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

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