Whither Basel II?

With implementation barely begun in the United States, the international capital rule is already considered out of date.

In fact, the Basel Committee on Banking Supervision has gone back to the drawing board to plug some gaps and add tools. The potential changes — including an international leverage ratio — are so sweeping that some say regulators are effectively moving on to Basel III.

"On its face, you've got to think that Basel II has seen an early demise," said Ken Bentsen, a former Democratic congressman from Texas who now leads the Equipment Leasing and Finance Association. "The idea of having a risk-based capital system that uses laser-like technology equivalent to a surgeon is not going to fly."

But the debate over what will take its place is just beginning. Some regulators are arguing that the whole point of Basel II — which relied on refined models to help banks gauge their risk and set capital levels accordingly — needs to change.

"The vision now is very different," said George French, the deputy director for policy in the Federal Deposit Insurance Corp.'s division of supervision and consumer protection. "We're moving toward less reliance on the bank's internal system a) in talking about a leverage requirement as a supplement and b) in talking about how we can make sure capital requirements don't go up and down so much during the cycle. I think everyone has come to realize we cannot put unlimited reliance on what the bank's internal systems are showing."

But Comptroller of the Currency John Dugan says a radical overhaul is not necessary. Regulators always had significant control over how banks modeled their risk, he said, and would have reined in any precipitous drop in capital levels.

"The heart of it is a model that regulators created, not the banks," he said in an interview. "That's still the essence of how we're thinking of doing this. We've gotten some things wrong, and we need to fix that, but I don't think from the U.S. point of view it changes the basic concept of Basel II."

Regulators appear agreed on some areas, however. Among other things, the Basel Committee is examining changes that might require capital for off-balance-sheet holdings and assets that lose value but have not gone into default. Mortgages — once regarded as low-risk — will also probably require more capital.

Those changes are being considered as banks in the United States are in the early stages of Basel II implementation. Institutions with more than $250 billion of assets were required to submit plans to their boards by last Oct. 1, detailing how they would comply with the rule. They have until April 1, 2011, to complete four consecutive quarters of a "parallel run" in which they comply with Basel I capital requirements but simultaneously calculate Basel II capital levels.

Dugan said only one bank has begun its parallel run so far but that he expects more to do so once the 2011 deadline nears. Though the Basel Committee is amending the rule, regulators still say banks should continue the transition to Basel II.

Perhaps the biggest change in the offing would be an international leverage ratio.

Nout Wellink, the chairman of the Basel Committee, laid the groundwork for an international ratio last month in a speech to the European Parliament.

"The capital framework needs to be underpinned by a non-risk-based supplementary measure," said Wellink, who is the president of the Netherlands Bank.

Over the strong objection of domestic banks, U.S. regulators already included a simple equity-to-assets leverage ratio in the version of Basel II completed here.

The measure stimulated one of the biggest fights during the drawn-out development of Basel II as bankers worried that being subject to a leverage ratio would put them at a competitive disadvantage if their European counterparts were not. Industry representatives now support an international leverage ratio — if only because it would subject international companies to what U.S. banks must already satisfy. "It's best for all concerned if there's a level playing field," said Rob Strand, a senior economist at the American Bankers Association.

But regulators worldwide are debating whether to make the leverage ratio more sensitive to risk, a departure from the ratio's structure in the United States. An April 2 report from the Financial Stability Forum said that as supervisors consider the leverage ratio they should examine how highly liquid government securities are treated.

"The report's language suggests … that they might find a way to have highly liquid government securities not count as 100% in that asset figure," said Susan Krause Bell, a partner at Promontory Financial Group who spent two decades at the Office of the Comptroller of the Currency. "This means it's a semi-risk-based measure."

For example, if a bank held $100 in highly liquid government securities that are seen as virtually risk-free, the bank would not have to count the full $100 in its leverage ratio. "It might be really helpful to do something like not treat government securities at 100%," Krause Bell said. "That's requiring too much capital against a highly safe security."But other observers expressed concern that adding such sensitivity to the leverage ratio would make Basel II — already famous for its complexity — all the more confounding. "We might be making this harder on ourselves than we have to," said Cornelius Hurley, a former Federal Reserve Board lawyer who is now director of the Morin Center for Banking and Financial Law at the Boston University School of Law.Alok Sinha, a principal at Deloitte & Touche LLP and its head of Basel II and economic capital services, also noted that even government securities are not without risk. "Government securities are not sensitive to risk from a credit risk standpoint but they do have market risk."The idea also seems to be a nonstarter with regulators. "We would probably be inclined to say that should not be done," the FDIC's French said. "Once you start down that road, all you're doing is starting a new risk-based system. We'd probably like to see a simple, straightforward ratio."Dugan said the issue is up for discussion, but he appeared to side with the FDIC. "One of the values of the leverage ratio is that it is blunt, no exceptions; this is what it is," he said. "When you move away from that, it's a slippery slope."Even if the Basel Committee ultimately decides to include some risk-sensitivity into the leverage ratio, Dugan said, the United States is not obliged to go along."We never cede our sovereignty to the Basel Committee," he said. "Having said that, there will be an effort to reach consensus and find something that would work in the U.S."The Financial Stability Forum also recommended that regulators consider how off-balance-sheet assets are treated in the leverage ratio. But regulators face the same problem they have struggled with as they try to clean up financial institutions — just how should some off-balance-sheet holdings be valued? "If you include off-balance-sheet assets in the leverage ratio, it does raise issues of how you value them," Krause Bell said. "What is the dollar value that you're going to put on the balance sheet? It can be done in a simple way, but doing so will likely generalize the risks and will therefore be inaccurate."Hurley, the former Fed lawyer, countered that, when institutions were forced to bring structured investment vehicles onto their balance sheets, they somehow found a value. "Citi gave them a value," he said. "It might have been overstated, but it was a value."Bentsen, the leasing group's leader, also argued that not every off-balance-sheet holding should be counted in the leverage ratio. "If it's a leased asset that can be put back to the initial owner and the entity has no obligation to take that at the end of the lease, we question whether that should be on that entity's balance sheet."Dugan said regulators have not concluded how to handle off-balance-sheet assets but acknowledged, "You have to draw some lines."Regardless of how regulators eventually proceed, French said, banks do not need to worry that changes in Basel II will somehow increase capital requirements during the financial turmoil."There is no intention to increase capital requirements right in the middle of the crisis," he said. "The plan is to develop the proposal, get comments and when the time is right, when the crisis is behind us, move ahead with implementing the reforms and put the whole system on a better framework."As this unfolds some observers worry that regulators will ignore the level of risk a bank might actually have in a quest to ensure that the industry is well capitalized."I worry about [Basel II reforms] not continuing down a risk-sensitive path," said Robin Lumsdaine, a former associate director in the Fed's banking regulation and supervision division, who is now a professor at American University. "If you think about the benefit of a blunt tool versus something that's risk-sensitive, a blunt tool can offer some protection in bad economic times, but it doesn't give you a glimpse of the risk the institution is facing, which you also need to know."French said he sympathizes with the industry's desire for profitability and its frustration with Basel II's complexity."But primarily this is a safety and soundness issue we're dealing with," he said. "We need to make sure banks have enough capital to weather a downturn."

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