative skills would be necessary. Regulatory officials  emphasized that, like their supervisory processes, these hiring and training  efforts were part of their evolving human capital plans and coincided with  increased oversight of banks’ models-based risk management approaches.  Therefore, officials said, the specific impact of Basel II on human capital  efforts was difficult to quantify. Regulatory officials stated that they had  been building the skill sets required to oversee economic capital models as  their responsibilities in this area increased and added that many of these  efforts would be under way even in the absence of Basel II. And while  several regulatory officials noted that they had hired some staff  specifically for Basel II that they would probably not have hired otherwise,  they said that not all staff involved in Basel II oversight needed to have  specialized skills. Generalist safety and soundness examiners with  traditional skill sets will continue to examine banks, including those under  Basel II. National teams will, however, assist these examiners with the  more technical aspects of the new capital regime.
Severl regtory offici emphasized the  difficlty of epting co for Basel II from  co tht wold hve een incrred nywasrt of effort to overee banks’ evolving  rik mgement prctice. Some offici  o noted tht they hd few ff dedicted  olely to Basel II effort. However, in the  regtory impct dy tht it compiled for  the Office of Mgement nd Bdget’s  review of the NPR, OCC etimted it own  co for trining, gidnce, nd superviion  t roghly $7 million throgh 2005 nd pproximtely $ million nnually etween  2006 nd 2011. In  imilr regtory impct  dy, OTStimted it co t roghly $4  million throgh 2005, with nother $2 million  probable for 2006. OTS offici said tht  fre co wold enitive to the ner  of thrift tht opted into Basel II. While the  Federl Reerve was not required to compile   imilr cot etimte for the Office of  Mgement nd Bdget, offici noted tht  it co nd OCC’s were likely to e higher  thn the FDIC’s nd OTS’s, given the ner  of Basel II bank for which the Federl  Reerve nd OCC were the primry federl  regtor.
Several regulatory officials noted that having staff with specialized skills in  quantitative risk management models and quantitative analysis would be  even more necessary under Basel II, while examiners would generally  need good skills in credit, capital markets, and information technology.  Regulatory officials said that they had set up national teams of staff with  this specialized expertise and were providing training to both specialist  staff as well as generalist examiners. Officials from all four regulators  emphasized the importance of training to their Basel II implementation  efforts. According to regulatory documentation and officials, supervisory  staff have been trained in numerous areas, including model validation,  internal control reviews, economic capital, operational risk, validation of  credit rating and scoring models, QIS-4, and possible ways that banks  could try to manipulate their Basel II systems.
Regulatory officials said that they faced several human capital challenges  in implementing Basel II. First, several officials said that regulators would  be challenged by the increased complexity of issues requiring examiner  judgment under Basel II and the need to apply Basel II requirements  consistently across banks. For example, examiners will need to review the  rank ordering of ratings for loans in banks’ two-dimensional ratings  systems developed for Basel II and make greater use of debt-rating models  that will require examiners to review management overrides and assess  model validation. OCC officials also noted that examiners currently have  to exercise judgment on increasingly complex issues, including validating  models and overrides, as banks increasingly use models. Federal Reserve  officials said the key to successfully meeting this challenge will be high- quality training and effective supervisory guidance that incorporates  comments from the industry. Second, several regulators said consistently  applying Basel II across banks would also be a challenge, especially for the  AMA approach to operational risk, because of the flexibility allowed under  the NPR. OCC officials said that the forthcoming supervisory guidance and  a recent Basel Committee paper would help clarify the allowable range of  practice. Both OCC and the Federal Reserve noted that their national  teams of quantitative experts should help regulators meet the challenge of  consistent application across banks. Third, regulators said that hiring new  personnel had been challenging and that retaining and continued training  of supervisory staff presented ongoing challenges. For instance, increased  competition for staff with these skills among the regulators themselves  and between the regulators and industry made hiring and retaining staff  more challenging. While some regulatory officials had some staffing  concerns, they also expressed confidence that they could fulfill their new  regulatory responsibilities from Basel II. Several regulatory officials also  said that they would continue assessing staffing needs as Basel II moved  forward and as the exact number of Basel II banks became clearer, they  would be reassessing the ideal number of staff they needed with  specialized skills.
section_title: Regulators Are Coordinating Domestically and Internationally, but Lack of a Final Rule Is a Complicating Factor
paragraphs: Regulators are coordinating their work with other U.S. regulators and with  those in other countries in order to provide more effective and consistent  oversight, but the lack of a final rule makes this coordination more  complicated. The four regulators’ strategic plans all place priority on this  effort, and several regulatory officials from these agencies emphasized the  importance of coordination, given the complexity of Basel II and the  regulators’ varied perspectives. Domestically, regulators use several  mechanisms to coordinate with their counterparts, including an  interagency steering group (which also coordinates with an association of  state bank supervisors), joint supervisory work and examinations,  interagency training, formal and informal examiner meetings, and  outreach to banks. While examiners generally said that their Basel II  coordination efforts were effective, the delays in various stages of the rule- making process indicate some difficulties at the policy-making level.
U.S. regulators are also working to coordinate with regulators from other  Basel II countries. For example, they are participating in the Accord  Implementation Group, one of a number of subgroups that the Basel  Committee formed to promote international consistency and address other  Basel II issues. The United States, as a home regulator (a regulator  overseeing domestic banks), communicates its qualification strategies and  processes to host regulators (foreign regulators overseeing U.S. banks in  their countries, or U.S. regulators overseeing foreign banks in the United  States). For their home responsibilities, U.S. regulators coordinate  supervisory work based on the Accord Implementation Group’s home-host  principles, including determining whether a bank’s capital model for a  global business is ready for Basel II. Home regulators will rely on the work  of foreign host regulators that approve banks’ local models and processes  and will share appropriate information, such as regulatory memorandums,  with host regulators. The United States is also a host regulator and as such  will share appropriate sections of supervisory plans, scopes, and product  memorandums regarding reviews of local models and processes. U.S.  regulators are also participating in supervisory colleges, or working  groups of supervisors that are formed on an as-needed basis to share  information about and coordinate supervision of international banking  organizations. One regulatory official noted that the colleges have been  and will continue to be critical to the success of the international Basel II  effort.
U.S. regulators face challenges regarding international implementation of  Basel II, in part because the United States is implementing Basel II one  year later than many other countries, including countries in the European  Union. U.S. regulators are working with U.S. and foreign banks and  regulators to address the implications of this so-called gap year. For  example, in several instances, U.S. regulators are trying to evaluate the  advanced systems of foreign banks’ U.S. subsidiaries to provide foreign  regulators with feedback on those systems to be used in foreign  regulators’ evaluations of banks attempting to become Basel II compliant  in their home countries in 2007, before the United States implements Basel  II in 2008. Similarly, according to U.S. regulatory officials, some U.S. banks  operating abroad are prevented by their host supervisors from using  advanced systems in the host jurisdiction before they are allowed to do so  at home, and some U.S. regulatory officials said they are working with the  foreign regulators in cases where U.S. banks want or need to use advanced  approaches in the host jurisdiction prior to a final rule in the United  States. Further, as stated earlier, countries have a limited degree of  national discretion, which, in part, requires U.S. and foreign regulators to  address challenges that internationally active banks are experiencing due  to differences between U.S. rules and those of other countries. U.S.  regulators are working to find effective mechanisms for cooperation and  information to resolve these issues, such as the supervisory colleges  previously discussed. One regulatory official said that international home- host efforts could tend to focus on the global parent company but added  that that regulator’s focus was on making sure that the allocation of capital  within that company was appropriate and covered the risk for the bank in  the United States.
section_title: Regulators Face Impediments in Finalizing the Rule That if Left Unresolved Could Result in Ongoing Regulatory Ambiguity for Banks and Uncertainty about the Appropriateness of the Basel II Framework
paragraphs: Although U.S. regulators have committed to working together to issue a  final rule and use prudential safeguards that would limit regulatory capital  reductions during a parallel run and transition period, they face a number  of ongoing impediments in agreeing on a final rule to implement Basel II.  First, regulators have somewhat differing perspectives and goals, which  fuels ambiguity and contributes to questions about the appropriateness of  the Basel II framework. Second, a lack of transparency and ongoing  ambiguity of some items in the NPR may contribute to ongoing questions  about the appropriateness of Basel II as a framework. Finally, regulators  will need to address banks’ concerns regarding Pillar 3 disclosure  requirements and the need to balance protecting proprietary information  and providing for public disclosure of capital calculations to encourage  market discipline.
subsections: section_title: Regulators’ Differing Perspectives and Goals Fuel Ambiguity
paragraphs: Each federal regulator oversees a different set of institutions and  represents an important regulatory perspective, which has made reaching  consensus on some issues more difficult than others. U.S. regulators  generally agree on the broad underlying principles at the core of Basel II,  including increased risk sensitivity of capital requirements and capital  neutrality. In a 2004 report, we found that although regulators  communicate and coordinate, they sometimes had difficulty agreeing. As  we reported, in November 2003 members of the House Financial Services  Committee warned in a letter to the bank regulatory agencies that the  discord surrounding Basel II had weakened the negotiating position of the  United States and resulted in an agreement that was less than favorable to  U.S. financial institutions. However, regulatory officials also told us that  the final outcome of the Basel II negotiations was better than it would  have been with a single U.S. representative because of the agencies’  varying perspectives and expertise.
These differing regulatory perspectives have contributed to difficulty  achieving a final rule and agreeing to specific operational details as well as  contributing in part to delays of the Basel II implementation process and  ongoing questions and unresolved issues. For example, officials from  FDIC—the deposit insurer and regulator of many smaller banks—while  acknowledging the limitations of Basel I for the largest banks, have  expressed concerns regarding required capital levels under Basel II and  potential competitive inequities between large and small banks in the  United States, if small banks are required to hold more regulatory capital  than large banks for some similar risks. FDIC officials have also expressed  some serious reservations about the availability of sufficient data  underlying certain aspects of the models, as well as the calibration of the  models themselves. Officials from the Federal Reserve and OCC—as the  regulators of the vast majority of core banks—while acknowledging the  uncertain impact on capital requirements and data limitations, have  highlighted the limitations of Basel I, the advances in risk management at  large banks, the safeguards in the NPR to ensure capital adequacy, and  regulator experience in reviewing economic capital models. OTS officials,  noting the thrift industry’s mortgage-heavy portfolios, have emphasized  the potential limitations on risk sensitivity imposed by the leverage ratio.  Specifically, they noted the potential impact on mortgages because, as  discussed previously, required capital for high-quality mortgages could fall  significantly under Basel II making the leverage ratio a potential regulatory  capital floor for some institutions.
As U.S. regulatory officials work to finalize Basel II, overcoming these  differences will likely be an ongoing challenge. While regulatory officials  said that they would work collaboratively to address comments on the  NPR, how they will reconcile potentially differing view points is not clear.  Further, while officials have said that they will monitor progress and  modify the Basel II rule as necessary during the transition period to ensure  that capital requirements are appropriate for credit, operational, and  market risks, they have not specified how that monitoring will take place  or under what circumstances regulators will revisit the rule. Given these  differences, failure to take steps to clarify remaining questions and  improve the transparency through regular public reporting of the process  going forward would result in ongoing questions and ambiguity about  Basel II as a viable framework for regulatory capital.
section_title: Lack of Transparency and Ongoing Ambiguity Contribute to Questions about the Overall Appropriateness of the Basel II
paragraphs: Although regulators have developed a set of safeguards that reduce the  chances of significant reductions in required regulatory capital during the  planned parallel run and transitional period, regulatory officials and others  remain uncertain about the potential impact of the final Basel II  framework on the safety and soundness of the banking system.  Specifically, some regulatory officials are concerned about the use of  banks’ models under Basel II because, while these models have been used  for internal risk assessment and management for years, with the exception  of certain market risk models, they are relatively unproven as a regulatory  capital tool. Others are concerned about potential drops in required  regulatory capital once the parallel run and transition period have been  completed. Regulatory concerns regarding possible large drops in  aggregate levels of minimum required risk-based capital were reinforced  after QIS-4 showed large reductions in minimum regulatory required  capital for credit risk using inputs from the banks’ models. As a result, U.S.  regulators have disagreed on how and how quickly to implement Basel II.  And some industry observers have questioned whether to proceed at all.
Further, regulators have requested comments on over 60 questions in the  NPR. For example, as stated earlier regulators have asked for comment on  whether banks should have the option of using a U.S. version of the  standardized approach rather than the advanced approach and for how  long. However, at the time of this review, the NPR did not discuss what  form a standardized approach would take in the United States or whether  it would mirror the international Basel Accord. Similarly, regulators have  not explained how they plan to calculate the 10-percent reduction in  aggregate minimum regulatory capital compared with Basel I and what  would happen if the 10-percent reduction was triggered, other than it will  warrant “modifications to the supervisory risk functions or other aspects  of this framework.” Under one scenario, for example, aggregate minimum  required capital could potentially fall by over 10 percent in an economy in  which borrowers were very unlikely to default, triggering a reexamination  of Basel II by federal regulators, according to the NPR. However, this 10- percent reduction might not be an indicator of a fundamental flaw in the  Basel II framework but rather a cyclical movement that could be reversed  in bad economic times—that is, if Basel II is intended to be on average  equal to Basel I over the business cycle. But this interpretation is only one  possible interpretation of capital neutrality. Alternatively, a 10-percent  reduction could indicate a problem if average (i.e., through the cycle)  capital requirements were falling significantly relative to Basel I capital  levels during less favorable economic conditions.
While several officials said that they would prefer not to define how the  regulators will assess the 10-percent trigger explicitly, and instead use  their own discretion in maintaining capital levels, bank officials have  expressed interest in knowing how the trigger will function. Moreover, it is  unclear what would happen if a 10-percent reduction relative to Basel I  were triggered. For example, would banks have to recalibrate their  models, would a floor be imposed, or would a multiplier be added, and  how would economic conditions be factored into the determination  process? Part of this process will have to include determining appropriate  levels of aggregate required capital and acceptable cyclical variation.  However, the NPR does not clearly state the regulators’ views on these  issues or their plans for making such determinations. Without additional  clarity in the final rule, these issues will result in ongoing uncertainty for  banks and lingering questions about required capital levels and how Basel  II’s implementation in the United States will affect banks’ regulatory  capital levels.
section_title: Questions about Reliability of Bank Data Remain an Issue
paragraphs: As mentioned, the appropriateness of the capital requirements generated  by the Basel II models depends in part on the sufficiency of the data inputs  used by banks, though views vary about some data requirements for their  portfolios. For example, officials at several core banks had differing views  about whether the 2001 recession represented a sufficiently stressed  economic period for calibrating their models. Specifically, officials at one  bank said that the 2001 recession was a sufficiently stressed period to  meet data requirements for their portfolios, but officials at another bank  were uncertain, and officials at a third bank stated that 2001 was likely not  sufficient. Because the 2001 recession was relatively mild by historical  standards, stressed scenarios and parameters based on it could  underestimate the risk associated with future downturns. Officials at  several banks stated that they already used or would use internal and  external data to capture time periods prior to 2001. Officials at several  banks also told us that a supervisory formula for calculating “downturn”  loss given default was helpful where they had insufficient default data; and  many banks had also purchased, or planned to purchase, external data  covering a longer time period to help estimate the effect of downturns on  their parameter estimates.
However, to address these data sufficiency challenges and their effect on  the ability of core banks to use the advanced approaches for all portfolios,  regulators will have to decide whether and how to qualify banks to move  to the advanced approaches when adequate data to assess the risks of  certain portfolios is limited. The NPR, for example, requests comment on  how to address the limited data availability and lack of industry  experience with incorporating economic downturn conditions into LGD  estimates. Given the importance of bank data requirements, lack of clarity  in the final rule could result in ongoing questions about the reliability and  sufficiency of the results generated by the banks’ models. For example,  without clarification, banks’ varying interpretations of the rule could result  in capital requirements that are not comparable or that increase reliance  on examiner judgment through the supervisory review process (Pillar 2),  thereby resulting in negotiations about capital adequacy between a bank  and its regulator.
section_title: Questions about Pillar 3 Disclosure Requirements Remain
paragraphs: Finally, regulators will need to resolve banks’ concerns regarding Pillar 3’s  disclosure requirements, since officials from some banks said that those  disclosures could be costly but of questionable value. Officials from some  core banks raised the possibility that they would need to make significant  investments to meet public disclosure requirements under Pillar 3 but that  the usefulness of the disclosures was uncertain. Some officials were  concerned that the information required might be too detailed or complex  for the markets to understand in a useful way. For example, officials at a  few banks noted that because banks used different methodologies to  manage risk, comparing disclosures across organizations would be  difficult. Similarly, another official pointed out that comparing disclosures  from banks in different countries would also be difficult if the banks were  not operating under the same rules. Still, other officials were concerned  that proprietary or strategic business information would be made public.  However, officials from a few banks noted that the disclosures could help  the markets better understand a bank’s risk profile. Regulators will need  to determine if the banks’ concerns merit changes to the disclosure  requirements.
section_title: Conclusions
paragraphs: Basel I has served regulators and banks well for many years and for many  smaller institutions, it is expected to continue to do so. However, for a  group of large, complex banking organizations it increasingly fails to  adequately align regulatory required capital and risks. Basel II represents a  fundamental shift in the regulatory capital framework by seeking to  leverage banks’ risk management systems and internal models for use in  estimating risk more precisely than the broad risk buckets used under  Basel I, thereby helping to strengthen the safety and soundness of the  banking system. Effective capital adequacy regulation requires balancing  the costs to business of holding capital and the need to provide protection  to depositors and the federal deposit insurance fund.
Given the limitations of Basel I, the goal of better aligning regulatory  capital with risks, and the use of safeguards during the parallel run and  transition period to ensure that a large drop in capital does not occur, we  support the regulators’ plans to continue to finalize the Basel II rule and  proceed with the parallel run and transition period in order to determine  whether the Basel II framework can be relied on to adequately capture  risks for regulatory capital purposes. It is appropriate for the regulators to  proceed for several reasons.
First, it will provide the regulators with critical information they currently  lack to assess the appropriateness of the Basel II framework relative to  Basel I.
Second, the proposed rules, issued in September 2006, contain important  safeguards that will help prevent large declines in regulatory capital. The  safeguards will help mitigate any risk to the system by requiring capital to  be held based on current Basel I rules during the parallel run and allowing  only limited reductions during each of 3 transition years, which will vary  depending on when a bank is qualified.
Third, maintaining the current leverage ratio and PCA will further guard  against any large declines in bank capital.
Finally, foreign regulators are moving to Basel II creating potential  competitive disadvantages for U.S. banks vis-à-vis foreign banks.
While Basel II seeks to establish a closer relationship between regulatory  capital and risk for the largest and most internationally active banking  organizations, there are many issues that will require ongoing supervision  and monitoring, including the ability of these banks’ models to adequately  measure risks for regulatory capital purposes and the regulators’ ability to  oversee them. For example, the Basel II models are driven by low- frequency catastrophic events that are inherently difficult to estimate,  which creates challenges for regulators both in developing appropriate  models and supervising models developed by banks. Regulators already  face resource constraints in hiring and retaining talent that are more  binding than the resource constraints faced by the banks they regulate and  this issue is likely to become more significant under Basel II. Yet, it is a  critical point because under Basel II regulators’ judgment will likely play  an increasingly important role in determining capital adequacy. We  recognize that these issues and others need to be addressed, and moving  forward is not without risks. However, as mentioned, the proposed  safeguards and retention of the leverage ratio should help mitigate  potential negative effects from moving forward while allowing the banks  and regulators to gather information to assess the appropriateness of the  Basel II framework.
As the regulators finalize Basel II, clarification of a number of issues  would make the final rule more transparent, the impact on capital more  predictable, and the treatment of portfolios with insufficient data more  consistent. Specifically, the proposed rule is ambiguous on a number of  important issues that, if left unresolved, could continue to result in  regulatory ambiguity for banks and concerns for industry observers,  including (1) what regulators plan to do when banks have limited data  available, especially for new financial products or portfolios that lack data  on the impact of a major economic downturn, and how they will ensure  that portfolios with insufficient data are treated prudently and  consistently, such as considering options like a higher risk-weight or  substituting Basel IA or the Basel Committee’s standardized approach for  these portfolios; (2) how regulators will calculate the 10-percent aggregate  reduction in minimum regulatory capital and what would happen if this is  triggered; and (3) the criteria for determining an appropriate average level  of aggregate capital and appropriate cyclical variation in regulatory  capital. Also, to address growing concerns from some large banks about  Basel II becoming an expensive compliance exercise, the regulators have  requested comments on many technical issues, as well as whether banks  should have the option of using a U.S. version of the standardized  approach. However, it is uncertain from the NPR what form a standardized  approach would take, whether it would mirror the international Basel  Accord, and how long banks would be able to use it.
Although the regulators have been operating in accordance with the  Administrative Procedure Act in their Basel II rule-making process, the  process could benefit from increased transparency to respond to broader  questions and concerns about transitioning to Basel II in the United States.  Specifically, the differing perspectives the regulators bring to the Basel II  negotiations make it difficult for them to explicitly define the criteria they  plan to use to judge Basel II’s success. This difficulty has, in turn, resulted  in considerable uncertainty about, and some opposition to, Basel II among  industry and other interested parties and stakeholders. As a result,  although the regulators have indicated that they plan to revise the  framework as needed during the transition, publicly reporting results of  the parallel runs and comparisons of Basel II and Basel I results for core  banks is particularly important given concerns about implementing Basel  II in the United States. Going forward, public reports could be used to  provide greater transparency on a number of issues and could help allay  concerns among banks and industry stakeholders about the transition to  Basel II. Issues that would benefit from greater transparency include (1)  the results of coordination and communication efforts among SEC and the  banking regulators; (2) changes to the Basel II rules during the transition  period and the safeguards, if any, that regulators believe are appropriate in  the absence of the transitional floors; and (3) updates to supervisory  guidance incorporating Basel II rule changes. Without added transparency,  the implementation will continue to generate questions and concerns  about the adequacy of the proposed framework. Moreover, regulators have  not articulated whether the safeguards will be retained at the end of the  parallel run and transition period if the new capital framework results in  significant declines in regulatory required capital or significant changes in  the regulatory approach.
Finally, Basel II raises a number of competitiveness concerns that warrant  further study and review. First, how Basel II will impact U.S. banks’  competitiveness internationally remains unknown. But this issue will  continue to be an ongoing concern, especially if the U.S. implementation  of Basel II results in higher regulatory required capital or greater  compliance costs for U.S. banks than for foreign banks. Second,  competitiveness issues also exist between U.S. institutions such as  investment banks and commercial banks. SEC, which has implemented  the Basel Accord for consolidated supervised entities, plans to revisit its  rules based on the Federal Reserve’s interpretation of Basel II as applied  to financial holding companies. Finally, Basel II also raises  competitiveness concerns between large and small U.S. banks. Lower  capital requirements for some assets could provide large banks with a  competitive advantage; however, retaining the leverage ratio will help  maintain the domestic competitive landscape. Going forward, regulators  will need to monitor the ability of U.S. banks to compete internationally  and balance their competitiveness with the need to protect the public  interests. Moreover, the Basel IA NPR, as proposed, attempts to mitigate  potential competitive inequities created by Basel II between large and  small U.S. banks by leveling the playing field to some degree. However,  these competitive concerns will continue into the transition period, and it  is too soon to tell whether these concerns are justified or whether they  will be adequately addressed by Basel IA.
section_title: Recommendations
paragraphs: To help reduce the uncertainty about the impact of Basel II on required  levels of regulatory capital, improve the transparency of the process, and  address the impediments regulators face in moving to Basel II, we are  making the following four recommendations. We recommend that, as part  of the process leading to the parallel run and during the proposed  transition period(s), the heads of the Federal Reserve, FDIC, OCC and OTS  take, at a minimum, the following steps:    Clarify and reach agreement on certain issues in the final rule, including    How to treat portfolios at Basel II banks that may lack the data to meet  regulatory standards for the advanced approaches. To ensure that  portfolios with insufficient data are treated prudently and consistently,  regulators should consider options such as a higher risk-weight, or  substituting Basel IA or the Basel Committee’s standardized approach  for these portfolios.
How to calculate the 10-percent reduction in aggregate minimum  regulatory capital and what will happen if the 10-percent reduction is  triggered.
What the criteria will be for determining an appropriate average level  of required capital and appropriate cyclical variation in minimum  required capital.
Issue a new NPR before finalizing the Basel II rule, if the final rule differs  materially from the NPR or if a U.S. standardized approach is an option in  the final rule. While this step may add months to the process, the  additional time may help provide more transparency and allow banks and  stakeholders to provide feedback before the rule is finalized.
Issue public reports at least annually on the progress and results of  implementation efforts and any resulting regulatory adjustments. This  reporting should include an articulation of the criteria for judging the  attainment of their goals for Basel II implementation and for determining  its effectiveness for regulatory capital-setting purposes. These reports  should also include analyses of (1) the results of the parallel runs and  transition periods and a comparison of Basel II and Basel I results for the  core banks and (2) the effect(s), if any, of Basel II or differences between  U.S. and international rules on the competitiveness of U.S. banks.
Finally, at the end of the last transition period, we recommend that the  regulators reevaluate whether the advanced approaches of Basel II can  and should be relied on to set appropriate regulatory capital requirements  in the longer term. Depending on the information collected during the  transition, any reevaluation should include a range of options, including  consideration of additional minor modifications to U.S. Basel II  regulations as well as whether more fundamental changes are warranted  for setting appropriate required regulatory capital levels.
section_title: Agency Comments and Our Evaluation
paragraphs: We provided the heads of the Federal Reserve, FDIC, OCC, OTS, SEC, and  the Department of the Treasury with a draft of this report for their review  and comment. We received written comments from the Federal Reserve,  OCC, FDIC and OTS in a joint letter, and Treasury. These comments are  summarized below and reprinted in appendixes IV through VII. The  banking agencies and SEC also provided technical comments that we  incorporated in the report where appropriate.
In its comments, the Federal Reserve said it concurred with our initial  finding that Basel I is particularly inadequate for large banking  organizations and agreed with our conclusion that the regulators should  continue their efforts to finalize the U.S. Basel II capital rule and proceed  with the parallel run and transition periods. In commenting on our  conclusion that the U.S. Basel II process has lacked transparency, the  Federal Reserve commented that it and the other regulators have  attempted to be as transparent as possible in their implementation efforts,  consistent with the letter and spirit of the Administrative Procedure Act.  However, the Federal Reserve commented that it understood that the  Basel II proposals contain a considerable amount of ambiguity and that it  expects to reduce this ambiguity as it works with the other regulators to  finalize the Basel II rule. We agree that the regulators have been operating  within the parameters of the Administrative Procedure Act in their rule- making process, but they have been less transparent with regard to  broader questions and concerns about transitioning to Basel II in the  United States. Especially going forward, additional public reporting would  be useful to provide greater transparency on a number of issues and could  help allay concerns among banks and industry stakeholders about the  transition to Basel II. In addition, the Federal Reserve concurred with our  recommendations and said it will seek to implement them.
Similarly, in its comments, OCC said it appreciated our recognition of the  limitations of Basel I for large and/or internationally active banks and  welcomed our conclusion that the regulators should finalize the rule and  proceed with the parallel run and transition period. OCC commented that  its position has been that the regulators should move forward on Basel II  with strong safeguards in place during a transition period and assess the  need for adjustments during this period before removing any safeguards.  OCC also noted that U.S. proposals leave two existing U.S. capital  safeguards in place that are not temporary—the leverage ratio and the  prompt corrective action framework. OCC also said it welcomed our  recommendations, which it, along with the other regulators, will consider  as part of the overall review of comments received on the NPR. With  regard to our recommendation on whether a new NPR might be necessary  before proceeding to a final rule, OCC said it believed that will ultimately  depend on whether actual changes made to the NPR in the subsequent  version of the Basel II rule are sufficiently different so as to require  another round of notice and comment and that it was premature to make  that determination until all comments had been received and evaluated  and the regulators decide what changes to make. OCC also pointed out  that further delay could have ramifications for international competition  and said it will ensure that the rule-making process complies with the  letter and spirit of the Administrative Procedure Act.
In their joint letter, FDIC and OTS commented that Basel II efforts to  improve the risk sensitivity of capital requirements for large, complex  banks has been rooted in the regulators’ shared objectives and said that  ensuring the achievement of these shared objectives will remain of  paramount importance to the regulators’ deliberations and review of  comments on the NPR. They also said that the regulators share a  commitment to maintaining a safe and sound banking industry and that  retention of the existing leverage ratio and prompt corrective action  framework, and other safeguards in the NPR, underscore that  commitment. In addition, they commented that, given the considerable  costs and complexity of the advance approach and its attendant  uncertainties and risks, FDIC and OTS noted that serious consideration  should be given to the implementation of a U.S. version of the Basel II  standardized approach as an option for all U.S. banks. Similar to OCC,  FDIC and OTS also said they will consider our recommendations as part of  the overall review of the comments received on the NPR.
In its comments, Treasury agreed that there are a number of significant  Basel II implementation challenges and uncertainties for the large,  complex banking organizations that will be subject to Basel II  requirements and for federal banking regulators. Treasury stated its view  that the regulators needed to reach a consensus on the major requirements  of a final rule soon after the NPR comment period closes for Basel II and  IA if the United States is going to meet the January 2008 goal for Basel II  implementation. Treasury noted that further delay would add to  uncertainty and potentially create burdens for domestic and foreign banks.  Treasury also expressed concern with our recommendation to issue a new  NPR before finalizing the Basel II rule, saying that the overlapping  comment period for Basel II and Basel IA, which is similar to the  standardized approach for credit risk in the international Basel Accord,  provides commenters the ability to opine on implementation and other  issues and options. We realize that an additional NPR would further delay  the Basel II process; however, under certain circumstances an additional  NPR would be a necessary step to provide more transparency to the  process and to ensure that the final rule is comprehensive and that the  implications are fully considered. In response to comments on this  recommendation from the Federal Reserve, OCC, and the Treasury, we  have clarified the wording of our recommendation to more clearly state  the need for a new NPR if the regulators intend to issue a final rule that is  materially different from the NPR or if they intend to provide a U.S.  standardized approach.
We are sending copies of this report to interested congressional  committees, the Chairman of the Federal Reserve Board, Chairman of the  Federal Deposit Insurance Corporation, the Comptroller of the Currency,  the Director of the Office of Thrift Supervision, the Chairman of the  Securities and Exchange Commission, and the Secretary of the Treasury.  We will also make copies available to others on request. In addition, the  report will be available at no charge on GAO’s Web site at  http://www.gao.gov.
If you or your staff have any questions regarding this report, please  contact Orice M. Williams at (202) 512-5837 or williamso@gao.gov or  Thomas J. McCool at (202) 512-2642 or mccoolt@gao.gov. Contact points  for our Offices of Congressional Relations and Public Affairs may be found  on the last page of this report. GAO staff who made major contributions to  this report are listed in appendix VIII.
section_title: Appendix I: Scope and Methodology
paragraphs: The objectives of this report were to describe (1) the developments  leading to the transition to Basel II, (2) the proposed changes to the U.S.  regulatory capital framework, (3) the potential implications of Basel II’s  quantitative approaches and their potential impact on required capital, (4)  banks’ preparations and related challenges, and (5) U.S. regulators’  preparations and related challenges.
For all our objectives, we reviewed a variety of documents, including  regulators’ statements; congressional testimony; the international Basel II  Accord (entitled “International Convergence of Capital Measurement and  Capital Standards: A Revised Framework”) and other documents from the  Basel Committee on Banking Supervision, such as the 1988 Basel Capital  Accord (Basel I); the Basel II and Basel IA Notices of Proposed  Rulemaking (NPR); the Basel II and Basel IA Advance Notices of  Proposed Rulemaking (ANPR); literature from the Congressional  Research Service, bank trade associations, academic articles, and our  previous reports on banking regulation. We also interviewed senior  supervisory officials at the Board of Governors of the Federal Reserve and  the Federal Reserve Bank of New York (Federal Reserve), Office of the  Comptroller of the Currency (OCC), Federal Deposit Insurance  Corporation, Office of Thrift Supervision, and the Securities and Exchange  Commission (SEC). We interviewed a former U.S. regulatory official, a  foreign banking regulatory official, a state regulator and an association of  state banking regulators. In addition, we interviewed officials from all core  and a selected group of opt-in banks, two bank trade associations, an  international banking association, and two credit rating agencies. Finally,  we attended several conferences held by regulators and trade associations  that included discussions related to Basel II.
To describe the developments leading to the transition to Basel II and the  proposed changes to the U.S. capital framework, in addition to the  foregoing, we reviewed a variety of documents, including the Market Risk  Amendment and official comments on the Basel II and Basel IA ANPRs.
As noted throughout the report, the rules for Basel II and Basel IA in the  United States were not yet final when we completed our audit work,  limiting our ability to assess the potential impact of regulatory changes. To  describe the potential implications of Basel II’s quantitative approaches  and their potential impact on required capital, we used data from the  fourth quantitative impact study, Moody’s Investors Service, and  regulatory, bank, and academic studies to analyze and illustrate how  proposed regulatory changes could affect capital requirements for a  variety of assets under a variety of economic conditions. For example, we  combined risk parameter estimates from those sources to estimate Basel II  credit risk capital requirements for externally-rated corporate exposures  and mortgages and compared those estimates to required capital under the  leverage ratio. We analyzed the advanced internal ratings-based approach  to credit risk and advanced measurement approaches to operational risk  based on the proposed rules, academic studies, Basel Committee  documents, and our interviews with core and opt-in bank officials, and  regulators.
To describe banks’ preparations and related challenges, as stated  previously, we interviewed officials from each of the likely core banks. To  identify the likely core banks, we used data available from public  regulatory filings to determine those whose total assets and/or foreign  exposure met the proposed criteria in the Basel II NPR as of December 31,  2005. We also collected information through interviews and written data  collection instruments from a sample of five possible opt-in banks,  selected on the basis of input from the regulators and bank associations,  size, and primary federal regulator.
To describe regulators’ preparations and challenges, we reviewed a variety  of documents as listed above, as well as other documents from the federal  banking regulators, such as the Federal Reserve’s Supervisory Letter 99-18  (SR 99-18), OCC’s Bulletin 2000-16, the Market Risk Rule, and regulators’  strategic and annual performance plans. At the Federal Reserve and OCC,  we also interviewed bank examiners for two of the largest U.S. banking  organizations and reviewed examination reports to understand how  regulators oversee risk management processes at core banks and how the  regulators are planning to incorporate Basel II into their examinations and  oversight processes.
We conducted our work in Washington, D.C.; Chicago, San Francisco, and  New York, between April 2006 and January 2007 in accordance with  generally accepted government auditing standards.
section_title: Appendix II: U.S. and International Transition to Basel II
paragraphs: July: Basel Committee issu Basel Cpitl Accord (Basel I), interntionl  rik-based cpitl requirement for bank in G10 contrie, to e flly  implemented y 1992.
Bnk regtory gencie—OCC, OTS, Federl Reerve, nd FDIC  (herefter “gencie”)—implement Basel I with  trition period to 1992.
Agencielly phase in Basel I asrt of roder chnge to cpitl  regtion.  The U.S. prompt corrective ction proviion require dequately  cpitlized nd well-cpitlized intittion to meet or exceed Basel I  rik-based cpitl requirement as well as  leverge requirement.
January: Basel Committee mend Basel I to incorporte mrket ri.
The Mrket Rik Amendment introdce the use of intittions’ internl  model of rik to determine regtory cpitl requirement.
September: OCC, Federl Reerve, nd FDIC issue finl rle implementing  the Mrket Rik Amendment, requiring intittion with ignificnt trding  ctivity to use internl model to measure nd hold cpitl in support of  mrket rik exposure.
June: Basel Committee propo for comment incrementl reviion to  Basel I for credit rik (ndrdized pproch), pl to develop lterntive internl rting-based (IRB) pproch, nd propoed cpitl  chrge for other mjor ri, inclding opertionl rik.
January: Basel Committee releas revied proposabased on consult- tion with industry nd supervior.  The Committee im to encoge  improved rik mgement prctice in prt throgh cpitl incentive for  bank to move to the more rik-enitive IRB pproch.
April-May: Basel Committee releas result of  globaquantittive impct  dy (QIS-) nd issu third consulttive pper for comment.
Aut: Agencie releasdvnce notice of propoed rlemking (ANPR)  on Basel II for comment. The propoed rle require the dvnced  pproche for credit nd opertionl rik to pplied y only the lrge  nd/or interntionlly ctive bank nd holding compnie. Exiting cpitl  rle wold e retined for ll other bank.
June: Basel Committee issu finl revied frmework for Basel II  (interntionccord). It reitertejective of rodly mintining the level  of ggregte required cpitl while o providing incentive to dopt the more  dvnced pproche. The frmework inclde chnge such as  1.06  ling fctor y which cpitl requirement for credit rik wold e mltiplied  in order to mintin cpitl netrlity with previously etimted result.
June: SEC releas lterntive net cpitl rle tht permit certin  roker-deler to use internl mthemticl model to clcte mrket nd  derivtive-relted credit rik.  To pply the rle,  roker-deler’s ltimte  holding compny must conent to gropwide superviion nd report cpitdequacy measure content with Basel ndrd.
April: Agencie nnonce dely in Basel II rlemking process, fter result  of  quantittive impct dy (QIS-4) etimted mteril redction in  ggregte cpitl requirement nd ignificnt vrition in result cross  intittion nd portfolio. Agencieter te thsuch result wold cceptable in ctual cpitl regime.
September: Agencie nnonce one-yer dely in implementtion nd  dditionsafeguard to prevent cceptable decline in required cpitastimted in QIS-4.  The gencie retin the leverge requirement, dd   trition yer, nd eablitricter trition period limit on cpitl  redction for individual intittion.
October: Agenciessue Basel IA ANPR. It revi Basel I to ddress  competitive inequitie etween lrge nd ll intittion y providing   more rik-enitive frmework imilr to the ndrdized pproch nder the  Basel II interntionccord.
March: Federl Reerve releas drft Basel II NPR to llow industry time to  comment nd prepre.  In ddition to previously nnonced safeguard, it  te thgencie wold view  10 percent or greter decline in ggregte  rik-based cpitl requirement (compred to Basel I) as teril drop  wrrnting chnge to the Basel II frmework.
June: Basel Committee releas result of  globaquantittive impct  dy (QIS-5) of etimted chnge in minimm required cpitnder Basel II.
September: Agencie release for comment officil NPR for Basel II nd for  mrket rik. The Basel II NPR requ comment on whether nd how the  ndrdized pproch hold e provided to bank as n option in ddition  to the dvnced pproch for credit rik. December: Agenciessue drft Basel IA NPR. The proposal requ com- ment on whether nd how Basel IA hold e provided to Basel II bank as n  option in ddition to the dvnced pproch for credit rik.
June: Eropen Union issu finl rle implementing Basel II  (EU Cpitl Directive).
March: Comment period for Basel II nd Basel IA NPR cloe. June: Agencie expect to issue finl Basel II rle.
Firt tranitional floor period (90% floor)
Second tranitional floor period (80% floor)
Firt tranitional floor period (95% floor)
Full implementation (firt date available for Bael II)
Second tranitional floor period (90% floor)
Third tranitional floor period (85% floor)
Floor pplie to individual intittion’s pitl redction.
Full implementation (firt date available for Bael II)
section_title: Appendix III: Basel II Descriptive Overview
subsections: section_title: Pillar 1: Minimum Capital Requirements
paragraphs: Pillar 1 of the U.S. Basel II proposal features explicit minimum capital  requirements, designed to ensure bank solvency by providing a prudent  level of capital against unexpected losses for credit, operational, and  market risk. The advanced approaches, which are the only measurement  approaches currently proposed in the United States, will make capital  requirements depend in part on a bank’s own assessment, based on  historical data, of the risks to which it is exposed.
subsections: section_title: Credit Risk
paragraphs: Under the advanced internal ratings-based (A-IRB) approach, banks must  establish risk rating and segmentation systems to distinguish risk levels of  their wholesale (most exposures to companies and governments) and  retail (most exposures to individuals and small businesses) exposures,  respectively. Banks use the results of these rating systems to estimate  several risk parameters that are inputs to supervisory formulas. Figure 7  illustrates how credit risk will be calculated under the Basel II A-IRB.  Banks must first classify their assets into exposure categories and  subcategories defined by supervisors: for wholesale exposures those  subcategories are high-volatility commercial real estate and other  wholesale; for retail exposures those subcategories are residential  mortgages, qualifying revolving exposures (e.g., credit cards), and other  retail. Banks then estimate the following risk parameters, or inputs: the  probability a credit exposure will default (probability of default or PD),  the expected size of the exposure at the time of default (exposure at  default or EAD), economic losses in the event of default (loss given default  or LGD) in expected and “downturn” (recession) conditions, and, for  wholesale exposures, the maturity of the exposure (M). In order to  estimate these inputs, banks must have systems for classifying and rating  their exposures as well as a data management and maintenance system.  The conceptual foundation of this proposal is that a statistical approach,  based on historical data, will provide a more appropriate measure of risk,  and capital, than a simple categorization of asset types, which does not  differentiate precisely between risks. Regulators provide a formula for  each exposure category that determines the required capital on the basis  of these inputs. If all the assumptions in the supervisory formula were  correct, the resulting capital requirement would exceed a bank’s credit  losses in a given year with 99.9 percent probability. That is, credit losses at  the bank would exceed the capital requirement with a one in one thousand  chance in a given year, which could result in insolvency if the bank only  held capital equal to the minimum requirement.
In contrast to Basel I, required capital by the A-IRB approach, as  previously described, will depend on the risk characteristics of a particular  asset rather than on broad risk weights for entire asset categories, as in  Basel I. For example, mortgage loans vary significantly in quality, and the  capital requirement will depend on the probability of default, along with  the other inputs, while the capital requirement for most mortgages is fixed  under Basel I.
section_title: Operational Risk
paragraphs: To determine minimum required capital for operational risk, banks would  be able to use their own quantitative models of operational risk that  incorporate elements required in the NPR. To qualify to use the advanced  measurement approaches (AMA) for operational risk, a bank must have  operational risk management processes, data and assessment systems, and  quantification systems. The elements that banks must incorporate into  their operational risk data and assessment system are internal operational  loss event data, external operational loss event data, results of scenario  analysis, and assessments of the bank’s business environment and internal  controls. Banks meeting the AMA qualifying criteria would use their  internal operational risk quantification system to calculate the risk-based  capital requirement for operational risk, subject to a solvency standard  specified by regulators, to produce a capital buffer for operational risk  designed to be exceeded only once in a thousand years.
section_title: Market Risk
paragraphs: 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-business- day 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.
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.
section_title: Pillar 2: Supervisory Review
paragraphs: The Pillar 2 framework for supervisory review is intended to ensure that  banks have adequate capital to support all risks, including those not  addressed in Pillar 1, and to encourage banks to develop and use better  risk management practices. Banks adopting Basel II must have a rigorous  process of assessing capital adequacy that includes strong board and  senior management oversight, comprehensive assessment of risks,  rigorous stress testing and validation programs, and independent review  and oversight. In addition, Pillar 2 requires supervisors to review and  evaluate banks’ internal capital adequacy assessments and monitor  compliance with regulatory capital requirements. Under Pillar 2,  supervisors must conduct initial and ongoing qualification of banks for  compliance with minimum capital calculations and disclosure  requirements. Regulators must evaluate banks against established criteria  for their (1) risk rating and segmentation system, (2) quantification  process, (3) ongoing validation, (4) data management and maintenance,  and (5) oversight and control mechanisms. Regulators are to assess a  bank’s implementation plan, planning and governance process, and  parallel run performance. Under Pillar 2, regulators should also assess and  address risks not captured by Pillar 1 such as credit concentration risk,  interest rate risk, and liquidity risk.
Importantly, the Pillar 2 of the international Basel II framework is already  largely in place in the United States. For example, Pillar 2 allows  supervisors the ability to require banks to hold capital in excess of the  minimum, an authority that federal regulators already possess under  prompt corrective action provisions.
section_title: Pillar 3: Market Discipline in the Form of Increased Disclosure
paragraphs: 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 risk- based capital ratios and their capital components, aggregated information  underlying the calculation of their risk-weighted assets, and the bank’s risk  assessment processes. In addition, federal regulators propose to collect,  on a confidential basis, more detailed data supporting the capital  calculations. Federal regulators would use this additional data, among  other purposes, to assess the reasonableness and accuracy of a bank’s  minimum capital requirements and to understand the causes behind  changes in a bank’s risk-based capital requirements. Federal regulators  have proposed detailed reporting schedules to collect both public and  confidential disclosure information.
section_title: Appendix IV: Comments from the Board of Governors of the Federal Reserve System
section_title: Appendix V: Comments from the Office of the Comptroller of the Currency
section_title: Appendix VI: Comments from the Federal Deposit Insurance Corporation and the Office of Thrift Supervision
section_title: Appendix VII: Comments from the Department of the Treasury
section_title: Appendix VIII: GAO Contacts and Staff Acknowledgments
subsections: section_title: GAO Contacts
section_title: Staff Acknowledgments
paragraphs: In addition to the contacts named above, Barbara I. Keller (Assistant  Director); Emily Chalmers; Michael Hoffman; Austin Kelly; Clarette Kim;  James McDermott; Suen-Yi Meng; Marc Molino; and Andrew Nelson made  key contributions to this report.
section_title: Related GAO Products
paragraphs: 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.