Springer Nature is making SARS-CoV-2 and COVID-19 research free. View research | View latest news | Sign up for updates

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

  • 404 Accesses

  • 14 Citations


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.

This is a preview of subscription content, log in to check access.

Fig. 1


  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.


  1. Basel Committee on Banking Supervision (1988). International convergence of capital measurement and capital standards. Basel Committee Publications No.4 July.

  2. Basel Committee on Banking Supervision (1996). Amendment to the capital accord to incorporate market risks. Basel Committee Publications No. 24, January.

  3. Basel Committee on Banking Supervision (2004). Basel II: International convergence of capital measurement and capital standards: A revised framework. Bank for International Settlements, June.

  4. Basel Committee on Banking Supervision (2006). International convergence of capital measurement and capital standards, A revised framework, comprehensive version. Bank for International Settlements, June.

  5. Berger, A. N. (2004). Potential competitive effects of Basel II on banks in SME credit markets in the United States. Working Paper Federal Reserve Board, February.

  6. Calem, P. S., & Follain, J. R. (2005). An examination of how the proposed bifurcated implementation of Basel II in the U.S. may affect competition among banking organizations for residential mortgages. Working paper presented at the AREUEA Meetings, January.

  7. Calomiris, C. W., & Herring, R. J. (2002). The regulation of operational risk in investment management companies. Perspective, Investment Company Institute, September, pp. 1–19.

  8. Carey, M. (2002). A guide to choosing absolute bank capital requirements. In R. M. Levich, G. Majnoni, & C. Reinhart (Eds.) Ratings, raring agencies and the global financial system (pp. 116–138). Norwell, MA: Kluwer.

  9. Credit Suisse Group (2003). The new Basel capital accord: Comments of Credit Suisse Group, November 3.

  10. Federal Reserve Board (2006). Draft interagency proposed rulemaking to implement Basel II risk-based capital standards for large, internationally active banking organizations. Draft Federal Register Notice, March 30.

  11. Federal Reserve Board Staff (2006). Memorandum on the notice of proposed rulemaking implementing new risk-based capital framework in the United States. March 22.

  12. Ferguson, R. W., Jr. (2000). Community banks: Opportunities and challenges in the ‘Post modernization era’. Remarks before the Independent Community Bankers of America, May 2.

  13. Ferguson, R. W., Jr. (2003a). Basel II” Testimony before the subcommittee on domestic and international monetary policy, trade, and technology, committee on financial services. US House of Representatives, February 27.

  14. Ferguson, R. W., Jr. (2003b) Basel II: A Realist’s perspective. Remarks at the risk management association’s conference on capital management. April 9.

  15. Ferguson, R. W., Jr. (2003c) Basel II: Scope of application in the United States. Remarks before the institute of international bankers, June 10.

  16. FDIC (2006). Key aspects of the proposed rule on risk-based capital standards: Advanced capital adequacy framework. Financial Institution Letters. Last updated September 25.

  17. Fontnouvelle, P., Garrity, V., Chu, S., & Rosengren, E. (2005). The potential impact of explicit Basel II operational risk capital charges on the competitive environment of processing banks in the United States. Working paper, Federal Reserve Bank of Boston, January 12.

  18. GAO (2007). Risk-based capital: Bank regulators need to improve transparency and overcome impediments to finalizing the proposed Basel II framework. United States Government Accountability Office, GAO-07–253, February.

  19. Hancock, D., Lehnert, A., Passmore, W., & Sherlund, S. (2006). The competitive effects of risk-based capital regulation: An example from U.S. mortgage markets. Working paper Federal Reserve Board, August.

  20. Hannan, T. H., & Pilloff, S. J. (2004). Will the proposed application of Basel II in the United States encourage increased bank merger activity? Evidence from past merger activity. Working Paper Federal Reserve Board, February 18.

  21. Heller, M., & Davenport, T. (2005). Congressional pressure for consensus on Basel II. American Banker, March 15.

  22. Herring, R. J. (2002). The Basel 2 approach to bank operational risk: Regulation on the wrong track. The Journal of Risk Finance, 4(1), 42–45 (Fall).

  23. Herring, R. J. (2004a). The subordinated debt alternative to Basel II. Journal of Financial Stability, 1, 137–155.

  24. Herring, R. J. (2004b). How can the invisible hand strengthen prudential supervision? In C. Hunter, G. Kaufman, C. Borio, & K. Tsatsaronis (Eds.) Market discipline: Evidence across countries and industries (pp. 363–379). Cambridge: MIT Press.

  25. Herring, R. J., & Carmassi, J. (2007). The structure of cross-sector financial supervision. Financial Markets, Institutions & Instruments (in press).

  26. Herring, R. J., & Litan, R. E. (1995). Financial regulation in the global economy. Washington, D.C.: The Brookings Institution.

  27. Joint Press Release (2007). Banking agencies reach agreement on Basel II implementation. Joint Press Release of the Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency, and Office of Thrift Supervision, July 20.

  28. Joint Release (2005). Banking agencies to perform additional analysis before issuing notice of proposed rulemaking related to Basel II. Joint Release of the Office of the Comptroller of the Currency, Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation and Office of Thrift Supervision, April 29.

  29. Joint Release (2006). Summary findings of the fourth quantitative impact study. Joint Release of the Office of the Comptroller of the Currency, Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation and Office of Thrift Supervision, February 24.

  30. Kane, E. J. (2007a). Basel II: A contracting perspective. Journal of Financial Services Research 32(1), 39–53.

  31. Kane, E. J. (2007b). Connecting national safety nets: The dialectics of the Basel II contracting process. Working paper, August 1.

  32. Lang, W. W., Mester, L. J., & Vermilyea, T. A. (2005). Potential competitive effects on U.S. bank credit card lending from the proposed bifurcated application of Basel II. Working Paper Federal Reserve Bank of Philadelphia, December 5.

  33. Paletta, D. (2005). Backlash on Basel hits fed—What now? American Banker, Thursday, October 6.

  34. Rehm, B. (2006). Settled issue on Basel now a roadblock? American Banker, Monday, July 31.

  35. Simmons, H. H. (2003). Zions bancorporation comment letter on proposal relating to the new Basel capital accord. November 3.

  36. Sivon, J. (2006). Letter to the editor: Big banks’ concerns over Basel warranted. American Banker, Friday, October 20.

  37. Sloan, S. (2006a). Why big banks’ Basel tactics may not work. American Banker, October 10.

  38. Sloan, S. (2006b). Fed executive on Basel II: Preserving capital crucial. American Banker, November 8.

  39. Sloan, S. (2007a).A green light, and a yellow, for Basel II. American Banker, February 16.

  40. Sloan, S. (2007b). Bies, bair diverge on readiness of Basel II proposal. American Banker, February 27.

  41. Sloan, S. (2007c). Bankers maintain criticisms of U.S. version of Basel II. American Banker, April 5.

  42. US Shadow Financial Regulatory Committee (2000). Reforming bank capital regulation. Statement No. 160, March 2.

  43. US Shadow Financial Regulatory Committee (2002). The Basel 2 approach to bank operational risk: Regulation on the wrong track. Statement No. 179, May.

Download references

Author information

Correspondence to Richard J. Herring.

Rights and permissions

Reprints and Permissions

About this article

Cite this article

Herring, R.J. The Rocky Road to Implementation of Basel II in the United States. Atl Econ J 35, 411–429 (2007).

Download citation


  • Basel II
  • Capital regulation
  • Competitive equity

JEL Classification

  • G228
  • G20