Risk-Based Capital: New Basel II Rules Reduced Certain Competitive Concerns, but Bank Regulators Should Address Remaining Uncertainties
Published: 2008-09-12T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Basel II, the new risk-based capital framework based on an international accord, is being adopted by individual countries. It includes standardized and advanced approaches to estimating capital requirements. In the United States, bank regulators have finalized an advanced approaches rule that will be required for some of the largest, most internationally active banks (core banks) and proposed an optional standardized approach rule for non-core banks that will also have the option to remain on existing capital rules. In light of possible competitive effects of the capital rules, GAO was asked to examine (1) the markets in which banks compete, (2) how new capital rules address U.S. banks' competitive concerns, and (3) actions regulators are taking to address competitive and other potential negative effects during implementation. Among other things, GAO analyzed data on bank products and services and the final and proposed capital rules; interviewed U.S. and foreign bank regulators, officials from U.S. and foreign banks; and computed capital requirements under varying capital rules.
section_title: What GAO Found
paragraphs: Large and internationally active U.S.-based banks (core banks) that will adopt the Basel II advanced approaches compete among themselves and in some markets with U.S.-based non-core banks, investment firms, and foreign-based banks. Non-core banks compete with core banks in retail markets, but in wholesale markets core banks often compete with investment firms and foreign-based banks. Because holding capital is costly for banks, differences in regulatory capital requirements could influence costs, prices, and profitability for banks competing under different capital requirements. The new U.S. capital rules addressed some earlier competitive concerns of banks; however, other concerns remain. By better aligning the advanced approaches rule with the international accord and proposing an optional standardized approach rule, U.S. regulators reduced some competitive concerns for both core and non-core banks. For example, the U.S. wholesale definition of default for the advanced approaches is now similar to the accord's. Core banks continue to be concerned about the leverage requirement (a simple capital to assets calculation), which they believe places them at a competitive disadvantage relative to firms not subject to a similar requirement. Foreign regulators have been working with U.S. regulators to coordinate Basel II implementation for U.S. banks with foreign operations. The proposed standardized approach addresses some concerns non-core banks raised by providing a more risk sensitive approach to calculating regulatory requirements. But other factors likely will reduce differences in capital for banks competing in the United States; for example, the leverage requirement establishes a floor that may exceed the capital required under the advanced and standardized approaches. Many factors have affected the pace of Basel II implementation in the United States and, while the gradual implementation is allowing regulators to consider changes in the rules and reassess banks' risk-management systems, regulators have not yet taken action to address areas of uncertainty that could have competitive implications. For example, the final rule provides regulators with considerable flexibility and leaves open questions such as which banks may be exempted from the advanced approaches. Although the rule provides that core banks can apply for exemptions and regulators should consider these in light of some broad categories, such as asset size or portfolio mix, the rule does not further define the criteria for exemptions. Some industry participants we spoke with said that uncertainties about the implementation of the advanced approaches have been a problem for them. Moreover, regulators have not fully developed plans for a required study of the impacts of Basel II before full implementation. Lack of specificity in criteria, scope, methodology, and timing will affect the quality and extent of information that regulators will have to help assess competitive and other impacts, determine whether there are any material deficiencies requiring future changes in the rules, and determine whether to permit core banks to fully implement Basel II.

section_title: Letter
paragraphs: Ensuring that banks maintain adequate capital is essential to the safety  and soundness of the banking system. Basel II, the newly revised risk- based capital framework, aims to better align minimum capital  requirements with enhanced risk-measurement techniques and to  encourage banks to develop a more disciplined approach to risk  management. Basel II rests on an international accord (the New Basel  Accord) adopted by the Basel Committee on Banking Supervision (Basel  Committee) in June 2004. The New Basel Accord includes a standardized  approach and advanced approaches, more complex approaches that large,  internationally active banks are encouraged to use. U.S. federal banking  regulators have been working to finalize capital rules based on this accord.  Since our February 2007 report on Basel II, U.S. federal banking regulators  have finalized the advanced approaches rules that are required for some of  the largest and most internationally active banking organizations (core  banks), which account for about half of U.S. banking assets. Some other  banks may choose to comply with the advanced approaches rule as well.  These rules lay out a phased implementation schedule, which generally  requires core banks to have Basel II implementation plans approved by  their boards of directors by October 1, 2008. In addition, in July 2008, U.S.  banking regulators published for comment a proposed rule on the  standardized approach, a simpler version of the new regulatory capital  framework that could be adopted by banks that were not required to adopt  the advanced approaches (non-core banks).
Though the goal of Basel II was to improve the safety and soundness of the  banking system through better risk management and create a level playing  field for internationally active banks, the development of Basel II has  generated concerns among banks, banking regulators, and other interested  parties that potentially different capital requirements and implementation  costs for various categories of U.S. and foreign banks could have  competitive effects. These concerns arose, in part, because U.S. banks  that all have been operating under the same risk-based capital rules— known as Basel I—may be operating under different capital rules in the  future—Basel II advanced approaches, Basel II standardized approach, or  Basel I. In addition, because the New Basel Accord identified certain areas  for national discretion, the capital regimes being adopted in various  countries differ from that being implemented in the United States.
The risk-management systems for financial institutions and the  information systems on which they rest have been called into question by  the failure of some of these systems during the market turbulence that  began with subprime mortgages in 2007. While this turmoil is not the focus  of this report, it is an important factor that is leading banking  organizations and their regulators to reassess capital requirements and  other aspects of bank regulation and supervision. These assessments  could lead to changes in the Basel II rules or could influence the  implementation of those rules in the United States. In addition, as a result  of concerns about the ability of U.S. financial institutions to compete with  institutions based in foreign countries, the U.S. Department of the  Treasury has proposed a restructuring of the complex U.S. regulatory  system. Various congressional committees have held hearings that  addressed this issue and in the past, we have recommended that the U.S.  regulatory system be restructured.
In light of concerns about possible competitive effects, you requested that  we review the competitive implications of Basel II for non-core U.S. banks  in comparison to core banks adopting the advanced approaches and how  differences in the implementation of Basel II in foreign countries might  affect the competitiveness of internationally active banks operating in the  United States. Specifically, this report examines (1) the nature of the  competitive environment in which U.S. banking organizations operate,   (2) the extent to which the new capital rules address competitive concerns  of U.S. banking organizations internationally and domestically, and (3)  actions regulators are taking to address competitive and other potential  negative effects of the new capital rules during implementation.
To meet our objectives, we reviewed the New Basel Accord, the U.S.  proposed rules on the advanced approaches and standardized approach,  the U.S. final advanced approaches rule, supervisory guidance, and related  materials. In addition, we reviewed research related to the impact of Basel  II in the United States and the European Union. We interviewed officials at  the federal bank regulatory agencies responsible for implementing Basel  II, including examination and policy staff. We also interviewed officials  from all of the core banks and other domestic and foreign banks with  operations in the United States. In addition, we interviewed officials from  several foreign bank regulatory agencies; domestic and foreign trade  associations; credit rating agencies; and several academics and  consultants with banking expertise. To describe the competitive  environment in which U.S. banking organizations operate, we analyzed  various data sources on the products and services that U.S. and foreign  banking organizations offer domestically and internationally. To assess the  competitive impact of the different capital rules on U.S. banks, we  computed capital requirements for certain products under the varying  rules and reviewed academic and other studies of the impact of regulatory  capital on bank behavior.
We conducted this performance audit from May 2007 to September 2008 in  accordance with generally accepted government auditing standards. Those  standards require that we plan and perform the audit to obtain sufficient,  appropriate evidence to provide a reasonable basis for our findings and  conclusions based on our audit objectives. We believe that the evidence  obtained provides a reasonable basis for our findings and conclusions  based on our audit objectives. Appendix I discusses our scope and  methodology in further detail.
subsections: section_title: Background
paragraphs: Basel II rests on the New Basel Accord, which established a more risk- sensitive regulatory framework that was intended to be sufficiently  consistent internationally but that also took into account individual  countries’ existing regulatory and accounting systems. The U.S. bank  regulators have been adapting the New Basel Accord for use by U.S.  banks.
subsections: section_title: U.S. Regulators Responsible for Implementing Basel II
paragraphs: In the United States, the four federal bank regulators oversee the  implementation of Basel II for banks and SEC oversees the  implementation of Basel capital rules for investment firms. The financial  institutions that will be involved in the implementation of Basel II are  organized as bank holding companies, thrift holding companies, or  consolidated supervised entities (CSE). At a consolidated level the Federal  Reserve supervises bank holding companies that are subject to Basel  capital requirements, OTS supervises thrift holding companies that are not  subject to Basel capital requirements, and SEC supervises CSEs that  voluntarily choose to be subject to consolidated oversight including Basel  capital reporting requirements. Each of these types of holding companies  has subsidiaries that are depository institutions that could be required to  adopt Basel II. Each of these banking institutions is regulated by a primary  federal regulator according to the rules under which it is chartered.
FDIC serves as the primary federal regulator of state chartered banks that  are not members of the Federal Reserve System (state nonmember banks).  It is also the deposit insurer for all banks and thrifts and has backup  supervisory authority for all banks it insures.
The Federal Reserve serves as the primary federal regulator for state  chartered banks that are members of the Federal Reserve System (state  member banks).
OCC serves as the primary federal regulator for national (i.e., federally  chartered) banks. Many of the nation’s largest banks are federally  chartered.
OTS serves as the primary federal regulator for all federally insured thrifts.
Under the dual federal and state banking system, state chartered banks are  supervised by state regulatory agencies in addition to a primary federal  regulator.
In 2004, SEC established a voluntary, alternative net capital rule for  broker-dealers whose ultimate holding company consents to groupwide  supervision by SEC as a CSE. This alternative net capital rule permits the  use of statistical models for regulatory capital purposes. At the holding  company level, CSEs are required to compute and report to SEC capital  adequacy measures consistent with the standards in the Basel Accord, and  SEC expects them to maintain certain capital ratios, though they are not  required to do so. According to SEC, all CSEs have implemented Basel II.  Primary U.S. broker-dealers affiliated with CSEs are required to comply  with a capital requirement that SEC says is not identical to the Basel  standards but makes use of statistical models in its computation.  Depository institutions within the CSEs are subject to the same  requirements as other banks of similar sizes and exposures including risk- based capital requirements, the leverage ratio, and PCA; however, there is  no leverage requirement at the consolidated level for CSEs.
section_title: Core Banks Compete among Themselves and with Other Financial Entities That Will Operate under Different Capital Regimes
paragraphs: Core banks face a range of competitors including non-core U.S. banks, other  financial institutions, and foreign-based banks. Core banks that have varying  business models—some focus on domestic retail banking activities, some on  wholesale activities, and others are engaged in the full range of these  activities—are overseen by a number of different bank regulators. Banks of  different sizes that are likely to be under different capital regimes are more  likely to compete with each other in retail markets, where they offer products  such as residential mortgages to the same customers, than in wholesale  markets. In certain wholesale markets, core banks often compete with U.S.  investment firms. U.S.-based core banks also compete with foreign-based  banks in foreign markets and in U.S. markets where foreign-based banks are  very active. Since core banks compete with other financial institutions across  various product and geographic markets, differences in capital rules or the  implementation of those rules may have competitive effects by influencing  such things as the amount of capital institutions hold, how banks price loans,  and the cost of implementing capital regulations.
subsections: section_title: Core Banks Compete with Other Core and Non-core Banks
paragraphs: Core banking organizations—those that meet the requirements in terms of  asset size and foreign exposure for mandatory adoption of the Basel II  advanced approaches—have adopted a variety of business models, but all  compete with some other core banks. Some of the core banks are active in  retail markets, some in wholesale markets, and some in the full range of  banking activities. As illustrated in table 1, which is based on publicly  available information, five core banking organizations—including one that  is foreign-based—have at least 25 percent of their assets in retail markets  and one of these, the only thrift that is a core banking organization  (Washington Mutual Bank), has more than 60 percent of its assets in retail  markets, while a few institutions have almost no activity in these markets.  In addition, two core banks that appear less active in retail markets—with  about 15 percent of their assets in these markets—may still have a major  presence there because of their overall size. In wholesale markets, table 1  shows that some banks are active in making commercial and industrial  loans while others hold a larger percentage of their assets as trading  assets—assets held to hedge risks or speculate on price changes for the  bank or its customers. However, the thrift institution has very little activity  in these markets. The three smaller U.S.-based core banks, which are  classified as core banks because they have large foreign exposures, engage  primarily in custodial activities where they manage the funds of their  clients. In this area they compete with the largest U.S. banks that are also  engaged in these activities.
Core banks are in some ways similar to non-core banks. For example,  banks of all sizes continue to participate in some activities historically  associated with banking, such as taking deposits and making loans. As  table 2 shows, bank holding companies of different sizes hold similar  proportions of certain loans such as residential mortgages and commercial  and industrial loans.
According to research conducted by Federal Reserve staff and other  experts, banks of different sizes compete with each other for retail  products such as residential mortgages. As illustrated in table 2, bank  holding companies in all size ranges hold a relatively large percentage of  their assets—from 15.5 to 23.1 percent—in residential mortgages.  Customers can obtain mortgages from banks across the United States and  generally can obtain pricing information from brokers or directly through  the Internet or financial publications. For small thrifts, which make up a  portion of the small non-core banking institutions in the United States but  are not included in table 2, the proportion of mortgages is much higher.  Unlike residential mortgages, only a few banks, including several core  banks, are active in the credit card market, but some non-core banks are  active in this market as well; and all credit card issuers generally compete  for the same customers.
For wholesale products, the competitive landscape is more complex. As  table 2 illustrates, in some areas core banks differ substantially from non- core banks and are thus not likely to compete with them in those markets.  For example, non-core banks hold a very small percentage of their assets  as trading assets, an area where some core banks are very active, and core  banks hold a relatively small proportion of their assets in commercial real  estate, an area where non-core banks are very active. While table 2 shows  that core and non-core banks are both active in the commercial and  industrial loan markets, the market for loans from large banks may be  quite different from those for smaller banks. According to a bank official  and other experts, larger banks do not price commercial and industrial  loans individually; instead, these loans generally are part of a package of  products and services offered to major corporate clients. Financial market  experts told us that often these loans are discounted to establish a  relationship with the customer. Because smaller banks do not offer a full  range of products and services, they likely are not competing for the same  customers as larger banks. In addition, we and others have shown that  smaller banks tend to serve the needs of smaller businesses with which  they can establish a personal relationship. Because obtaining credit  information on small businesses is difficult, community banks often have  an advantage with these customers in that they may have better  information about small businesses in their local market than do large  national or internationally active banks. As a result, the largest banks are  unlikely to be competing with community banks in these markets. At the  same time, research conducted by Federal Reserve staff has shown that  large non-core banks may compete with core banks for corporate  customers.
section_title: In Some Markets, Core Banks Compete with Other U.S. Financial Institutions
paragraphs: Core banks are much more likely than smaller or regional non-core banks  to participate in activities often associated with investment banking. For  example, core banks are much more likely to hold trading assets that  typically are used to hedge risks or speculate on certain market changes  either for the banking organization or its customers (see table 2).
In addition, core banks are involved in international activities where they  often provide investment banking products and services in the major  capital markets around the world. In the United States and abroad, U.S.- based core banks, especially Citigroup and JPMorgan Chase, compete with  the four major U.S. investment firms—Goldman Sachs, Merrill Lynch,  Morgan Stanley, and Lehman Brothers. The core banks also are involved in  custodial and asset management activities domestically and  internationally. In this capacity, core U.S.-based banks compete with  foreign-based banks, with investment firms, and with asset management  firms that do not own depository institutions and are not subject to  regulatory capital requirements.
section_title: U.S.-Based Banks Compete with Foreign-Based Banks in Foreign and U.S. Markets
paragraphs: Basel capital requirements were established, in large part, to limit  competitive advantages or disadvantages due to differences in capital  requirements across countries; however, the New Basel Accord allows for  certain areas of national discretion and this could create competitive  advantages or disadvantages for banks competing in various countries. In  addition, because a major part of Basel II involves direct supervision of the  risk management processes of individual banks, further opportunities  exist for differences across countries to develop as the new rules are  implemented.
While all but one of the core banks has some foreign exposure, some of  the nine U.S.-based core banks have foreign exposures that are large  relative to the size of the institution (see fig. 2). As noted above, most of  these banks are engaged in asset management and investment banking  activities globally. In addition, one of the banks is heavily engaged in retail  banking activities in a wide range of countries where each country likely  comprises a separate market. To the extent that U.S.-based banking  institutions that have subsidiaries in foreign countries face more stringent  capital requirements for the parent institution at home, U.S.-based banks  could be disadvantaged in foreign markets.
Much of the competition between U.S.- and foreign-based banks takes  place in the United States, where foreign based-banks are very active  through their subsidiaries, branches, and offices. Foreign-based banks  account for about $2.8 trillion of the approximately $15 trillion of U.S.  banking assets and subsidiaries of those banks account for 11 of the 50  largest U.S. bank holding companies. Further, as noted in table 1, three of  the core banks in the United States are subsidiaries of foreign-based  banks. Two of these operate primarily in wholesale markets, while the  third, HSBC, is active in both retail and wholesale banking markets in the  United States. In addition, some large U.S. non-core banks that are  subsidiaries of foreign-based banks are likely to adopt the advanced  approaches in the United States.
The extent to which differences in capital requirements will affect  competition in the United States between U.S.-based and foreign-based  banks will depend, in part, on how the U.S. activities of the foreign-based  banks are organized. For capital purposes, although foreign-based banks  with U.S. subsidiaries will likely follow the Basel II rules in their home  countries, the U.S. subsidiaries are regulated as U.S. banks within the  United States and will follow U.S. rules. However, branches of foreign  banks are not required to meet the U.S. rules. As a result, some foreign- based banks that have substantial U.S. operations, but conduct their  banking activities in the United States through branches, will be following  the Basel II rules in their home country rather than in the United States.
section_title: Differences in Capital Requirements Have the Potential to Create Competitive Disparities
paragraphs: Because holding capital is costly for banks, differences in regulatory  capital requirements could influence costs, prices, and profitability for  banks competing under different capital frameworks. If regulatory capital  requirements increase the amount of capital banks hold relative to what  they would hold in the absence of regulation, then the requirements would  increase banks’ costs and reduce their profitability. Depending on the  structure of markets, these higher costs could be passed on to bank  customers in the form of higher prices—interest rates on loans or fees for  services—or absorbed as reduced lending and profits. For example, higher  capital costs driven by higher capital requirements could result in a  competitive disadvantage for banks that compete for similar customers  with banks subject to different capital rules. Conversely, lower capital  requirements that allow banks to reduce the capital they hold for a  particular asset could allow them to price those assets more aggressively,  thereby increasing market share or earning higher returns at existing  prices.
Bank officials with whom we spoke and some empirical evidence we  reviewed suggested that regulatory capital requirements are one of several  key factors banks consider in deciding how much capital to hold. Other  factors include management views on the amount of capital the firm needs  internally and market expectations. These multiple and overlapping  motivations for holding capital make it difficult to isolate the impact of  regulatory capital on the amount of capital banks hold. Nevertheless,  there is some evidence that banks hold more than the minimum required  capital—a buffer—in part to reduce the risk of breaching that minimum  requirement. For example, one study of United Kingdom banks found that  an increase in required capital was followed by an increase in actual  capital, although the increase was only about half the size of the increase  in required capital. Thus, changes in minimum required capital could  cause banks to change the amount of capital they hold to maintain a  similar buffer of capital, consistent with the other goals of the bank. The  study also found that banks with small buffers reacted more to a given  change in individual capital requirements—and banks with larger buffers  reacted little, if at all—supporting the view that the capital buffer is a form  of insurance against falling below regulatory minimums.
Differences in the implementation costs of capital requirements also could  have competitive effects. In principle, higher implementation costs could  lead to a one-time increase in costs or ongoing costs associated with  compliance. One-time costs would influence profitability directly, while  ongoing costs also could influence the cost of lending for banks in the  same way that higher capital costs could influence pricing and  profitability. Significant implementation costs are likely to be easier to  bear the larger the institution—the costs of implementing regulation are  on average higher (as measured by cost per employee) for smaller firms.
The possible effects of differences in regulatory capital requirements on  implementation and capital costs also could influence incentives for  consolidation by making acquisitions more or less advantageous for banks  operating under different capital rules. Such advantages would imply that  those banks under a given capital regime might be able to use the capital  resources of banks under a different regime more effectively, making it  profitable for the former banks to acquire the latter ones. Conversely, if  implementation costs for a capital regime imposed on larger banks were  high, this might discourage some banks from merging because they would  become large enough to be required to adopt a capital regime with high  implementation costs.
section_title: New U.S. Capital Rules Have Reduced Some Competitive Concerns about Basel II
paragraphs: The new U.S. capital rules address some competitive concerns of banks;  however, other concerns remain. Regulators analyzed some competitive  issues raised by banks during the development of the Basel II rules in the  United States. In the final rule for the advanced approaches, the regulators  addressed concerns about differences between the NPR and the New  Basel Accord that could have led to greater implementation costs. For  example, in the final rule they harmonized the definition of wholesale loan  default with the accord, thus responding to banks’ concerns that  differences in the definition of wholesale loan default between the NPR  and the accord could have led to increased costs of operating in multiple  countries. However, core banks remain concerned that the leverage  requirement will affect their ability to compete with both foreign- and  some U.S.-based competitors. The coordination between U.S. and foreign  regulators on implementation issues for core banks may address some  competitive concerns of internationally active core banks. For non-core  banks, the proposed standardized approach rule may address some  concerns—for example, that core banks could hold less capital for similar  assets. The proposed rule is more risk sensitive than Basel I, providing  non-core banks with the possibility of lower regulatory capital minimums  for certain assets or activities. Other factors, such as the leverage  requirement, may reduce differences in capital for banks competing in the  United States.
subsections: section_title: U.S. Regulators Recognized Some Competitive Concerns during the Development of the Rules
paragraphs: As a result of the potential for large banks to hold less capital under Basel  II, at least for certain assets, researchers, primarily at the Federal Reserve,  conducted studies of the potential impact of Basel II on specific markets  and on aspects of the rule, including the impact on residential mortgages,  credit cards, operational risk, and mergers and acquisitions. These studies  were limited by the availability of data and by a lack of information on the  impact regulatory capital has on bank behavior. Nonetheless, the studies  identified that there could be competitive impacts in the residential  mortgage market and helped to lead to the development of alternatives to  Basel I for non-core banks.
OCC and OTS provided the Office of Management and Budget (OMB) with  regulatory impact analyses that included examination of the impact of the  rules on domestic competition. In addressing competitive issues in this  analysis, OCC relied primarily on the studies conducted at the Federal  Reserve. In its regulatory impact analysis, OTS incorporated OCC’s  analysis adding appropriate material specifically related to the thrift  industry. For example, OTS noted that because thrifts have high  concentrations of assets in residential mortgages, the leverage  requirement would be more likely to impose greater capital requirements  on these firms than would the Basel II requirements and, as a result, would  have a negative impact on the ability of thrifts to compete with other  banking organizations. OTS also pointed out that interest rate risk for  those mortgage-related assets that a bank is planning to hold rather than  trade is particularly important to thrifts. However, the adequacy of capital  held for these risks is being assessed in Pillar 2 rather than in Pillar 1,  where the risks associated with changes in interest rates on mortgage  related assets that are being actively traded are assessed. Since there is  more regulatory flexibility in Pillar 2 than in Pillar 1, OTS expressed  concern that thrifts could be disadvantaged if different regulatory agencies  did not implement Pillar 2 consistently.
The regulators did less analysis regarding the international competitive  impact of the new rules. At the time that the capital rules were being  developed, OMB provided little guidance on analyzing the international  impact of U.S. rules and the agencies did not discuss international  competition issues in their analyses. Alternatively, European Union  guidance for regulatory impact analyses includes a more detailed  evaluation of impacts on international trade and investment, and OMB is  considering including more explicit guidance on the analysis of the impact  on international trade and investment in the United States. During the  development of Basel II, U.S. banks raised concerns about being  disadvantaged internationally by certain aspects of the U.S. rules.
section_title: U.S. Final Rule on the Advanced Approaches Addresses Some Competitive Concerns Raised by Banks, but the Leverage Ratio Continues to Be a Concern
paragraphs: Although regulators have harmonized some aspects of the advanced  approaches final rule with the New Basel Accord, concerns remain about  remaining differences in the final rule and other issues such as the  leverage requirement that could have competitive effects. The final rule  removed an important technical difference in the definition of default for  wholesale products that existed between the U.S. NPR and the New Basel  Accord. However, other differences were retained, such as the U.S.  implementation schedule and the amount by which regulatory capital  could decrease during a bank’s transition to the final rule. Core banks are  specifically concerned that the leverage requirement will have negative  effects on their ability to compete with CSEs and foreign-based banks.
subsections: section_title: Final Rule Eliminated Some Technical Differences That Raised Concerns about Competitive Effects, but Other Differences Remain
paragraphs: U.S. banking regulators harmonized certain aspects of the U.S. final rule  on the advanced approaches with the New Basel Accord, reducing some  concerns of core banks. For example, one of the major concerns of U.S.  core banks was that the proposed rule included a different definition of  default for wholesale products, which could lead to increased  implementation costs through the need to maintain separate systems for  data in the United States and in those foreign countries where U.S. core  banks were required to adopt Basel II. The definition of default for  wholesale products in the final rule now closely resembles the New Basel  Accord’s definitions for these types of products, thus limiting the potential  for higher implementation costs for core banks. Other technical  differences that have been diminished for core banks include how core  banks have to estimate their losses after a borrower has defaulted on a  loan. Table 3 outlines several key technical differences between the earlier  proposed U.S. rules and the New Basel Accord and highlights where U.S.  regulators diminished or retained differences in the final rule.
One technical difference that remains between the U.S. final rule on  advanced approaches and the New Basel Accord is the treatment of SME  loans. U.S. regulators believe that an adjustment to lower the capital  charge for such business loans is not substantiated by sufficient empirical  evidence. In other words, this suggests that, all other things equal, SME  loans have risks comparable to those posed by larger corporate loans. U.S.  regulators also noted that the SME treatment in the Accord might give rise  to a domestic competitive inequity between core banks and banks subject  to other regulatory capital rules, such as Basel I. Officials at one rating  agency with whom we spoke said that a lower capital requirement for  SME loans in the New Basel Accord was not reflective of the risk for these  exposures, and the rating agency did not treat these loans differently from  other business loans in their own assessments of capital adequacy. In  addition, several experts with whom we spoke noted that this difference in  capital requirements for SME loans would likely not have any immediate  or major impact on competition between U.S. and foreign banks.
In addition to the technical differences discussed above, the final rule  addressed one concern related to a prudential safeguard U.S. regulators  introduced in the 2006 NPR, but some core banks remain concerned about  the implementation schedule. The NPR contained a benchmark—a 10  percent reduction in aggregate minimum capital among core banks—that  would have been viewed as a material reduction in capital requirements  that warranted modification in the rule. Core banks had commented that  this safeguard could affect them negatively because of the uncertainty  surrounding its application. In the final rule, U.S. regulators eliminated the  benchmark. However, retention of the implementation schedule proposed  in the 2006 NPR continues to raise concerns for some core banks because  it will lead to a longer transition period in the United States than in other  countries and delay any possible capital reductions. European banks and  most Canadian banks on the advanced approaches most likely will exit  their transitional periods by January 2010. In contrast, U.S. core banks  cannot exit their transitional periods before April 2012 and could do so in  2014 or later. Furthermore, European banks will be able to reduce capital  to 90 percent of Basel I requirements in 2008 and to 80 percent of Basel I  requirements in 2009 while Canadian banks will be able to apply for   approval to reduce their capital by similar amounts under the same  timeframes. Under the final rule, U.S. core banks will have three distinct  transitional periods during which required risk-based capital may be  reduced to only 95 percent, 90 percent, and 85 percent of Basel I  requirements respectively. The different implementation schedules and  maximum capital reductions may provide foreign competitors of U.S. core  banks an earlier opportunity to make use of any decreases in capital costs  associated with lower required capital for certain assets or activities.  Therefore, by making the transition to Basel II lengthier for U.S. core  banks, foreign competitors may be able to take better advantage of  strategic opportunities, such as a mergers or acquisitions. Though several  core bank officials with whom we spoke remained concerned about the  time difference, officials at one core bank explained that the current  market environment may limit the competitive implications of that  difference.
Several core bank officials with whom we spoke mentioned that they  would have wanted to have the option to select the standardized approach  with some officials suggesting that the lack of a choice may lead to higher  implementation costs. In the United States, the final rule requires all core  banks to adopt the advanced approaches for both credit and operational  risk, but affords opportunities for the primary federal supervisor to  exercise some flexibility when applying the final rule to core banks. The  advanced approaches rule specifically allows for the exemption of  subsidiary depository institutions from implementing the advanced  approaches, and, under the reservation of authority, the primary  federal regulator can require a different risk weighted asset amount for  one or more credit risk exposures, or for operational risk, if the regulators  determine that the requirement under the advanced approaches is not  commensurate with risk. However, some U.S. regulatory officials with  whom we spoke noted the potential risk of a piecemeal approach and  emphasized that they do not want banks to apply the advanced approach  for credit risk to their least risky portfolios and to apply Basel I or the  proposed standardized approach for their riskier portfolios.
In contrast, some foreign banks have not been explicitly required to adopt  the advanced approaches for credit and operational risk. For example,  Canadian regulators told us that they have an expectation for their  domestic banks with significant global operations to move to the advanced  approach for credit risk and that there is no such expectation for domestic  banks to use the advanced approach for operational risk. Furthermore, all  other banks in Canada can decide to adopt the advanced approaches with  the condition that the bank must adopt the advanced approach for credit  risk before adopting the advanced approach for operational risk. In  addition, regulatory officials from the United Kingdom told us that all  banks were required to adopt the standardized approach in 2007, but some  banks applied for a waiver to allow them to adopt the advanced  approaches for determining capital requirements for credit risk or for  operational risk. Moreover, officials from one European bank told us that  they entered their first transitional year in their country with  approximately three-quarters of their portfolios on the advanced approach  for credit risk.
section_title: Retention of Leverage Requirement Has Raised Concerns of Core Banks about Competitive Effects
paragraphs: Officials from some of the core banks with whom we spoke expressed  concerns that they may be at a competitive disadvantage due to the  retention of the U.S. leverage requirement, which applies to all depository  institutions and U.S.-based bank holding companies. Foreign banks based  in other industrialized countries are generally not subject to a leverage  requirement. Some U.S.-based core banks are concerned about the  impact of the leverage requirement for bank holding companies on their  operations abroad. That is, in meeting the leverage requirement, a U.S.  bank holding company must include the assets of its foreign operations,  potentially increasing the amount of required regulatory capital in  comparison with the regulatory capital requirements for foreign-based  bank holding companies. For example, the additional capital needed to  meet the leverage requirement may exceed the additional capital required  under the advanced approaches for certain corporate loans that are  estimated by banks to be relatively low-risk, as demonstrated in figure 3.  Most core bank officials with whom we spoke also said that by  maintaining the leverage requirement, U.S. regulators were preserving a  regulatory capital requirement that was not aligned with the improved  risk-management practices promulgated by the final rule on the advanced  approaches. Officials from one trade association said that because the  leverage requirement does not require additional capital as risk increases,  banks may have an incentive to increase their return on equity by holding  assets with higher risk and return, but no additional capital required by the  leverage requirement. In contrast, regulatory officials have stated that risk- based and leverage requirements serve complementary functions in which  the leverage requirement can be seen as offsetting potential weaknesses or  supplementing the risk-based capital requirements.
In terms of potential competitive effects domestically, some core bank  officials with whom we spoke expressed concerns that certain financial  firms, primarily the CSEs, offer similar wholesale products but lack similar  regulatory capital requirements, while other core bank officials were no  longer concerned. As noted previously, CSEs are required to compute and  report to SEC capital adequacy measures consistent with the standards in  the New Basel Accord, and SEC expects them to maintain certain capital  ratios, though they are not required to do so. SEC has said that it will make  modifications in light of the final rule adopted by U.S. bank regulators and  subsequent interpretations. In addition, bank holding companies are  subject to a leverage requirement, but CSEs do not have a similar  requirement. For example, in December 2007, the leverage ratio for core  bank holding companies ranged from about 4.0 percent to about 6.8  percent and for CSEs ranged from about 3 percent to 3.8 percent.
section_title: International Coordination among Regulators Has Contributed to Reducing Competitive Concerns for Core Banks
paragraphs: U.S. regulators and their foreign counterparts are coordinating in ways  that contribute to reducing the potential for adverse competitive effects on  U.S. banks operating abroad. These efforts aim to resolve some issues that  develop between regulators in a bank’s home country and those in other  countries where the bank operates, usually referred to as home-host  issues. Handling home-host issues is an essential element of the New Basel  Accord framework because it allows for national discretion in a number of  areas.  Several foreign regulators with whom we spoke discussed how  well U.S. regulators have been able to collaborate with their foreign  counterparts on a variety of supervisory issues. Specific to Basel II  implementation, U.S. regulators have been able to provide needed  information to foreign bank supervisors that could limit the compliance  costs of subsidiaries of U.S. banks operating abroad. For example, OCC  examiners explained to us how they assisted a foreign regulator in better  understanding some of the information a core bank was using in  estimating credit risk for a certain loan portfolio. In another instance of  collaboration, foreign regulators explained to us that they waived the  requirement for a core bank to adopt the advanced approaches for its  foreign-owned subsidiary until the core bank adopted the advanced  approaches in the United States.
Over the years, the U.S. regulators have entered into various information- sharing agreements that facilitate cooperation with their foreign  counterparts. These agreements are intended to expedite the meeting of  requests posed by foreign regulators for supervisory information from U.S.  regulators. As of July 2008, OCC and Federal Reserve officials explained  that they had some form of an information-sharing agreement with 25 and  16 foreign jurisdictions respectively. Likewise, FDIC and OTS officials  both described good working relationships with their foreign counterparts  as they related to U.S. banks with international operations that they  supervise.
U.S. regulators have been and continue to be active members in the Basel  Committee and its various subcommittees, including the Accord  Implementation Group. In addition, U.S. regulators participate in colleges  of supervisors and other international bodies, such as the Joint Forum.  Participation in such entities further provides U.S. regulators information  on how U.S. banks may be treated by foreign regulators, thus allowing for  more dialogue among regulators to preemptively address any home-host  issues. The Accord Implementation Group’s purpose is to exchange views  on approaches to implementation of Basel II, and thereby to promote  consistency in the application of the New Basel Accord. Colleges of  supervisors are meetings at which regulators from various countries  discuss supervisory matters that relate to a specific bank that has global  operations. Officials from the Federal Reserve stated that the colleges are  more often better for sharing information among regulators than for  addressing a specific regulatory issue. Though regulators from various  countries are sharing information, several core banks expressed concerns  to us that their foreign regulators have been implementing Basel II  differently.
section_title: Proposed Standardized Approach May Reduce Competitive Concerns of Non-core Banks, as May Other Factors
paragraphs: As discussed earlier, because non-core banks compete with core banks in  some markets, non-core banks were concerned that core banks would be  able to hold less capital than non-core banks were holding under Basel I  for the same assets. Part of this concern came from the April 2005 results  of the fourth quantitative impact study (QIS-4), which estimated that Basel  II could result in material reductions in aggregate minimum required risk- based capital among potential core banks. By holding less capital for  certain products, such as residential mortgages, core banks might charge  less for these products than non-core banks. Two studies of the potential  impact of Basel II on the market for residential mortgages have disagreed  as to the magnitude of any competitive impact—one suggested a  potentially significant shift in income from mortgages toward banks on the  advanced approaches, while the other argued that any competitive impact  was unlikely. In addition, U.S. regulators have recognized that some  banks were concerned about core banks being required to hold less capital  overall, thus making it advantageous to acquire non-core banks. The  proposed standardized approach rule should address some of the  competitive concerns non-core banks expressed in the early 2000s, while  several other factors, including the leverage requirement, also may reduce  differences in capital between core and non-core banks.
subsections: section_title: Proposed Standardized Approach Provides a More Risk-sensitive Option for Non- core Banks
paragraphs: U.S. regulators have proposed the standardized approach in part to  mitigate potential competitive differences between core and non-core  banks. The U.S. version of the standardized approach features more risk- sensitive capital requirements than Basel I. In particular, it adds risk  sensitivity for mortgages based on their loan-to-value (LTV) ratios and has  lower capital requirements than Basel I for some lower-risk (lower LTV)  mortgages (see fig. 4).
The proposed standardized approach rule is also similar to the  standardized approach under the New Basel Accord in that, like the  accord, it features increased risk sensitivity for some externally rated  exposures, including corporate loans. This is in contrast to the single risk  weight for corporate credits and most mortgages in Basel I. Figure 5  demonstrates that the minimum required capital under the standardized  approach for the credit risk associated with externally-rated corporate  loans will be much more similar to that required under the advanced  approaches than that required under Basel I. In addition, the standardized  approach expands incentives for better risk management in that it allows  banks to reduce capital in light of certain additional practices that could  reduce risk, such as the use of collateral or third-party guarantees, and  explicitly requires banks to set aside capital for operational risk. The  added risk sensitivity of the standardized approach proposal should  reduce some differences in risk-based capital requirements, as compared  with the advanced approaches, for adopting banks.
Once the standardized approach rule becomes final, non-core banks will  have the option of choosing it or the advanced approaches, or remaining  on Basel I. Presumably, non-core banks will take into consideration a wide  range of issues when deciding what regulatory capital framework to adopt,  including potential competitive effects. For example, a growing non-core  regional bank that competes principally with core banks in wholesale and  retail lending may find it beneficial to adopt the advanced approaches in  order to model and receive lower risk-based capital requirements for  certain lower-risk credits. Similarly, a smaller non-core bank that found  itself increasingly competing with regional banks might opt for the  additional risk-sensitivity of the standardized approach. However, one  trade association representing some of the smallest non-core banks with  whom we spoke said the standardized approach may not fully address the  competitive concerns of these banks because the capital relief associated  with holding some lower risk assets might be offset by additional capital  required for operational risk. Officials at one large non-core bank told us  that the bank was considering all of its options carefully and noted that  there were a large number of factors to consider in deciding which risk- based capital rule to adopt.
section_title: Other Factors, Such as the Leverage Requirement, May Reduce Competitive Effects of Multiple U.S. Capital Rules
paragraphs: While the leverage requirement, particularly for bank holding companies,  remains a competitive concern for core banks, the leverage requirements  that all depository institutions must meet may limit competitive  differences resulting from banks in the United States operating under  multiple risk-based capital rules. Because these banking institutions must  meet both risk-based and leverage requirements, the leverage requirement  may be the effective or binding requirement for lower-risk assets held on  the balance sheet, or more generally for banks with a relatively low-risk  portfolio. The additional capital needed to meet the leverage requirement  likely will exceed both the additional advanced and standardized  approaches risk-based capital requirements for certain lower-risk assets  held on balance sheets, such as low LTV mortgages and highly rated  corporate credits. Figure 6 compares the capital required by the  advanced approaches with the capital required by the leverage  requirement for certain externally rated corporate loans.
Because U.S. banks hold capital for a number of reasons and are generally  expected to hold more than the minimum amount of capital required,  banks under different risk-based capital rules may nevertheless hold  similar capital for similar assets and activities—and therefore have similar  capital costs—despite differences in minimum required capital. As already  discussed, banks hold capital based on management views on the amount  of capital the bank needs internally and market expectations, in addition  to regulatory requirements. Furthermore, regulators generally expect  banks to hold capital above these minimum requirements, commensurate  with their risk exposure. For example, as part of Pillar 2, banks and  regulators will assess risks not covered or not adequately quantified by  Pillar 1 minimum requirements.
Another factor that may reduce competitive effects resulting from  differences in risk-based capital requirements is the ability of banks to  originate loans and subsequently securitize and sell them to other entities.  Differences in required capital for credit risk across multiple risk-based  regimes would likely have a competitive impact only to the extent that  banks retain the credits they originate on their balance sheets or retain a  significant portion of the credit risk off their balance sheets. Banks may  securitize residential mortgages and other types of loans into other  marketable investments in order to raise further funds to originate  additional loans. This is also known as an originate-to-distribute model  where revenues are derived from the sale of assets rather than an ongoing  stream of interest payments. However, the recent turmoil in the credit  markets has reduced the volume of some securitizations and highlighted  weaknesses in underwriting standards associated with the originate-to- distribute model. As a result, incentives for securitization could be  influenced by changes in capital requirements and the market  environment.
section_title: Potential Impact of New Rules on Mergers and Acquisitions Is Uncertain
paragraphs: The potential impact of the new regulatory capital rules on incentives for  mergers and acquisitions remains uncertain because it is not clear how  much capital requirements and other regulatory costs will change under  the new capital rules. As noted earlier, differences in regulatory capital  requirements could influence incentives for consolidation by making  acquisitions more or less advantageous for banks operating under  different capital rules, such as the multiple risk-based capital rules being  introduced in the United States. However, several industry participants  with whom we spoke said that mergers and acquisitions generally were  driven by strategic concerns such as gaining access to a new market rather  than capital concerns. In addition to the new capital rules, changes in  credit markets may be affecting the benefits and costs of certain mergers.  For example, one regional bank told us that the costs of implementing the  advanced approaches is high especially for smaller banks and that the  benefits of the advanced approaches were less certain in the current  financial climate where credit quality has deteriorated. As a result, some  industry participants said that regional banks may be forgoing mergers  with each other to avoid being classified as core banks that would have to  adopt the advanced approaches.
section_title: Bank Regulators Have Taken Limited Actions to Address Additional Competitive Effects of Basel II Implementation on U.S. Banking Organizations
paragraphs: Many factors have affected the pace of Basel II implementation in the  United States, and while the gradual implementation is allowing regulators  to consider changes in the rules and reassess banks’ risk-management  systems, regulators have not yet addressed some areas of uncertainty that  could have competitive implications. The final rule provides regulators  with considerable flexibility and leaves open questions about which banks  will be exempted from the advanced approaches. Without such  clarification, core banks may expend greater resources to prepare for  implementation than otherwise would be necessary. In addition,  opportunities for regulatory arbitrage exist if regulators use different  standards for exemptions. Regulators also have not fully developed plans  for a required study of the impacts of Basel II implementation. Lack of  development or specificity in criteria, scope, methodology, and timing will  affect the quality and extent of information that regulators would use to  help address competitive and other effects and make future changes in the  rules.
subsections: section_title: A Number of Factors Have Affected the Pace of Basel II Implementation, Including Market Turmoil
paragraphs: The financial market turmoil that began in the subprime housing market in  2007 accounts, in part, for banks’ delaying implementation of the Basel II  advanced approaches. In part, because the economy had been  experiencing benign conditions, in 2005, U.S. regulators had estimated in  QIS-4—a study of the potential impact of Basel II as then proposed—that  minimum capital requirements for credit risk would fall once Basel II was  fully implemented. And, according to the head of one of the regulatory  agencies, many were impatient with a gradual approach to implementing  Basel II at that time. Now that credit markets are experiencing turmoil,  some bank officials and regulators told us that banks will implement Basel  II more slowly.
As a result of the current financial turmoil, regulators have been  considering modifications in the advanced approaches to Basel II and are  assessing banks’ risk management systems. The Basel Committee has been  reviewing certain aspects of the capital framework including the treatment  of securitizations, greater specification of scenario testing in Pillar 2, and  the treatment of credit risk charges for trading assets. The Basel  Committee is also considering principles for sound risk management and  supervision related to liquidity risk and issued a consultative document on  this issue in June 2008. U.S. regulators have noted that the gradual  implementation of Basel II in the United States is allowing them to better  understand how the rules might need to be adapted or implemented in the  changed financial climate. Regulators have also been speaking to bankers  in a number of forums on the need to improve risk management practices  in relation to Basel II.
Gradual implementation is also built into the advanced approaches. (See  app. III for an illustration of the timeline for the development and  implementation of the advanced approaches.) As noted earlier, the  advanced approaches rule took effect on April 1, 2008. Core banks  generally must adopt an implementation plan approved by the bank’s  board of directors by October 1, 2008, but do not actually have to begin the  four intermediate phases that lead to full implementation of Basel II until  April 1, 2010. If banks begin then and each of the four intermediate phases  takes a year, they would then be ready to fully adopt Basel II by April 1,  2014. At the time the rule took effect, banks could start their parallel run,  the first of the four intermediate phases, at the beginning of any quarter  ranging from the second quarter of 2008 to the second quarter of 2010.
The 2007 decision to offer non-core banks an option to adopt the  standardized approach also has affected the pace of implementation in the  United States. As a result of comments received on NPRs related to Basel  II in 2006, U.S. regulators decided to offer non-core U.S. banking  institutions the option of a standardized approach. Regulators issued the  NPR in July 2008 but are uncertain as to when they will issue a final rule.  In addition, the new NPR again asks the question of whether core banks  should be permitted to adopt the standardized approach rather than  advanced approaches creating uncertainties that will be discussed later.
section_title: Some Uncertainties about Basel II Implementation Remain to Be Addressed
paragraphs: A primary goal of federal bank regulators is to promote the safety and  soundness of the banking institutions they oversee. To fulfill this obligation,  bank regulators must have the authority and flexibility to take actions to  achieve this objective. The Federal Reserve and OCC have taken a number of  steps to help ensure that Basel II is implemented consistently across the  banking organizations they supervise and regulators have issued some joint  statements and guidance to address some of the remaining uncertainty for  banks. Nonetheless, the flexibility afforded by the rule for the advanced  approaches could lead to inconsistent application of the rules, which could, in  turn, produce competitive differences among the banks or provide  opportunities for regulatory arbitrage.
subsections: section_title: The Final Rule for the Advanced Approaches Allows Regulators to Exercise Some Regulatory Flexibility
paragraphs: A certain amount of flexibility for primary bank supervisors and related  uncertainty for banks is necessary for maintaining the safety and  soundness of the banking system. Under the final rule for the advanced  approaches, regulators can respond to new or unforeseen situations that  pose risks to safety and soundness without having to first change the rule.  The rule reserves the authority of primary federal bank regulators to  require that banks hold an amount of capital greater than the minimums  dictated by the rule. This authority is being maintained both in the  application of Pillar 1, where regulators can require that a bank calculate  required capital in ways that recognize the individual situation of that  institution and in Pillar 2, which by its very nature promotes supervision  that uniquely addresses the situations of specific banks, while following  general principles. For example, under the advanced approaches,  regulators can generally allow U.S.-based banks with foreign subsidiaries  to use a different retail definition of default for subsidiaries in foreign  countries unless the primary supervisor determines that the banking  organization is using the differences in the definitions of default to engage  in regulatory arbitrage.
Given the provisions for primary federal regulators to exercise their  judgment during the implementation of Basel II, the Federal Reserve and  OCC, which oversee all but one of the banks that meet the asset size and  foreign exposure criteria for core banks, have taken a number of steps to  help ensure that Basel II is implemented consistently within and across the  banking organizations they supervise. As we have noted in a previous  report, the Federal Reserve has been aware that its decentralized structure  could lead to inconsistent supervisory treatment of large banks it oversees  and had developed some procedures to limit these differences. These  procedures include having a management group, which consists of  officials from the Federal Reserve Board of Governors and Federal  Reserve District Banks, provide additional review of supervisory plans and  findings for large, complex banks. They have been relying on this process  to help ensure consistency in the application of Basel II. OCC also has  been taking actions to help ensure that examiners will implement Basel II  in an equitable manner across the banks it supervises. Heretofore, the  OCC examination process permitted lead examiners to provide  information to banks without obtaining specific input from headquarters  staff; however, OCC has been requiring that information about Basel II be  raised to higher levels and that some of the same personnel be involved in  Basel-related examinations across banks. These two agencies also have  taken a number of actions to ensure consistent application of Basel II  across the agencies. For example, Federal Reserve and OCC examiners  have conducted joint examinations to look at how banks are implementing  some processes related to the advanced approaches.
The other two primary bank regulators—OTS and FDIC—which oversee  fewer core banks, have also participated in activities related to ensuring  consistency in the implementation of Basel II. OTS is the primary regulator  for the only thrift that meets the definition of a core bank on its own and is  thus interested in ensuring that its processes for that bank are consistent  with those of the other regulators overseeing similar institutions. OTS and  FDIC oversee a number of depository institutions that have been identified  as core banks because they are subsidiaries of U.S.-based banks that meet  the asset size and foreign exposure criteria for core banks, and FDIC also  oversees subsidiaries of foreign-based banks that may adopt the advanced  approaches. Officials at both agencies said that they are active in Basel  Committee activities and that they played a role in the Federal Reserve  and OCC’s joint examination of credit risk. In addition, according to some  of the regulators, all four primary regulators have participated in joint  examinations of operational risk across some of the core banks.
section_title: Regulators Have Taken Some Actions to Reduce Uncertainty but Have Not Clarified Which Banks They Will Exempt from the Advanced Approaches
paragraphs: Regulators have taken actions to reduce uncertainty by jointly providing  some clarifying information about certain aspects of the capital rules. For  example, during the development of the advanced approaches rule the  regulators issued proposed guidance and interagency statements that  helped to clarify certain aspects of the rules and, beginning in July 2008,  updated some of these to reflect the final rule. They updated the  interagency statement on the qualification process that had first been  issued in 2005, following the Basel Committee’s issuance of the New Basel  Accord. They also issued updated supervisory guidance for Pillar 2 that  had been proposed initially in February 2007 to provide banks with more  detail on the NPR for the advanced approaches. Regulators and examiners  at one agency said that, in their view, it is not necessary to update the  guidance on Pillar 1 that had been issued under the NPR because of the  time and care that went into crafting the extensive and detailed preamble  that accompanied the advanced approaches rule. Nonetheless, officials at  many of the core banks with whom we spoke said that the lack of  additional or updated guidance, including the standards by which  examiners will judge the banks’ compliance, had been a problem for them.
Regulators may provide additional joint information to banks and  examiners based on the questions they have received from banks since the  advanced approaches rule was issued. Regulators told us they are  considering providing this information in a question and answer format on  their Web sites. In addition, each of the regulators will be providing  separate guidance for its examiners to determine whether the banks they  oversee are complying with the rule.
Regulators said they do not intend to issue any joint guidance for the  proposed standardized approach rule while it is out for comment or when  a final rule is issued beyond information provided in a preamble. However,  to ensure that non-core banks are not disadvantaged by core banks  moving onto the advanced approaches, regulators have said they are  planning to issue the standardized approach rule before core banks move  into the first transitional period for the advanced approaches. Timely  issuance of the final rule and any clarifying information will help to ensure  that non-core banks have adequate information on which to base decisions  about which capital regime—advanced approaches, standardized  approach, or Basel I—will be best for them.
While some flexibility is necessary and regulators have taken some steps to  ensure greater consistency in the implementation of the rules, there are  actions the regulators could take to further reduce banks’ uncertainty about  Basel II without necessarily jeopardizing the safety and soundness of the  banking system. One area where uncertainty could be reduced is in clarifying  which core banking institutions would be exempt from the application of the  advanced approaches rule. The rule allows for exempting any core bank—a  bank that meets the size or foreign exposure criteria for core banks or a  depository institution that is a core bank because it is a subsidiary of a core  bank that meets those criteria. Although the rule outlines a mechanism for  certain banks to be exempted and provides some broad factors regulators will  use in making these determinations (asset size, level of complexity, risk  profile, or scope of operation), the regulators have not been specific in the  current rule about whether they will grant these exemptions and under what  circumstances. The regulators have said that they will not grant many  exemptions and did not specify these exemptions because they believe it is  important for them to retain supervisory flexibility as they move forward with  implementation of the final rule. As such, they said each decision is to be  made on a case-by-case basis.
Throughout the development of the rules, regulators had introduced  uncertainty about the extent to which foreign-based banks with  subsidiaries that are U.S. bank holding companies will be subject to the  advanced rules in the United States and the current rule continues to  provide the Federal Reserve, the regulator of bank holding companies,  considerable flexibility in making these decisions. The Federal Reserve  has not answered the question of which specific bank holding companies  that are subsidiaries of foreign-based banks and qualify as U.S. core banks- —they have assets of $250 billion or greater—will be exempted from using  the advanced approaches in the United States. When the advanced  approaches NPR was issued in 2006, some foreign-based institutions with  large bank holding companies in the United States but relatively small  depository institutions were surprised to find that they would be treated as  core banks in the United States. The final rule acknowledged the concerns  of those institutions and noted that the Federal Reserve may exempt them,  but it does not make it clear that they will be exempt. Because the Federal  Reserve, the regulator of bank holding companies, has not issued more  specific criteria or guidance for reviewing requests for exemptions, these  banks (at least one bank has requested an exemption) may have to devote  resources to complying with the U.S. final rule until they receive an  answer on whether they will be exempted. On the other hand, while only  one banking organization is affected, the rule specifically exempts bank  holding companies with significant insurance underwriting operations that  otherwise would meet the requirements to be a core bank.
Similarly, the rule states that regulators will consider the same factors— asset size, level of complexity, risk profile, and scope of operations—in  making a determination as to whether depository institutions that are  subsidiaries of U.S. core banks can be exempted. As a result, institutions  have little guidance concerning the likelihood that some of their depository  institutions will be exempt and will need to prepare for a full  implementation of the advanced approaches in each entity until they receive  a response from their regulator on whether they will be exempted.  Moreover, because the factors are so broad, if different regulators use  different specific criteria to exempt entities, they may set up the potential  for regulatory arbitrage. For example, a U.S. banking organization could  hold higher-risk assets in subsidiary banks that are exempt and remain on  Basel I and could hold lower-risk assets in subsidiary banks that are not  exempt from the advanced approaches. And banks that do not currently  have a structure that would allow them to reduce capital in this way could  change their structure accordingly by acquiring or changing bank charters.  The overall result could be lower capital held in the bank or resources being  devoted to reducing capital that do not properly align capital with risk.  However, officials from the Federal Reserve noted that regardless of the  structure of the bank, at the holding company level, all material bank assets  would be consolidated and subject to the advanced approaches rule.
This continuing uncertainty could make it difficult for banking organizations  to pursue the most cost-effective route to complying with Basel II and could  create more risk for the banks at a time when risks are already high because  of the turmoil in financial markets. For example, some industry participants  told us that those parts of Basel II that do not improve risk management  divert resources that banks otherwise would use to better manage risk. In  addition, resources devoted to circumventing certain aspects of the rule  through regulatory arbitrage will divert the attention of bank officials from  improving banks’ risk-management systems.
Finally, the uncertainty over which banking institutions ultimately will have to  adopt the advanced approaches continues because the advanced approaches  rule says all core banks will be required to adopt detailed implementation plans  for the complex advanced approaches by October 1, 2008, and the proposed  standardized approach rule, which will not be finalized by that time, contains a  question about whether and to what extent core banks should be allowed to  use the simpler proposed standardized approach. The advanced approaches  rule generally requires core banks to comply with the advanced approaches  and adopt an implementation plan no later than October 1, 2008. Under this  rule, the Federal Reserve can exempt bank holding companies from meeting  the requirements of the final rule for the advanced approaches and primary  federal regulators can exempt depository institutions that meet the definition of  a core bank from the advanced approaches requirements. Given the authority  of the primary federal regulator, once the standardized approach rule is  finalized, those regulators would be able to require that exempt banking  organizations adopt that approach. However, the proposed standardized  approach rule, which will not be finalized by the time the core banks must  adopt their implementation plans, asks whether core banks should be allowed  to use the standardized approach instead of the advanced approaches.
In the press release accompanying the proposed standardized approach rule,  the FDIC Chairman stated, “Given the turbulence in the credit markets, I take  some comfort with the fixed risk weights established under the standardized  approach as they provide supervisors with some control over unconstrained  reductions in risk-based capital.” However, the interagency statement on U.S.  implementation of the advanced approaches issued in July 2008, stressed the  existing timelines for the advanced approaches. The continued discussion on  whether core banks should be exempt from the advanced approaches and  permitted to adopt the standardized approach indicates that the primary  federal regulators continue to have questions about whether the advanced  approaches are the best risk-based capital requirements for core banks. Thus,  it is difficult to tell whether the regulators have found a solution to difficulties  that resulted from the differing perspectives they brought to negotiations  during the development of the advanced approaches. We recommended in  our February 2007 report on Basel II that regulators take actions to jointly  specify the criteria they will use to judge the attainment of their goals for  Basel II implementation and for determining its effectiveness for regulatory  capital-setting purposes. We noted that without clarification on the criteria to  evaluate or make changes in the Basel II rules, the implementation will  continue to generate questions about the adequacy of the framework.
section_title: Plans for Studying the Competitive Impacts of the Final Rules Have Not Been Fully Developed
paragraphs: The regulators have not fully developed plans for an interagency study that  is to assess implementation and provide the information to form the basis  for allowing banks to fully transition to Basel II. Partly in response to  recommendations we made in 2007, the final rule says that the regulators  will issue annual reports during the transitional period and conduct a  study of the advanced approaches after the second transitional period.  According to the rule, the annual reports are to provide timely and  relevant information on the implementation of the advanced approaches.  The interagency study is to be conducted to determine if there are material  deficiencies in the advanced approaches and whether banks will be  permitted to fully transition to Basel II. In its regulatory impact analysis,  OCC said that the regulators will consider any egregious competitive  effects associated with implementation of Basel II, whether domestic or  international in context, to be a material deficiency.
Among the items the rule specifies that the study will cover, several are  important first steps in studying the competitive effects of the rule. These  include  the level of minimum required regulatory capital under U.S. advanced  approaches compared to the capital required by other international and  domestic regulatory capital standards;    comparisons among peer core banks of minimum regulatory capital  requirements;  the processes banks use to develop and assess risk parameters and  advanced systems, and supervisory assessments of their accuracy and  reliability; and    changes in portfolio composition or business mix.
Some of these steps are similar to the calculations the regulators  performed as part of QIS-4. The advantage of the future study over QIS-4 is  that it will be based on actual data provided by banks whose risk  management and data systems have been reviewed by regulators as part of  the approval process for banks to enter the first two transitional periods.  In addition, one regulator noted that the study will also benefit from the  stresses of the recent market turmoil. This study should allow the  regulators to determine the extent to which total regulatory capital  changes in the short run, the specific behavior in which banks engage to  comply with some aspects of the rule, and how the rule affects the capital  of different banks.
However, plans for the study do not address a number of factors including the  establishment of shared overall goals and criteria for Basel II that will help  delineate the study’s scope, methodology, and timing. For example, while  OCC in its impact study said that the evaluation of competitive impacts will  be an important part of the study, the rule does not specify how this will be  measured and the scope and methodology of the study are not clearly  designed to achieve this objective. Because regulators design the study to  evaluate Basel II in light of clearly specified overall objectives or criteria for  Basel II, it will be difficult to jointly determine the extent to which the rules  need to be modified or whether implementation of Basel II should proceed. If  some regulators object to the full implementation of Basel II while others do  not, the rule specifies that a regulator can permit the banking organizations  for which it is the primary federal regulator to move forward with the  advanced approaches if it first provides a public report explaining its  reasoning. However, such an outcome would not provide confidence in the  current regulatory system and could allow for regulatory arbitrage.
Further, the scope of the study has not been well defined. While the study  contemplates calculations of capital using the standardized approach,  Basel I, and other international rules as well as the actual data on the  banks following the advanced approaches, regulators have not said that  they plan to collect comparable data on financial entities not adopting  these approaches—specifically, those banking institutions that will adopt  the standardized approach or remain on Basel I. In addition, the regulators  have not explicitly included the CSEs in the study. The effectiveness of the  study will be limited if the CSEs are not included because information on a  major segment of competitors of core banks that has had significant  experience with some aspects of the advanced approaches will have been  excluded. The agreement signed on July 7, 2008, between the Federal  Reserve and SEC regarding coordination and information sharing in areas  of common regulatory interest should facilitate the inclusion of the CSEs  in any study of the advanced approaches. Finally, the regulators have  conducted little research on international differences that could have  competitive effects in the past, and the study’s design does not explicitly  include research on international differences that could have competitive  effects. However, since U.S. regulators participate in the Capital  Monitoring Group, Accord Implementation Group, and other similar  groups, they will have some perspective on Basel II implementation in the  other countries in that group including some European Union countries  and Canada that they will be able to use for this purpose. OCC officials  explained that the Capital Monitoring Group will collect and analyze  information on the implementation of Basel II in other countries and  suggested that this information will inform the U.S. study. In addition,  some U.S. regulators noted that the study outlined in the rule will not  preclude them from looking at a broad range of data.
The methodology the study will use to evaluate competitive impacts  initially is not fully developed, although from a methodological perspective  Basel II affords an opportunity to consider the impacts of regulatory  capital on bank behaviors and among groups of banks adopting different  requirements at different times. While the measurements and comparisons  envisioned for the study are a necessary first step for evaluating  competitive impacts among the core banks and between the core banks  and other groups, they do not take full advantage of the opportunities to  better understand the impact of regulatory capital on a range of bank  behavior. Because banks in the United States and around the world are  adopting a range of capital requirements at different times, Basel II affords  a unique opportunity to consider whether event studies could contribute  to a better understanding of the impact of regulatory capital on a variety of  bank behaviors. While regulators at OCC noted that with banks on  different capital regimes, academics and other researchers, including  those at the regulatory agencies, will have data available to study the  impact of regulatory capital on bank behavior, they said that they had not  thoroughly considered the use of event studies as part of the study  planned by the regulators. Because regulators have not clearly specified  how they will evaluate the competitive impacts of Basel II, there is an  increased likelihood that the kinds of data needed to complete an effective  study will not be available.
In addition, the advanced approaches rule does not specify a methodology for  the study to analyze the extent to which the new rules provide opportunities for  regulatory arbitrage that could limit the effectiveness of the rules in promoting  improved risk management throughout the banking system. Several industry  participants noted that having multiple capital requirements with different  levels of risk sensitivity provides incentives for core banks to hold less risky  assets and leave more risky assets in banks using the standardized approach or  Basel I. Higher risk-based capital requirements for high-risk assets at core  banks may increase their cost of holding these assets. Greater costs would  reduce the supply of credit for these types of loans, and thus returns would  increase. As a result, banks with less risk-sensitive capital requirements under  Basel I or the standardized approach might find some higher risk credits more  attractive at these higher rates of return. (As illustrated earlier in fig. 2, there  may be different amounts of capital required for the same asset across the  different risk-based rules.) Officials at one regulatory agency said that all of the  regulators were aware of this potential outcome and planned to look at changes  in the portfolios of core banks in the study. Further, for non-core banks,  regulators at another agency said they would become aware of non-core banks  increasing their holdings of high-risk assets through their normal oversight  duties. However, the advanced approaches rule does not specify how the study  would more fully explore this potentially important outcome of the new rules.  If this arbitrage took place, the rules could require less capital overall in the  banking system and would leave banks with the least well-developed risk  management systems with the riskiest assets, thus exposing the U.S. banking  system to greater systemic risk.
Finally, the timing of the study is unclear. The rule specifies that the study  will be published after the second transitional period, but core banks  could begin the four intermediate phases required for full implementation  in 2008, 2009, or 2010 and different banks (as well as different types of  banks) could enter the second transitional period in different years. The  phased implementation produces uncertainty about timing and could  throw into question how many banks will be included in the study, and  whether the results of the study will provide relevant information for all of  the banks. For example, if the banks in the second transitional period in  2011 are primarily retail banks, the results are not likely to be applicable  for the custodial banks, or vice versa. As a result of this and other factors  discussed, the use of the study for taking actions that would improve risk  management or reduce competitive concerns may be limited.
Some regulators told us that they have not yet focused on plans for the  study, in part, because it is early in the Basel II implementation process  and they and the banks they supervise have been dealing with the financial  turmoil. In addition, some regulators said that the language and factors  laid out in the final rule should be viewed as a starting point, and officials  at one regulatory agency said that the study will benefit from the data that  will be available from the financial turmoil in the world’s credit markets.
section_title: Conclusions
paragraphs: A global effort is underway to implement the New Basel Accord, which  aims to improve the risk-management practices of banks, in part, by  aligning the capital banks hold more closely with the risks they face.  Capital’s role becomes more important in periods of economic uncertainty  because banks rely on capital to weather unexpected losses. Although the  impact of regulatory capital on a bank’s ability to compete is not always  obvious because banks often hold more than their minimum required  capital, regulatory capital is one of many factors that affects competition.  And, the adoption of Basel II in the United States has raised concerns  about competitive effects it could have on banks of varying sizes and in  various locations. In addition, regulators have made clear that in light of  the current market turmoil further revisions will be made in Basel II.
Uncertainty about how to implement Basel II, to whom the rules will  apply, and the effects the rules will have may lead banks to devote  resources to information gathering and implementation that could  otherwise be dedicated to improving risk management or other purposes.  In our 2007 report, we noted that the rulemaking process for Basel II could  benefit from increased transparency to respond to broader questions and  concerns about transitioning to Basel II in the United States. The  regulators referred to the recommendation in the advanced approaches  rule and, with that rule and the proposed standardized approach rule, they  have provided greater clarity about some aspects of Basel II. We recognize  that the time table for Basel II implementation in the United States has  slowed since we issued our earlier report and that both the regulators and  the banks have been dealing with the market turmoil that began in mid- 2007. This gradual implementation is allowing bank regulators to reassess  banks’ risk-management systems and consider changes in the rules before  any banks begin their Basel II implementation. As part of this preparation  period, regulators have taken and are planning some actions to reduce  uncertainty, but could take further actions to address remaining  uncertainties about the implementation of the rules and facilitate banks’  planning and preparation for their implementation of a new capital regime.
Regulators have taken actions to reduce some of the uncertainty  surrounding implementation of Basel II by providing information to aid  examiners and banks in interpreting the rules. Regulators have updated  some publicly available information on the process they will use to qualify  banks for the advanced approaches and examine them under Pillar 2.  Regulators have also engaged in discussions among themselves  concerning posting additional information in a question and answer format  on their Web sites. The timely issuance of additional information on the  advanced approaches and a final standardized approach rule, which is in  process, will enable banks to best prepare to meet the new risk-based  capital requirements and will help to ensure regulatory consistency across  the banks. As a result, we encourage the regulators to continue providing  joint information in a timely manner on both the advanced and  standardized approaches.
We recognize that regulators have taken steps to reduce some uncertainties  related to Basel II; however, the regulators could take additional steps to  address uncertainties that are not related to their need for flexibility to  respond to innovation in the industry and to unintended consequences that  the rules may have. For example, in the final rule, the regulators did not  specify which banks technically met the definition of core banks. Although,  the rule specifically says that certain banks may be exempted by their primary  regulator from the advanced approaches requirements, it does not provide  well-defined criteria for evaluating requests for exemptions. Because this  clarity has not been provided and specific criteria have not been laid out,  regulators may not provide exemptions in a consistent manner. The issuance  of more specific guidance on which banks will be exempt from applying the  advanced approaches would provide clarity and enable banks to plan  accordingly. Also, the question in the NPR for the standardized approach  about whether core banks should be able to use the proposed standardized  approach indicates that the primary federal regulators continue to have  questions about whether the advanced approaches are the best risk-based  capital requirements for core banks. Regulatory differences on these issues  can lead to increased costs for the banks, inefficiencies for their regulators,  and may weaken the overall effectiveness of the regulatory system by  creating opportunities for banks to engage in regulatory arbitrage.
In our 2007 report, we recommended that regulators issue public  reports on the progress and results of implementation efforts and that  this reporting should include an articulation of the criteria by which  they would assess the success of Basel II. While the regulators have  proposed a study of the core banks after the second transitional year  of the implementation of the advanced approaches, they have not yet  developed the criteria on which to base the study’s design and  objectives. These are needed for a determination of whether Basel II  is effective for regulatory capital-setting purposes and whether to  ultimately allow banks to move past the third transitional period to  full Basel II implementation. As delineated in the advanced  approaches rule, the study will measure the changes in capital and  portfolios held by the core banks and will look at the differences in  required capital for these banks if they were under the standardized  approach rule or Basel I—necessary steps for evaluating the  competitive impact of Basel II—but it does not explicitly describe  components needed to determine if there are material deficiencies in  the rule or for regulators to reach agreement on whether banks should  be permitted to fully implement the advanced approaches. However,  the gradual implementation of the advanced approaches in the United  States affords regulators time to jointly establish criteria for  evaluating Basel II and to fully develop a study that flows from those  criteria—including (1) a broad enough scope—inclusion of non-core  banks, CSEs, and foreign-based banks—to capture competitive  effects; (2) consideration of a number of methodologies; and (3) the  resolution of the timing issue. Such actions would help the regulators  make better-informed decisions on an interagency basis about  whether changes to the rules were necessary and whether to permit  banks to fully implement Basel II. Without these criteria, it will be  difficult for regulators to make these judgments and provide  consistent guidance for banks.
section_title: Recommendations for Executive Action
paragraphs: We are making two recommendations to the heads of the FDIC, Federal  Reserve, OCC, and OTS:  To further limit any potential negative effects, where possible, regulators  should move to minimize the uncertainty surrounding certain aspects of  Basel II. Specifically, regulators should clarify how they will use certain  regulatory flexibility under the advanced approaches rule, particularly  with regard to how they will exercise exemptions for core banks from the  advanced approaches requirement and the extent to which core banks will  be allowed to adopt the standardized approach.
To improve the understanding of potential competitive effects of the new  capital framework, the regulators should take steps jointly to plan for the  study to determine if major changes need to be made to the advanced  approaches or whether banks will be able to fully implement the current  rule. In their planning, they should consider such issues as the objectives,  scope, methodology, and timing needs for the future evaluation of Basel II.  The plan should include how the regulators will evaluate competitive  differences between core and non-core banks in the United States,  between core banks and CSEs, and between U.S.-based banks and banks  based in other countries.
section_title: Agency Comments and Our Evaluation
paragraphs: We provided the heads of the Federal Reserve, FDIC, OCC, OTS, SEC, and   Department of the Treasury with a draft of this report for their review and  comment. We received written comments from the banking regulators in a  joint letter. These comments are summarized below and reprinted in  appendix IV. The banking regulators also provided technical comments  that we incorporated in the report where appropriate. We did not receive  comments from SEC or the Department of the Treasury.
In their letter, the banking regulators strongly endorsed our opening  statement that ensuring that banks maintain adequate capital is essential to  the safety and soundness of the banking system and said that it is this  overarching objective that will guide their efforts and has led them to include  additional prudential safeguards in their implementation of the Basel II rules.  In a somewhat related matter, the regulators said that the report emphasizes  the cost to banks of holding capital but did not discuss how a bank’s strong  capital base confers competitive strength and create strategic opportunities.  While we describe some of the costs to banks of holding additional capital  because this is an important channel through which the new capital rules  could affect the competitiveness of U.S. banking organizations, we also note  that more capital reassures creditors and reduces the cost of borrowing. In  addition, as noted in the draft, banks hold capital for this and other reasons  including the ability to take advantage of strategic opportunities such as  acquiring other banking institutions.
As we detailed in the draft, the banking regulators highlighted the actions  they have taken to address many of the concerns that bankers and others  have raised about the potential competitive equity effects of the  implementation of Basel II and said that they are in general agreement  with our recommendations. Specifically, they said that they will work  together to resolve, at the earliest possible time, the question posed for  comment in the proposed standardized approach rule regarding whether  and to what extent core banks should be able to use the standardized  approach. With regard to clarifying how they will decide whether to grant  requests from core banks to be exempt from the requirement to adopt the  advanced approaches, the regulators said they will assess each exemption  request in light of the specific facts and circumstances applicable to the  institution seeking the exemption and that they have already commenced  discussions to ensure a clear and consistent interpretation of these  provisions is conveyed to U.S. banks.
Regarding the need to jointly plan the required study, the regulators  commented that they will work together to develop “plans for the required  study of the impact of the advanced approaches of Basel II.” Specifically, they  said that they will begin to develop more formal plans for the study once they  had “a firmer picture of banks’ implementation plans” but noted the  difficulties concerning drawing definitive conclusions about the effects of  changes in regulatory capital rules. They also said that they would consider  including in their analysis the potential competitive effects with CSEs and  foreign banks as we recommended. While we are encouraged by the  regulators’ recognition of the need for more formal plans and consideration of  the scope of the study to include CSEs and foreign banks, we noted a number  of additional factors that also should be considered, such as developing  criteria that will help them determine whether there are material deficiencies  that can be attributed to the new rules and what changes, if any, could  address those deficiencies. Finally, because Basel II affords an opportunity to  consider the impacts of regulatory capital on bank behaviors and among  groups of banks adopting different requirements at different times, we noted  in the draft that it is important that regulators consider a number of  methodologies for evaluating the new capital rules and potential competitive  effects to determine which are the most appropriate.
As agreed with your offices, unless you publicly release its contents  earlier, we plan no further distribution of this report until 30 days from its  date of issue. At that time we will send copies of this report to interested  congressional committees, the Chairman of the Board of Governors of the  Federal Reserve System, Chairman of the Federal Deposit Insurance  Corporation, the Comptroller of the Currency, the Director of the Office of  Thrift Supervision, the Chairman of the Securities and Exchange  Commission, and the Secretary of the Treasury. We will also make copies  available to others on request. In addition, the report will be available at  no charge on GAO’s Web site at http://www.gao.gov.
If you or your staff have any questions regarding this report, please  contact me at (202) 512-8678 or williamso@gao.gov. Contact points for our  Offices of Congressional Relations and Public Affairs may be found on the  last page of this report. GAO staff who made major contributions to this  report are listed in appendix V.
section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: Our objectives in this report were to discuss (1) the nature of the  competitive environment in which U.S. banking organizations compete, (2)  the extent to which different capital requirements may have competitive  impacts on U.S. banking organizations internationally and domestically,  and (3) actions regulators could take to address competitive effects and  other potential negative effects of the new capital rules during  implementation.
For all our objectives, we reviewed a variety of documents, including  regulators’ statements; the international Basel II framework (entitled  “International Convergence of Capital Measurement and Capital  Standards: A Revised Framework”) and other documents from the Basel  Committee, such as the 1988 Basel Capital Accord (Basel I); the Basel II,  Basel 1A, and Standardized Approach Notices of Proposed Rulemaking  (NPR) and the final rule on the advanced approaches; supervisory  guidance; academic articles, and our previous reports on banking  regulation. We interviewed senior supervisory officials at the Board of  Governors of the Federal Reserve System and Federal Reserve Banks of  Boston, New York, and Richmond (Federal Reserve), Office of  Management and Budget, Office of the Comptroller of the Currency  (OCC), Federal Deposit Insurance Corporation (FDIC), Office of Thrift  Supervision (OTS), Securities and Exchange Commission, and Department  of the Treasury. We also interviewed officials from the Accord  Implementation Group, several foreign banking regulatory agencies,  domestic, international, and foreign trade associations, credit rating  agencies, and several academics and consultants with banking expertise.  In addition, we interviewed officials from all of the core banks and other  banks, both foreign and domestic, with operations in the United States.  Finally, we attended several conferences held by regulators and trade  associations that included discussions related to Basel II.
To describe the competitive environment in which U.S. banks operate, we  collected data from several sources to illustrate which types and sizes of  banks are active in which kinds of products. We used data from the  Federal Reserve’s Structure and Share Data for U.S. Banking Offices of  Foreign Entities, and Consolidated Financial Statements for Bank Holding  Companies (i.e., FR Y-9C). These data include the amount of assets in  particular products that bank holding companies hold on and off of their  balance sheets. For banks and thrifts that do not report assets in particular  products at the consolidated level to their regulator, we used data on  banks and thrifts in the Federal Financial Institutions Examination  Council’s (FFIEC) Consolidated Reports of Condition and Income (FFIEC  031 or Call Report) and OTS’s Thrift Financial Reports, respectively. We  also used data from FFIEC’s Country Exposure Lending Survey.
To compare activities across banks of different sizes, we used data at the  consolidated level because banks generally compete on an enterprisewide  basis. For bank holding companies, we used data provided by the Federal  Reserve. Almost all bank holding companies that have assets greater than  $500 million report assets in particular product categories on a  consolidated basis to the Federal Reserve using the Y-9C form; however, a  large proportion of those with assets under $500 million about 80 percent  of the bank holding companies and a few larger bank holding companies  do not report consolidated assets on a product basis to the Federal  Reserve. We included these bank holding companies that have few assets  outside their chartered commercial banks in our analysis, by having staff  at the Federal Reserve group the commercial banks by bank holding  company and sum the assets reported in the Call Reports accordingly.  Thrift holding companies do not report data on assets by product category  to OTS on a consolidated basis. Because thrift holding companies are  often engaged in a wide variety of activities outside of banking, we could  not rely on the thrift financial report data on individual thrifts to  approximate the holding company for some thrifts as we did in the case of  some bank holding companies. However, we were able to have OTS staff  provide thrift financial report data that we used to approximate the thrift  holding companies for those thrift companies primarily in banking. We did  this by having OTS staff group the thrifts by holding company for those  where thrifts make up 95 percent of the assets of the holding company and  where they make up 75 percent of the assets of the holding company. The  allocation of assets across product lines was substantially the same for  these two categories, which allowed us to conclude that the data gave us a  good approximation of differences between thrift holding companies that  are primarily in the business of banking and bank holding companies. We  concluded that they do differ in that thrifts that are engaged primarily in  the business of banking hold a much larger percentage of their assets in  residential mortgages than do bank holding companies across all size  categories. To assess the reliability of these data, we talked with  knowledgeable agency officials about the data and tested the data to  identify obvious problems with completeness or accuracy. We determined  the data were sufficiently reliable for the purposes of this report.
To determine the extent to which different capital requirements may  impact how various U.S. banking organizations compete, we reviewed the  available academic literature on the role capital plays in bank competition.  We also estimated minimum required capital for some assets under the  advanced and standardized approaches for credit risk, Basel I, and  leverage requirements, based on available information and data from the  U.S. federal banking regulators’ fourth quantitative impact study (QIS-4)  and Moody’s Investors Service. There are some limitations associated with  the data from QIS-4. At the time, the regulators emphasized that QIS-4 was  conducted on a “best efforts” basis without the benefit of either a  definitive set of proposals or meaningful supervisory review of the  institutions’ systems. We assessed the reliability of the data we used and  found that, despite limitations, they were sufficiently reliable for our  purposes.
We conducted this performance audit from May 2007 to September 2008 in  Amsterdam, The Netherlands; Brussels, Belgium; Boston, Massachusetts;  Chicago, Illinois; and Charlotte, North Carolina; London, United Kingdom;  New York, New York; Toronto, Canada; and Washington, D.C., in  accordance with generally accepted government auditing standards. Those  standards require that we plan and perform the audit to obtain sufficient,  appropriate evidence to provide a reasonable basis for our findings and  conclusions based on our audit objectives. We believe that the evidence  obtained provides a reasonable basis for our findings and conclusions  based on our audit objectives.
section_title: Appendix II: Three Pillars of the Advanced Approaches
subsections: section_title: Pillar 1: Minimum Capital Requirements
paragraphs: Pillar 1 of the advanced approaches rule features explicit minimum capital  requirements, designed to ensure bank solvency by providing a prudent  level of capital against unexpected losses for credit, operational, and  market risk. The advanced approaches, which are the only measurement  approaches available to and required for core banks in the United States,  will make capital requirements depend in part on a bank’s own  assessment, based on historical data, of the risks to which it is exposed.
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 regulators: for wholesale exposures those  subcategories are high-volatility commercial real estate and other  wholesale; for retail exposures those subcategories are residential  mortgages, qualifying revolving exposures (e.g., credit cards), and other  retail. Banks then estimate the following risk parameters, or inputs: the  probability a credit exposure will default (probability of default or PD),  the expected size of the exposure at the time of default (exposure at  default or EAD), economic losses in the event of default (loss given default  or LGD) in “downturn” (recession) conditions, and, for wholesale  exposures, the maturity of the exposure (M). In order to estimate these  inputs, banks must have systems for classifying and rating their exposures  as well as a data management and maintenance system. The conceptual  foundation of this process is that a statistical approach, based on historical  data, will provide a more appropriate measure of risk and capital than a  simple categorization of asset types, which does not differentiate precisely  between risks. Regulators provide a formula for each exposure category  that determines the required capital on the basis of these inputs. If all the  assumptions in the supervisory formula were correct, the resulting capital  requirement would exceed a bank’s credit losses in a given year with 99.9  percent probability. That is, credit losses at the bank would exceed the  capital requirement with a 1 in 1,000 chance in a given year, which could  result in insolvency if the bank only held capital equal to the minimum  requirement.
Banks may incorporate some credit risk mitigation, including guarantees,  collateral, or derivatives, into their estimates of PD or LGD to reflect their  efforts to hedge against unexpected losses.
section_title: Operational Risk
paragraphs: To determine minimum required capital for operational risk, banks will  use their own quantitative models of operational risk that incorporate  elements required in the advanced approaches rule. To qualify to use the  advanced measurement approaches (AMA) for operational risk, a bank  must have operational risk management processes, data and assessment  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.
In previous work, regulatory officials generally said that changes to the  rules for determining capital adequacy for market risk were relatively  modest and not a significant overhaul. The regulators have described the  objectives of the new market risk rule as including enhancing the  sensitivity of required capital to risks not adequately captured in the  current methodologies of the rule and enhancing the modeling  requirements consistent with advances in risk management since the  implementation of the MRA. In particular, the rule contains an incremental  default risk capital requirement to reflect the growth in traded credit  products, such as credit default swaps, that carry some default risk as well  as market risk.
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.
subsections: 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 will collect, on a  confidential basis, more detailed data supporting the capital calculations.  Federal regulators would use this additional data, among other purposes,  to assess the reasonableness and accuracy of a bank’s minimum capital  requirements and to understand the causes behind changes in a bank’s  risk-based capital requirements. Federal regulators have developed  detailed reporting schedules to collect both public and confidential  disclosure information.
section_title: Appendix III: Basel II Timeline
paragraphs: July: Basel Committee issu Basel Cpitl Accord (Basel I), interntionl  rik-based cpitl reqirement for bank in G10 contrie, to e flly  implemented y 1992.
Bnk regtor—OCC, OTS, Federl Reerve, nd FDIC (herefter  “regtor”)—implement Basel I with  trition period to 1992.
Regtorlly phase in Basel I asrt of roder chnge to cpitregtion.  The prompt corrective ction proviion of FDICIA reqire  dequately cpitlized nd well-cpitlized intittion to meet or exceed  Basel I rik-based cpitl reqirement as well as  leverge reqirement.
January: Basel Committee mend Basel I to incorporte mrket ri.
The Mrket Rik Amendment introdce the use of intittion’ internl  model of rik to determine regtory cpitl reqirement.
September: OCC, Federl Reerve, nd FDIC issue finl rle  implementing the Mrket Rik Amendment, reqiring 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 the propoed  cpitl chrge for other mjor ri, inclding opertionl rik.
Aut: Regtor releasdvnce NPR on Basel II for comment.  The propoed rle reqire 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.
January: Basel Committee releas revied proposabased on  consulttion 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  global quantittive  impct  dy (QIS-) nd issu third conective pper for comment.
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’  ltimte holding compny must conent to gropwide superviion nd  report cpitdequacy measure content with Basel ndrd.
June: Basel Committee issu finl revied frmework for Basel II  (New Basel Accord). It reitertejective of rodly mintining the level of  ggregte reqired cpitl while o providing incentive to dopt the more  dvnced pproche. The frmework inclde chnge such as  1.06  ling fctor y which cpitl reqirement for credit rik wold e mltiplied  in order to mintin cpitl netrlity with previously etimted result.
January: Regtorssue intergency tement on qualifiction  process for dvnced pproche based on New Basel Accord.
April: Regtor nnonce dely in Basel II rlemking process, fter  result of uantittive impct dy (QIS-4) etimted mteril redction  in ggregte cpitl reqirement nd ignificnt vrition in result cross  intittion nd portfolio. Regtorter te thsuch result wold cceptable in ctual cpitl regime. September: Regtor nnonce 1-yer dely in implementtion nd  dditionsafeguard to prevent cceptable decline in reqired cpitastimted in QIS-4.  The gencie retin the leverge reqirement, dd   trition yer, nd eablitricter trition period limit on cpitl  redction for individual intittion.
October: Regtorssue Basel IA dvnce NPR. It revi Basel I to  ddress competitive ineqitie etween lrge nd ll intittion y  providing  more rik-enitive frmework imilr to the ndrdized  pproch nder the Basel II interntionccord.
June: Basel Committee releas result of  global quantittive impct  dy (QIS-5) of etimted chnge in minimm reqired cpitnder Basel II.
June: EU issu finl rle implementing Basel II (EU Cpitl Directive).
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 reqirement (compred to Basel I) as teril drop wrrnting chnge  to the Basel II frmework.
September: Regtor release for comment officil NPR for Basel II nd for  mrket rik. The Basel II NPR req 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: Regtor release NPR for Basel IA.
February: Regtorssue propoed gidnce for dvnced pproche  nd superviory review.
March: Comment period for Basel II nd Basel IA NPR cloe. July: Regtor gree to issudvnced pprochele more content with  New Basel Accord nd to issun NPR for n optionndrdized pproch.
December: Regtorssudvnced pprochele.
July: Regtorssue NPR for optionndrdized pproch contining  tion on whether core bank hold able to chooe thi pproch.  Regtorssupdted gidnce for superviory review.
October: Last dte for core bank to dopt implementtion pligned rd  of director.
Firt tranitional floor period (90% floor)
Second tranitional floor period (80% floor)
Core bank mut bein 4 quarter for parallel run (200-2010 April)
Full implementation (firt date available for Bael II)
Core bank will enter firt tranitional floor period (95% floor) (2009-2011)
Core bank will enter econd tranitional floor period (90% floor) and  tudy to assss material deficiencie will be conducted (2010-2012)
Core bank will enter third tranitional  floor period (85% floor) (2011-2013)
Core bank will be ready to implement advanced  approache  (2012-2014 April)
Floor pplie to individual intittion’pitl redction.
section_title: Appendix IV: Comments from Federal Banking Regulators
section_title: Appendix V: GAO Contact and Staff Acknowledgments
subsections: section_title: Staff Acknowledgments
paragraphs: In addition to the contact named above, Barbara I. Keller (Assistant  Director), Nancy Barry, Emily Chalmers, Michael Hoffman, Joe Hunter,  Robert Lee, Marc Molino, Carl Ramirez, Barbara Roesmann, Paul  Thompson, and Mijo Vodopic made key contributions to this report.
section_title: Related GAO Products
paragraphs: Financial Market Regulation: Agencies Engaged in Consolidated  Supervision Can Strengthen Performance Measurement and  Collaboration. GAO-07-154. Washington, D.C.: March 15, 2007.
Risk-Based Capital: Bank Regulators Need to Improve Transparency and  Overcome Impediments to Finalizing the Proposed Basel II Framework.  GAO-07-253. Washington, D.C.: February 15, 2007.
Deposit Insurance: Assessment of Regulators’ Use of Prompt Corrective  Action Provisions and FDIC’s New Deposit Insurance System.   GAO-07-242. Washington, D.C.: February 15, 2007.
Financial Regulation: Industry Changes Prompt Need to Reconsider U.S.  Regulatory Structure. GAO-05-61. Washington, D.C.: October 6, 2004.
Risk-Focused Bank Examinations: Regulators of Large Banking  Organizations Face Challenges. GAO/GGD-00-48. Washington, D.C.:  January 24, 2000.
Risk-Based Capital: Regulatory and Industry Approaches to Capital and  Risk. GAO/GGD-98-153. Washington, D.C.: July 20, 1998.
Bank and Thrift Regulation: Implementation of FDICIA’s Prompt  Regulatory Action Provisions. GAO/GGD-97-18. Washington, D.C.:  November 21, 1996.