BASEL II: QUO VADIS?
George G. Kaufman
(Loyola University Chicago and Federal Reserve Bank of Chicago)

BASEL II 

International capital requirements (standards) for commercial banks developed by the Basel Committee on Banking Supervision for staged implementation in most industrial countries and some developing economies starting in 2007 (?) to replace Basel I.

Presentation will: 
•	Brief history of Basel
•	Describe Basel II 
•	Evaluate Basel II 
•	Compare with SEIR
•	Speculate on future 

BASEL 
•	City in Switzerland 
•	Long history 
•	Major phannaceutical center
•	Major art center 
•	Home of the Bank for International Settlements (BIS) 

Basel Committee on Banking Supervision
Wherefrom? 
. Meets in Basel, Switzerland at BIS and uses BIS secretariat, but is not part of and independent of BIS.  Currently 13 industrial country central bank/FSA members.  
. Established in 1974 in response to failure of Herstatt Bank (Germany) that impacted foreign exchange markets and banks in other countries (regulatory failure). 
. Initial purpose to facilitate sharing of information among bank regulators and policy-makers in major countries (G-10) and to develop principles for supervision of internationally active large banks (fear of cross-border systemic risk). 
. In mid-1970s, number of large banks experienced large losses on LDC loans and concern that these banks had insufficient capital and national governments were reluctant to require higher capital for competitive reasons, particularly Japan, which permitted capital gains to be included in capital. 
. In response, Committee shifted focus to developing uniform minimum capital standards across countries. Introduced Basel I standards in 1988, which were risk- based. But much criticism, e.g., risk buckets too simple, broad, and arbitrary; one-size- fits-all.

Basel II: Proposed New Basel Capital Accord 
. Basel II consultative document (CPI) was annolillced with much fanfare in 1999, after some 10 years work in revising Basel I. 
. 3 pillars: 
	1. Minimum capital requirements (revised) 
	2. Supervisory review (new) 
	3. Market discipline (new) 
. CP3 based on revisions of CP 1 and 2 in April 2003 
. U.S. regulators issued Advance Notice of Proposed    Rulemaking (ANPR) in August 2003 for public comment and will issue NPR soon (Delayed) 
. European Union has incorporated in its Capital Adequacy Directive (CAD) for financial institutions, subject to approval by European Parliament and national governments. 
. Adopted by Basel Committee in June 2004 for proposed staged implementation starting in 2007 (?) (Pushed back a number of times.)

Pillar 1: Minimum Capital Requirements (1) 
. Risk-based capital (RBC) requirement computation changed in response to criticism of Basel I and new knowledge. Primarily credit risk. 
. Credit risk divided into 
	. Probability of default (PD)
	. Loss given default (LGD) 
	. Exposure at default
	  Maturity 
. Noncredit risks 
	. Operational (new) 
	. Market and trading (old) 

New Credit Risk Capital Charge Computation

•	Banks given choice of 3 models

RBC
(capital / risk weighted total assets)

Standardized Approach (modification of Basel I) 

Internal Rating-Based (IRB) Approach (new)

Foundations Approach

Advanced Approach

					PD by Bank/ LGD by regulator	Both by bank
Small, unsophisticated banks						Large, sophisticated banks

Pillar 1: Minimum Capital Requirements (2) 
Prob1ems/ Criticisms/ Comments 
. Standardized approach risk buckets still overly arbitrary; not equivalent to economic risk weights; encourages misallocations. 
. Advanced IRB approach excessively complex 
	. 30 small font 3 column pages in ANPR 
	. Complexity per se does not equate to "reality" 
	. Difficult for supervisors to evaluate bank models 
. PD and particularly ex-ante LGD difficult to measure accurately and regulator determined risk values likely to differ from market determined risk values and to lead to gaming and misallocations. Little historical data for banks. 
. Bypasses issues: 
	. Definition of capital (subdebt?) 
	. Measurement of capital (book or market values) 
	. Meaning of capital "tiers" 
	. Portfolio (diversification) effects 
	. Loan loss provisioning procyclicality 
	. Relationship with loan loss provisioning (expected vs. 	unexpected losses) - solved 

Pillar 2: Supervisory Review (1) 
. Supervisory review "is intended... to ensure that banks have adequate capital to support all the risks in their business" (includes risks both explicit in pillar 1 and implicit in supervisory review, e.g., interest rate risk, credit concentration) 
. "Supervisors are expected to evaluate how well banks are assessing t11eir capital needs relative to their risks" and to intervene, where appropriate. This interaction is intended to foster an active dialogue between banks and supervisors such that when deficiencies are identified, prompt and decisive action can be taken to reduce risk or restore capital" 
. Principle 4: "supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels ... and should require remedial action if capital is not maintained or restored. 

Pillar 2: Supervisory Review (2) 
Criticisms/Comments  
. B II does not grant supervisors the tools or 
authority to perfonn these functions. 
. In contrast, in U.S., FDICIA not only provides supervisors explicit tools and authority to intervene on a timely basis but requires them to do so with mandatory sanctions in PCA and LCR, including legal "closure rule." 
. Does not adjust for large differences in quality 
, and quantity of regulation and supervision across 
countries. 

Pillar 3: Market Discipline 
Criticisms/Comments
. B II focuses only on disclosure (transparency) and enumerates in great detail balance sheet, income, and other information to be publicly released and at what frequencies. 
. Problem is that to be effective, disclosure requires some. at-risk claimants. B II contains nothing to encourage or enlarge de-jure and de-facto at-risk claimants. Disclosure is necessary but not sufficient condition. Effective market discipline (monitoring 
and influencing) is about at-risk claimants. Demand by sufficient at-risk claimants 'will encourage disclosure, per se. Currently, outside U.S., few depositors are at de-facto risk. Blanket guarantees common. . 
. U.S. has increased de-facto uninsured claimants since FDICIA. In contrast to before, since 1992, effectively no protection provided for uninsured claimants in bank failures and some depositors have suffered large losses, e.g., over 40%. But no large money center bank in serious trouble. Thus, no real test yet. 
. Recent BIS study on "subordinated debt" finds widespread issue in Europe as well as U.S. Could recommend to enlarge pool of uninsured claimants. 

Conclusions (1) 
. Basel II announced with great fanfare after" some 10 
years of work, but ran into major criticism from many, e.g., U.S. regulators, ECB, large banks, small banks, and academics. Support waning, but pushed through. 
. Pillar 1 - capital requirements more complex, but not necessarily much closer to market detern1ined "truth." 
. Pillar 2 - supervisory review without enough teeth. 
. Pillar 3 - market discipline question of impo11ance of at-risk claimants not disclosure per se. Market discipline is difficult if few if any at- risk claimants. 

Conclusions (2) 
. U.S. regulators, led by OCC and FDIC, critical. 
	. Will apply only "advanced IRB" to only 10 or so largest 	internationally active banks. Others subject to revised Basel 	I or can adopt A-IRB voluntarily. 
	. Potential education in capital requirements for A- IRB not 	major concern if all banks subject to current simple 	leverage ratio by PCA (?) 
	. In-place PCA and Closure rule requirements superior to 	proposed pillars 1 and 2 requirements. 
	. Most disclosure recommendations already in place in U.S. 	and remaining need to be subject to cost-benefit test. 
. But Basel process has increased knowledge of and sensitivity to risk management in banking by bankers, regulators, academics, and analysts. Net societal benefit. 'Basel should be ongoing process but never adopted! 

POSTSCRIPT 
. In December 2003, FDIC published shldy that showed AIRB would lower total risk-based capital requirements by 17% from Basel I and translate into total leverage ratio below _4%. In2005, OCC reported mean reduction of 17%, median reduction of 26%, and individual bank changes ranging from -47% to +56% in regulatory capital requirement for sample of very large bank testing AIRB (Advanced Internal Ratings Based) approach 
. FDIC concluded "U.S. regulators will have to choose between ignoring the output of Basel ll's formulas or significantly weakening the current PCA framework." 
. FDIC concerned that pressure from largest banks that are spending very heavily to develop AIRB models that will permit them to lower risk-based capital ratios willI) put small banks at competitive disadvantage and 2) make regulators bend on numerical value of leverage ratio defined as "adequately capitalized, (reduce from 4%)" or redesign Basel .1 to lower capital requirement. 
. Where does the Fed stand? 
. FDIC also argues that "unless PCA is significantly weakened, the already wide disparity in core capital requirements between U. S. banks and other banks (chart 1) will be widened." So what? 

The Fed 
.. . [There is ] concern that perhaps the lower regulatory capital that some large banks may incur under Basel II... may distort the competitive balance between adopters and non-adopters.. .If we see evidence supporting competitive distortions... we will make necessary modifications to blunt them by doing one of the following... changing the capital rules that apply to non-adopters... We will not be precluded from proposing any measure... necessary to retain a level playing field. 
Alan Greenspan March 17, 2004