U.S. Banks Having Trouble with Basel 2

Stephen DeAngelis

March 22, 2007

One the international standards that was aimed at improving the banking industry was hammered out in Basel, Switzerland, three years ago. According to an article in The Economist, the U.S. banking industry is having more difficulty than its European counterparts in implementing the Basel 2 accord [“A twist or two of Basel,” 24 Feb 2007].

Since January 1st many European banks have begun implementing the new [Basel 2] rules, which govern how much capital they must set aside to cushion themselves from various calamities. The same process was meant to be unfolding in America. But there the banks are struggling to get their mouths around the new accord. A great deal of money is on the line for banks on both sides of the Atlantic. The more capital they must squirrel away to satisfy regulators, the more insulated they are from untoward events—but the less money remains to be put to work in order to make profits.”

Considering shockwaves that have hit Wall Street as a result of defaulted high-risk mortgages, one would think that banks would have firm plans in place for making themselves more resilient to such calamities. In Europe, they apparently are:

“Happily for the bottom lines of big European banks, regulatory capital is expected to drop under the new regime—perhaps dramatically. Under Basel 2, the amount of capital a bank must sit on depends on the riskiness of its loans and other assets. So those expert in managing and minimising risk—by packaging loans into securities and selling them on, for example—can get away with a thinner cushion than others. Indeed, big, sophisticated banks will largely make up their own minds about how much capital to set aside, as long as their internal risk-management models are up to snuff. This is meant to reward the banks that already invest in cutting-edge risk-management methods, and prod others to catch up.”

The news is not as good for U.S. banks:

“Banks in America, on the other hand, are glum. Their regulators have taken fright over studies showing that banks’ required capital could fall by an average of 16% if they embraced the new accord. European regulators are inclined to let regulatory capital fall (subject to the discretion of national authorities). American regulators are not. They have now proposed changes in America’s version of Basel 2 that will delay its implementation until at least January 2009. Under their proposals American banks will be subject to a number of ‘safeguards’ that keep capital cushions plump. These include the ‘leverage ratio,’ a blunt measure of a bank’s lending exposure that is not linked to the riskiness of its activities.”

One of the real peace dividends brought by the end of the Cold War was the fact that the global economy could move forward using the same rules. Basel 2 was supposed to establish that sort of international standard.

“The accord was intended as a single worldwide standard. But it now threatens to be qualitatively different in Europe and America. International banks that straddle the Atlantic are in a bind and America’s large banks are especially irritated. On February 7th four of them, including Citigroup and JPMorgan Chase, wrote a letter of complaint to regulators. These extra restrictions, the banks wrote, give foreign competitors an edge, because they can hold less capital for identical assets. There may be some truth in this. But America’s regulators are too uneasy about the Basel 2 project to lighten up. They think the accord relies too heavily on banks’ in-house risk models, which are fallible and ‘highly subjective,’ as one regulator put it. Quietly, some also worry about European banks, which already have much higher levels of leverage than American ones and hold less capital to offset it. Others fret about a lack of transparency. Under Basel 2, national regulators can force individual banks to boost capital reserves if they see fit. But in Europe it is unclear what an unacceptable level of capital might be, or how bank regulators would react if a bank edged towards it.”

U.S. regulators, according to the article, have reasons for being more rigid in their approach. The U.S. has suffered a series of financial institutional failures that resulted in losses for millions of victims. Since the government had to pick up the bill for many of the consequences of these failures, regulators are not eager to ease regulations aimed at preventing future financial crises. The Economist writes:

“There is no such ambiguity in America, where banks have been held to a stringent regime known as ‘prompt corrective action.’ This came into law in 1991 in the wake of America’s savings-and-loan debacle, in which more than 2,900 banks failed. Then, regulators repeatedly threw lifelines to struggling banks, which only postponed their inevitable collapse. Now, they have much less scope for leniency. They must take specific, and increasingly severe, actions—from curbing lending to closing a bank—as a bank’s capital ratios deteriorate. The idea is to intervene before banks get into trouble, and to make the consequences of falling into the red zone clear to banks and investors well before anything bad happens. American regulators will not budge on these issues soon. Indeed, Sheila Bair, one of America’s bank regulators, thinks that her foreign counterparts should adopt something like the American approach to buttress Basel 2. A number of European bank regulators and academics agree. But politicians in Europe have reservations. They point out, rightly, that America’s approach is largely untested, because the country’s banks have enjoyed good times since 1991. They also worry that adding the leverage ratio, which disregards risk, to Basel 2 would render all their past work irrelevant.”

American banking customers are much more interested in the security of their accounts than in the profitability of their bank. Basel 2 doesn’t necessarily make these two positions mutually exclusive:

“In fact, each side can learn from the other. The Europeans should add clarity to Basel 2. The Americans should add a bit of urgency to implementing it. No doubt the accord has flaws, but these can be fixed later. In the meantime, it would be better to finalise a rule on Basel 2.”

International cooperation and standards are critical for moving the global economy forward. Trying to find a European way or an American way or an Asian way to globalize will undermine the hope that this wave of globalization has brought with it.