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The Rocky Road to Implementation of Basel II in the United States

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Abstract

This paper contends that the problems US officials have encountered in their efforts to implement Basel II reflect inherent weaknesses in the structure of the approach. It begins with a brief overview of the original Basel Accord on Capital Adequacy (Basel I) and a summary of the Basel II approach, with emphasis on the Pillar I weights for credit risk. Next an analysis of the Fed’s bifurcated approach to implementation of Basel II is followed by an examination of three unanticipated obstacles: (1) perceived competitive inequities within the USA; (2) the surprisingly lower and variable capital charges revealed in the fourth quantitative impact study; and (3) the request by four leading banks for permission to implement the simpler, Standardized Approach rather than the Advanced Internal Ratings Approach (A-IRB). These reflect the erosion of several crucial predeal understandings as described by Kane (J Financ Serv Res 32(1):39–53, 2007a). The paper concludes with a consideration of whether it may have been possible to achieve equivalent improvements in risk management with lower compliance costs and less uncertainty about the impact on financial stability.

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Fig. 1

Notes

  1. 1.

    See Basel Committee (2006) for a comprehensive statement of the revised framework.

  2. 2.

    After the collapse of Bankhaus Herstatt in 1974, the governors of the Group of Ten established the Standing Committee on Banking Regulations and Supervisory Practices comprised of representatives of the supervisory authorities and central banks of the Group of Ten countries plus Switzerland and Luxembourg. The official name of the committee was subsequently shortened to “The Basel Committee on Banking Supervision,” but for brevity, it is usually referred to as the Basel Committee. More recently Spain has joined the Basel Committee. See Herring and Litan (1995) for a more extensive discussion of the Basel Committee and the process that led to the Accord.

  3. 3.

    For brevity, the regulation of operational risk will be largely ignored. Nonetheless, the Basel II approach to operational risk is less defensible than the approach to credit risk. For a critique of the capital charge for operational risk see Herring (2002). Also, Pillar 3, Market Discipline, will be given short shrift although it has many defects as well. For a critique of Pillar 3 see Herring (2004a, b).

  4. 4.

    With the adoption of the Market Risk Amendment in 1996, the Basel Committee (1996) recognized a third kind of regulatory capital, Tier 3, which consisted largely of shorter-term subordinated debt. The qualifying restrictions proved so onerous, however, that virtually no Tier 3 capital has been issued.

  5. 5.

    Subordinated debt was relegated to Tier 2 status. Internationally active banks are not currently required to issue subordinated debt and, if they should chose to do so, the amount that they can count as Tier 2 capital can be no more than 50% of their Tier 1 capital. Thus subordinated debt has a distinctly second-class status under the Accord. The US Shadow Financial Regulatory Committees has long argued that a suitably designed capital requirement, focused on the mandatory issuance of subordinated debt, provides a much simpler and more effective way to harness market discipline to strengthen the safety and soundness of internationally active banks. For more details see US Shadow Financial Regulatory Committee (2000) and Herring (2004a).

  6. 6.

    This choice of safe asset is much more plausible in G-10 countries than in emerging markets such as Argentina, Russia, or Turkey.

  7. 7.

    Although Carey (2002) has provided an interesting empirical rationalization of these regulatory minimums, the Committee did not attempt to do so in the original Accord nor has it attempted to do so in Basel II.

  8. 8.

    Oddly, interest rate risk, something that can be measured with relative precision, is relegated to supervisory discretion while operational risk, which is intrinsically very difficult to define, much less measure, is subject to quantitative capital requirements. See Shadow Financial Regulatory Committee (2002), Herring (2002) and Calomiris and Herring (2002) for additional discussion about the weaknesses of the framework for applying capital requirements to operational risk.

  9. 9.

    The Basel Committee (2004, June) has also proposed multiplying the IRB capital requirement by a single scaling factor (in principle, either greater or less than one) to maintain the overall level of minimum capital requirements.

  10. 10.

    Credit Suisse (2003, p. 36) wrote, “Although this approach initially surprised the international banking community we believe that it reflects the original objectives of Basel II....” Whether the international banking community should have been surprised is open to question. As early as 2000, Vice Chairman Ferguson had spoken of the possibility of a bifurcated approach to capital requirements (Ferguson 2000).

  11. 11.

    US banks will not be permitted to adopt any of the less advanced alternatives for computing capital charges for credit risk and operational risk.

  12. 12.

    See Ferguson (2003b). The European Union (EU) viewed Basel II as internationally accepted standards that should apply to all banks. It has incorporated the Basel II framework in the Capital Requirements Directive that applies to all depository institutions and most types of investment firms. Since EU-based institutions can generally choose from all three approaches, the EU is sometimes said to have adopted a trifurcated approach.

  13. 13.

    In contrast, institutions in the EU will be able to choose from more than 100 different implementation options.

  14. 14.

    FDICIA requires regulators to set the threshold for a fifth category, critically undercapitalized, at no less than 2% of tangible equity capital.

  15. 15.

    The reductions in capital charges for credit risk, however, would be offset by a new capital charge for operational risk.

  16. 16.

    Heller and Davenport (2005) who wrote that “Ms. Bies made it clear that the Fed still intends to jettison the straight capital-to-assets leverage rate eventually.”

  17. 17.

    See Calomiris and Herring (2002) for a discussion of the calibration of the operational risk capital charge.

  18. 18.

    The agencies also speculated that some of the decrease in required capital might be due to a recalibration of the regulatory model to focus exclusively on unexpected losses, with expected losses to be supervised under Pillar 2 (Federal Reserve Board 2006, p. 81).

  19. 19.

    Loans in the portfolio had the same underwriting characteristics with a FICO score of 660 and loan-to-value ratio of 80%.

  20. 20.

    The Federal Reserve Board Staff (2006, p.4) published the draft NPR before the other banking agencies had completed their internal review and approval procedures because “Board staff believes it is important to move forward with the Basel II implementation process to further industry dialogue on the proposed framework....”

  21. 21.

    An anonymous regulator told a reporter for the American Banker (Rehm 2006) that “If the mandatory banks don’t support it, I don’t think you have any one supporting it—other than the Fed.”

  22. 22.

    They also included an additional safeguard to limit reductions in capital charges by emphasizing that banks should employ LGDs based on economic downturns.

  23. 23.

    The administrative guidance was notably prescriptive. The Director of the Office of Thrift Supervision noted (Sloan 2007a, b, c) that the document contained the word must 455 times and probably contained an equal number of “shoulds.”

  24. 24.

    Herring and Carmassi (2007) note that over the last two decades, 30 countries have formed unified financial supervisory organizations.

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Correspondence to Richard J. Herring.

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Herring, R.J. The Rocky Road to Implementation of Basel II in the United States. Atl Econ J 35, 411–429 (2007). https://doi.org/10.1007/s11293-007-9094-6

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Keywords

  • Basel II
  • Capital regulation
  • Competitive equity

JEL Classification

  • G228
  • G20