Tower of Basel

Mortal that I am, I have been really confused about how US bank regulators — notably the Federal Reserve, Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation — coordinate when they make safety and soundness regulations for US banks. Confused enough to make fragmentation of US bank regulation – from the creation of the dual banking system through the apparent implementation of Basel II – the topic for my column in the upcoming July HousingWire magazine. The exercise gave me a kind of framework for my confusion and answered some of my questions (as I hope it does for readers too, so get your subscriptions to the magazine in order). If nothing else, it reassured me that my confusion has an excuse – US bank regulation is a maze, Basel perpetual enhancement. A couple of things particularly struck me, things I wanted to pursue a bit further. For one, although the financial media is now headlining the approach of Basel III, the US is way behind the other members of the Basel Committee on Banking Supervision in implementing Basel II, adopted back in 2005. Lagged them demonstrably. Also striking is the fact that the US has only, thus far, adopted in regulation the complex and expensive approach to calculating risk-based capital requirements for banks that relies on banks own internal models (a.k.a. the advanced approach). A simpler, “standardized” approach to risk-weighted capital requirements, intended for less massive banks, was also part of Basel II, but has not been adopted in the US at all. In fact, this “detail” is now lost on financial mediacrats, who use Basel II synonymously for internal model based approach (standardized approach relegated to oblivion). Even the US media branch seems to have forgotten that US regulators once toyed with a simplified version of the standardized approach, stripped of any charge for operational risk, dubbed Basel IA, but summarily dropped it when the advanced approach was approved in July 2007 (published November 2007). In June 2008 a Notice of Proposed Rulemaking (NPR) appeared, proposing to adopt the standardized approach, but there, as they say in westerns, the trail grows cold. International banking bureaucrats haven’t forgotten though. Indeed, US difficulties with Basel II appear to be a bit of a scandal in international banking circles. This May, the IMF/World Bank Financial Assessment Program published the results of its examination of Basel II Implementation Preparedness in the United States. Much as I did, frantically googling for the disposition of the June 2008 NPR, the Assessment Program found the standardized approach is still only a proposal in the US. “There was no indication from the authorities of their intention as to whether or when the proposal will be adopted,” the proposal states, or what alterations could be introduced. But then, the assessors were focused on implementation of the kinkier advanced approach. The Assessment Program concluded that there is still “uncertainty in banks about the status of Basel II in the United States going forward.” Banks are apprehensive and no wonder. The Assessment Program adds, “Despite the leading role played by the United States in developing Basel II, considerable and protracted inter-agency disagreement delayed US implementation, and these interagency disagreements still do not appear to be fully resolved.” Questions remain regarding such basic issues as “how the implementation will work in practice,” whether banks will ever be permitted to exit parallel runs or capital floors and “what, if any of the standardized approach will be implemented.” For their part, the authorities indicated to the Assessment Program that “they are continuing to work domestically and with the Basel Committee to strengthen the Basel II framework, including issues associated with the use of internal models for determining capital requirements.” Huh? It was Federal Reserve officials who were so enthusiastic about the technologies US banks were developing, along with the introduction of new financial instruments and derivatives, during the 1990s to measure, price and manipulate risk. The banks convinced them the existing risk-weighting system was too arbitrary, required more capital than their models indicated was economic. Converted, the Fed believed using model-based approaches to calculate capital requirements would induce banks that had the models to improve them and deepen their risk management infrastructure, while their example would induce banks that did have internal models to develop them. The same Fed led the push in the Basel Committee to use those models to determine risk-based capital requirements. The expectation was that capital requirements would fall a bit, but they would be, item by item across a bank portfolio, far more precise and robust. Now, at least twelve years after convincing the G-10 (subsequently the G-20 plus 7) that their biggest, systemically most important banks should use their own models to determine capital requirements, the Fed has issues? Problems that weren’t noticed in the half a decade it took to develop Basel II? (Well, the Assessment program simply identifies “agencies” but if we’re talking about banking groups, the primary regulator would be the Fed.) That’s not an irony, that’s a comedy. Which isn’t a bad thing – classic comedy is built from misunderstanding, error, reconciliation. Comedies have happy endings because the protagonists wise up. In this case, the lessons learned may be those taught by the financial crisis about excessive reliance on models as well as on assets built and risk-rated by models. NOTE: Linda Lowell writes a regular column, called Kitchen Sink, for HousingWire magazine. Editor’s note: Linda Lowell is a 20-year-plus veteran of MBS and ABS research at a handful of Wall Street firms. She is currently principal of OffStreet Research LLC.