Risk-Based Capital:

Bank Regulators Need to Improve Transparency and Overcome Impediments to Finalizing the Proposed Basel II Framework

GAO-07-253: Published: Feb 15, 2007. Publicly Released: Feb 15, 2007.

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Concerned about the potential impacts of the proposed risk-based capital rules, known as Basel II, Congress mandated that GAO study U.S. implementation efforts. This report examines (1) the transition to Basel II and the proposed changes in the United States, (2) the potential impact on the banking system and regulatory required capital, and (3) how banks and regulators are preparing for Basel II and the challenges they face. To meet these objectives, GAO analyzed documents related to Basel II and interviewed various regulators and officials from banks that will be required to follow the new rules.

Rapid innovation in financial markets and advances in risk management have revealed limitations in the existing Basel I risk-based capital framework, especially for large, complex banks. U.S. banking regulators have proposed a revised regulatory capital framework that differs from the international Basel II accord in several ways, including (1) requiring adoption of the most advanced Basel II approaches and by only the largest and most internationally active banks; (2) proposing Basel IA, a simpler revision of Basel I, and retaining Basel I as options for all other banks; and (3) retaining the leverage requirement and prompt corrective action measures that exist under the current regulatory capital framework. While the new capital framework could improve banks' risk management and make regulatory capital more sensitive to underlying risks, its impact on minimum capital requirements and the actual amount of capital held by banks is uncertain. The approaches allowed under Basel II are not without risks, and realizing the benefits of these approaches while managing the related risks will depend on the adequacy of both internal and supervisory reviews. The move to Basel II has also raised competitiveness concerns between large and small U.S. banks domestically and large U.S. and foreign banks internationally. The impact of Basel II on the level of required capital is uncertain, but in response to quantitative impact study results showing large reductions in minimum required capital, U.S. regulators have proposed safeguards, such as transitional floors, that along with the existing leverage ratio would limit regulatory capital reductions during a multiyear transition period. Finally, the impact on actual capital held by banks is uncertain because banks hold capital above required minimums for both internal risk management purposes as well as to address the expectations of the market. Banks and regulators are preparing for Basel II without a final rule, but both face challenges. Bank officials said they were refining their risk management practices, but uncertainty about final requirements has made it difficult for them to proceed further. Banks also face challenges in aligning their existing systems and processes with some of the proposed requirements. While regulators plan to integrate Basel II into their current supervisory process, they face impediments. The banking regulators have differing regulatory perspectives, which has made reaching consensus on the proposed rule difficult. Banks and other stakeholders continue to face uncertainty. Among the issues that regulators have yet to resolve are how the rule will treat bank portfolios that do not meet data requirements, how they will calculate reductions in aggregate minimum regulatory capital and what they will do if the reduction exceeds a proposed 10 percent trigger, and what criteria they will use to determine the appropriate average level of required capital and cyclical variation. Increased transparency going forward could reduce ambiguity and respond to questions and concerns among banks and industry stakeholders about how the rules will be applied, their ultimate impact on capital, and the regulators' ability to oversee their implementation.

Status Legend:

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  • Review Pending-GAO has not yet assessed implementation status.
  • Open-Actions to satisfy the intent of the recommendation have not been taken or are being planned, or actions that partially satisfy the intent of the recommendation have been taken.
  • Closed-implemented-Actions that satisfy the intent of the recommendation have been taken.
  • Closed-not implemented-While the intent of the recommendation has not been satisfied, time or circumstances have rendered the recommendation invalid.
    • Review Pending
    • Open
    • Closed - implemented
    • Closed - not implemented

    Recommendations for Executive Action

    Recommendation: To help reduce the uncertainty about the impact of Basel II on required levels of regulatory capital, improve the transparency of the process, address the impediments regulators face in moving to Basel II, and as part of the process leading to the parallel run and during the proposed transition period(s), the heads of the Federal Reserve, FDIC, OCC and OTS should issue a new Notice of Proposed Rule Making (NPR) before finalizing the Basel II rule, if the final rule differs materially from the NPR or if a U.S. standardized approach is an option in the final rule. While this step may add months to the process, the additional time may help provide more transparency and allow banks and stakeholders to provide feedback before the rule is finalized.

    Agency Affected: Department of the Treasury: Office of Thrift Supervision

    Status: Closed - Implemented

    Comments: The Federal Deposit Insurance Corporation, Federal Reserve Board, Office of the Comptroller of the Currency, and office of Thrift Supervision issued the final rule for Basel II on November 2, 2007. This final rule moved the US requirements closer to the international Basel Accord and did not include the standardized approach as an option, therefore, there was no need to issue a new notice of proposed rulemaking and go through an additional comment period.

    Recommendation: To help reduce the uncertainty about the impact of Basel II on required levels of regulatory capital, improve the transparency of the process, address the impediments regulators face in moving to Basel II, and as part of the process leading to the parallel run and during the proposed transition period(s), the heads of the Federal Reserve, FDIC, OCC and OTS should issue a new Notice of Proposed Rule Making (NPR) before finalizing the Basel II rule, if the final rule differs materially from the NPR or if a U.S. standardized approach is an option in the final rule. While this step may add months to the process, the additional time may help provide more transparency and allow banks and stakeholders to provide feedback before the rule is finalized.

    Agency Affected: Federal Reserve System

    Status: Closed - Implemented

    Comments: The Federal Deposit Insurance Corporation, Federal Reserve Board, Office of the Comptroller of the Currency, and office of Thrift Supervision issued the final rule for Basel II on November 2, 2007. This final rule moved the US requirements closer to the international Basel Accord and did not include the standardized approach as an option, therefore, there was no need to issue a new notice of proposed rulemaking and go through an additional comment period.

    Recommendation: To help reduce the uncertainty about the impact of Basel II on required levels of regulatory capital, improve the transparency of the process, address the impediments regulators face in moving to Basel II, and as part of the process leading to the parallel run and during the proposed transition period(s), the heads of the Federal Reserve, FDIC, OCC and OTS should issue a new Notice of Proposed Rule Making (NPR) before finalizing the Basel II rule, if the final rule differs materially from the NPR or if a U.S. standardized approach is an option in the final rule. While this step may add months to the process, the additional time may help provide more transparency and allow banks and stakeholders to provide feedback before the rule is finalized.

    Agency Affected: Department of the Treasury: Office of the Comptroller of the Currency

    Status: Closed - Implemented

    Comments: The Federal Deposit Insurance Corporation, Federal Reserve Board, Office of the Comptroller of the Currency, and office of Thrift Supervision issued the final rule for Basel II on November 2, 2007. This final rule moved the US requirements closer to the international Basel Accord and did not include the standardized approach as an option, therefore, there was no need to issue a new notice of proposed rulemaking and go through an additional comment period.

    Recommendation: To help reduce the uncertainty about the impact of Basel II on required levels of regulatory capital, improve the transparency of the process, address the impediments regulators face in moving to Basel II, and as part of the process leading to the parallel run and during the proposed transition period(s), the heads of the Federal Reserve, FDIC, OCC and OTS should issue a new Notice of Proposed Rule Making (NPR) before finalizing the Basel II rule, if the final rule differs materially from the NPR or if a U.S. standardized approach is an option in the final rule. While this step may add months to the process, the additional time may help provide more transparency and allow banks and stakeholders to provide feedback before the rule is finalized.

    Agency Affected: Department of the Treasury: Office of Thrift Supervision

    Status: Closed - Implemented

    Comments: The Federal Deposit Insurance Corporation, Federal Reserve Board, Office of the Comptroller of the Currency, and office of Thrift Supervision issued the final rule for Basel II on November 2, 2007. This final rule moved the US requirements closer to the international Basel Accord and did not include the standardized approach as an option, therefore, there was no need to issue a new notice of proposed rulemaking and go through an additional comment period.

    Recommendation: To help reduce the uncertainty about the impact of Basel II on required levels of regulatory capital, improve the transparency of the process, address the impediments regulators face in moving to Basel II, and as part of the process leading to the parallel run and during the proposed transition period(s), the heads of the Federal Reserve, FDIC, OCC and OTS should issue public reports at least annually on the progress and results of implementation efforts and any resulting regulatory adjustments. This reporting should include an articulation of the criteria for judging the attainment of their goals for Basel II implementation and for determining its effectiveness for regulatory capital-setting purposes. These reports should also include analyses of (1) the results of the parallel runs and transition periods and a comparison of Basel II and Basel I results for the core banks and (2) the effect(s), if any, of Basel II or differences between U.S. and international rules on the competitiveness of U.S. banks.

    Agency Affected: Department of the Treasury: Office of the Comptroller of the Currency

    Status: Closed - Implemented

    Comments: As part of the final rule for the advanced approaches for Basel II, the regulators said they would jointly evaluate the effectiveness of the capital framework and committed to issuing a series of annual reports during the transition periods that will provide timely and relevant information on the implementation of the advanced approaches.

    Recommendation: To help reduce the uncertainty about the impact of Basel II on required levels of regulatory capital, improve the transparency of the process, address the impediments regulators face in moving to Basel II, and as part of the process leading to the parallel run and during the proposed transition period(s), the heads of the Federal Reserve, FDIC, OCC and OTS should issue public reports at least annually on the progress and results of implementation efforts and any resulting regulatory adjustments. This reporting should include an articulation of the criteria for judging the attainment of their goals for Basel II implementation and for determining its effectiveness for regulatory capital-setting purposes. These reports should also include analyses of (1) the results of the parallel runs and transition periods and a comparison of Basel II and Basel I results for the core banks and (2) the effect(s), if any, of Basel II or differences between U.S. and international rules on the competitiveness of U.S. banks.

    Agency Affected: Department of the Treasury: Office of the Comptroller of the Currency

    Status: Closed - Implemented

    Comments: As part of the final rule for the advanced approaches for Basel II, the regulators said they would jointly evaluate the effectiveness of the capital framework and committed to issuing a series of annual reports during the transition periods that will provide timely and relevant information on the implementation of the advanced approaches.

    Recommendation: To help reduce the uncertainty about the impact of Basel II on required levels of regulatory capital, improve the transparency of the process, address the impediments regulators face in moving to Basel II, and as part of the process leading to the parallel run and during the proposed transition period(s), the heads of the Federal Reserve, FDIC, OCC and OTS should issue public reports at least annually on the progress and results of implementation efforts and any resulting regulatory adjustments. This reporting should include an articulation of the criteria for judging the attainment of their goals for Basel II implementation and for determining its effectiveness for regulatory capital-setting purposes. These reports should also include analyses of (1) the results of the parallel runs and transition periods and a comparison of Basel II and Basel I results for the core banks and (2) the effect(s), if any, of Basel II or differences between U.S. and international rules on the competitiveness of U.S. banks.

    Agency Affected: Department of the Treasury: Office of Thrift Supervision

    Status: Closed - Implemented

    Comments: As part of the final rule for the advanced approaches for Basel II, the regulators said they would jointly evaluate the effectiveness of the capital framework and committed to issuing a series of annual reports during the transition periods that will provide timely and relevant information on the implementation of the advanced approaches.

    Recommendation: To help reduce the uncertainty about the impact of Basel II on required levels of regulatory capital, improve the transparency of the process, address the impediments regulators face in moving to Basel II, and as part of the process leading to the parallel run and during the proposed transition period(s), the heads of the Federal Reserve, FDIC, OCC and OTS should issue public reports at least annually on the progress and results of implementation efforts and any resulting regulatory adjustments. This reporting should include an articulation of the criteria for judging the attainment of their goals for Basel II implementation and for determining its effectiveness for regulatory capital-setting purposes. These reports should also include analyses of (1) the results of the parallel runs and transition periods and a comparison of Basel II and Basel I results for the core banks and (2) the effect(s), if any, of Basel II or differences between U.S. and international rules on the competitiveness of U.S. banks.

    Agency Affected: Federal Deposit Insurance Corporation

    Status: Closed - Implemented

    Comments: As part of the final rule for the advanced approaches for Basel II, the regulators said they would jointly evaluate the effectiveness of the capital framework and committed to issuing a series of annual reports during the transition periods that will provide timely and relevant information on the implementation of the advanced approaches.

    Recommendation: At the end of the last transition period, the heads of the Federal Reserve,FDIC, OCC, and OTS should reevaluate whether the advanced approaches of Basel II can and should be relied on to set appropriate regulatory capital requirements in the longer term. Depending on the information collected during the transition, any reevaluation should include a range of options, including consideration of additional minor modifications to U.S. Basel II regulations as well as whether more fundamental changes are warranted for setting appropriate required regulatory capital levels.

    Agency Affected: Department of the Treasury: Office of Thrift Supervision

    Status: Closed - Implemented

    Comments: In the final rule for the advanced approaches, the regulators committed to publishing an interagency study at the end of the second transition year that will evaluate the advanced approaches to determine if there are any material deficiencies. For any federal supervisor to authorize any bank to exit to the third transitional floor period, the study must determine that there are no such material deficiencies that cannot be addressed by then-existing tools or, if such deficiencies are found, they must first be remedied by changes to regulation.

    Recommendation: At the end of the last transition period, the heads of the Federal Reserve,FDIC, OCC, and OTS should reevaluate whether the advanced approaches of Basel II can and should be relied on to set appropriate regulatory capital requirements in the longer term. Depending on the information collected during the transition, any reevaluation should include a range of options, including consideration of additional minor modifications to U.S. Basel II regulations as well as whether more fundamental changes are warranted for setting appropriate required regulatory capital levels.

    Agency Affected: Federal Reserve System

    Status: Closed - Implemented

    Comments: In the final rule for the advanced approaches, the regulators committed to publishing an interagency study at the end of the second transition year that will evaluate the advanced approaches to determine if there are any material deficiencies. For any federal supervisor to authorize any bank to exit to the third transitional floor period, the study must determine that there are no such material deficiencies that cannot be addressed by then-existing tools or, if such deficiencies are found, they must first be remedied by changes to regulation.

    Recommendation: At the end of the last transition period, the heads of the Federal Reserve,FDIC, OCC, and OTS should reevaluate whether the advanced approaches of Basel II can and should be relied on to set appropriate regulatory capital requirements in the longer term. Depending on the information collected during the transition, any reevaluation should include a range of options, including consideration of additional minor modifications to U.S. Basel II regulations as well as whether more fundamental changes are warranted for setting appropriate required regulatory capital levels.

    Agency Affected: Department of the Treasury: Office of Thrift Supervision

    Status: Closed - Implemented

    Comments: In the final rule for the advanced approaches, the regulators committed to publishing an interagency study at the end of the second transition year that will evaluate the advanced approaches to determine if there are any material deficiencies. For any federal supervisor to authorize any bank to exit to the third transitional floor period, the study must determine that there are no such material deficiencies that cannot be addressed by then-existing tools or, if such deficiencies are found, they must first be remedied by changes to regulation.

    Recommendation: At the end of the last transition period, the heads of the Federal Reserve,FDIC, OCC, and OTS should reevaluate whether the advanced approaches of Basel II can and should be relied on to set appropriate regulatory capital requirements in the longer term. Depending on the information collected during the transition, any reevaluation should include a range of options, including consideration of additional minor modifications to U.S. Basel II regulations as well as whether more fundamental changes are warranted for setting appropriate required regulatory capital levels.

    Agency Affected: Department of the Treasury: Office of the Comptroller of the Currency

    Status: Closed - Implemented

    Comments: In the final rule for the advanced approaches, the regulators committed to publishing an interagency study at the end of the second transition year that will evaluate the advanced approaches to determine if there are any material deficiencies. For any federal supervisor to authorize any bank to exit to the third transitional floor period, the study must determine that there are no such material deficiencies that cannot be addressed by then-existing tools or, if such deficiencies are found, they must first be remedied by changes to regulation.

    Recommendation: To help reduce the uncertainty about the impact of Basel II on required levels of regulatory capital, improve the transparency of the process, and address the impediments regulators face in moving to Basel II, as part of the process leading to the parallel run and during the proposed transition period(s), the heads of the Federal Reserve, Federal Deposit Insurance Corporation (FDIC), the Office of the Comptroller of the Currency (OCC), and the Office of Thrift Supervision (OTS) should clarify and reach agreement on certain issues in the final rule, including first, how to treat portfolios at Basel II banks that may lack the data to meet regulatory standards for the advanced approaches. To ensure that portfolios with insufficient data are treated prudently and consistently, regulators should consider options such as a higher risk-weight, or substituting Basel IA or the Basel Committee's standardized approach for these portfolios. Secondly, how to calculate the 10-percent reduction in aggregate minimum regulatory capital and what will happen if the 10-percent reduction is triggered. And lastly, what the criteria will be for determining an appropriate average level of required capital and appropriate cyclical variation in minimum required capital.

    Agency Affected: Federal Reserve System

    Status: Closed - Implemented

    Comments: The heads of the Federal Deposit Insurance Corporation, Federal Reserve Board, Office of the Comptroller of the Currency, and Office of Thrift Supervision reached agreement on issues needed to finalize the rule, which was issued in November 2007. They determined a method to prudently treat portfolios with insufficient data, removed the provision regarding the 10 percent reduction in aggregate minimum regulatory capital, and plan to consider potential cyclical implications of the advanced approaches in the study they will conduct.

    Recommendation: To help reduce the uncertainty about the impact of Basel II on required levels of regulatory capital, improve the transparency of the process, and address the impediments regulators face in moving to Basel II, as part of the process leading to the parallel run and during the proposed transition period(s), the heads of the Federal Reserve, Federal Deposit Insurance Corporation (FDIC), the Office of the Comptroller of the Currency (OCC), and the Office of Thrift Supervision (OTS) should clarify and reach agreement on certain issues in the final rule, including first, how to treat portfolios at Basel II banks that may lack the data to meet regulatory standards for the advanced approaches. To ensure that portfolios with insufficient data are treated prudently and consistently, regulators should consider options such as a higher risk-weight, or substituting Basel IA or the Basel Committee's standardized approach for these portfolios. Secondly, how to calculate the 10-percent reduction in aggregate minimum regulatory capital and what will happen if the 10-percent reduction is triggered. And lastly, what the criteria will be for determining an appropriate average level of required capital and appropriate cyclical variation in minimum required capital.

    Agency Affected: Department of the Treasury: Office of the Comptroller of the Currency

    Status: Closed - Implemented

    Comments: The heads of the Federal Deposit Insurance Corporation, Federal Reserve Board, Office of the Comptroller of the Currency, and Office of Thrift Supervision reached agreement on issues needed to finalize the rule, which was issued in November 2007. They determined a method to prudently treat portfolios with insufficient data, removed the provision regarding the 10 percent reduction in aggregate minimum regulatory capital, and plan to consider potential cyclical implications of the advanced approaches in the study they will conduct.

    Recommendation: To help reduce the uncertainty about the impact of Basel II on required levels of regulatory capital, improve the transparency of the process, and address the impediments regulators face in moving to Basel II, as part of the process leading to the parallel run and during the proposed transition period(s), the heads of the Federal Reserve, Federal Deposit Insurance Corporation (FDIC), the Office of the Comptroller of the Currency (OCC), and the Office of Thrift Supervision (OTS) should clarify and reach agreement on certain issues in the final rule, including first, how to treat portfolios at Basel II banks that may lack the data to meet regulatory standards for the advanced approaches. To ensure that portfolios with insufficient data are treated prudently and consistently, regulators should consider options such as a higher risk-weight, or substituting Basel IA or the Basel Committee's standardized approach for these portfolios. Secondly, how to calculate the 10-percent reduction in aggregate minimum regulatory capital and what will happen if the 10-percent reduction is triggered. And lastly, what the criteria will be for determining an appropriate average level of required capital and appropriate cyclical variation in minimum required capital.

    Agency Affected: Federal Deposit Insurance Corporation

    Status: Closed - Implemented

    Comments: The heads of the Federal Deposit Insurance Corporation, Federal Reserve Board, Office of the Comptroller of the Currency, and Office of Thrift Supervision reached agreement on issues needed to finalize the rule, which was issued in November 2007. They determined a method to prudently treat portfolios with insufficient data, removed the provision regarding the 10 percent reduction in aggregate minimum regulatory capital, and plan to consider potential cyclical implications of the advanced approaches in the study they will conduct.

    Recommendation: To help reduce the uncertainty about the impact of Basel II on required levels of regulatory capital, improve the transparency of the process, and address the impediments regulators face in moving to Basel II, as part of the process leading to the parallel run and during the proposed transition period(s), the heads of the Federal Reserve, Federal Deposit Insurance Corporation (FDIC), the Office of the Comptroller of the Currency (OCC), and the Office of Thrift Supervision (OTS) should clarify and reach agreement on certain issues in the final rule, including first, how to treat portfolios at Basel II banks that may lack the data to meet regulatory standards for the advanced approaches. To ensure that portfolios with insufficient data are treated prudently and consistently, regulators should consider options such as a higher risk-weight, or substituting Basel IA or the Basel Committee's standardized approach for these portfolios. Secondly, how to calculate the 10-percent reduction in aggregate minimum regulatory capital and what will happen if the 10-percent reduction is triggered. And lastly, what the criteria will be for determining an appropriate average level of required capital and appropriate cyclical variation in minimum required capital.

    Agency Affected: Federal Reserve System

    Status: Closed - Implemented

    Comments: The heads of the Federal Deposit Insurance Corporation, Federal Reserve Board, Office of the Comptroller of the Currency, and Office of Thrift Supervision reached agreement on issues needed to finalize the rule, which was issued in November 2007. They determined a method to prudently treat portfolios with insufficient data, removed the provision regarding the 10 percent reduction in aggregate minimum regulatory capital, and plan to consider potential cyclical implications of the advanced approaches in the study they will conduct.

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