Risk-Based Capital:

New Basel II Rules Reduced Certain Competitive Concerns, but Bank Regulators Should Address Remaining Uncertainties

GAO-08-953: Published: Sep 12, 2008. Publicly Released: Oct 14, 2008.

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Basel II, the new risk-based capital framework based on an international accord, is being adopted by individual countries. It includes standardized and advanced approaches to estimating capital requirements. In the United States, bank regulators have finalized an advanced approaches rule that will be required for some of the largest, most internationally active banks (core banks) and proposed an optional standardized approach rule for non-core banks that will also have the option to remain on existing capital rules. In light of possible competitive effects of the capital rules, GAO was asked to examine (1) the markets in which banks compete, (2) how new capital rules address U.S. banks' competitive concerns, and (3) actions regulators are taking to address competitive and other potential negative effects during implementation. Among other things, GAO analyzed data on bank products and services and the final and proposed capital rules; interviewed U.S. and foreign bank regulators, officials from U.S. and foreign banks; and computed capital requirements under varying capital rules.

Large and internationally active U.S.-based banks (core banks) that will adopt the Basel II advanced approaches compete among themselves and in some markets with U.S.-based non-core banks, investment firms, and foreign-based banks. Non-core banks compete with core banks in retail markets, but in wholesale markets core banks often compete with investment firms and foreign-based banks. Because holding capital is costly for banks, differences in regulatory capital requirements could influence costs, prices, and profitability for banks competing under different capital requirements. The new U.S. capital rules addressed some earlier competitive concerns of banks; however, other concerns remain. By better aligning the advanced approaches rule with the international accord and proposing an optional standardized approach rule, U.S. regulators reduced some competitive concerns for both core and non-core banks. For example, the U.S. wholesale definition of default for the advanced approaches is now similar to the accord's. Core banks continue to be concerned about the leverage requirement (a simple capital to assets calculation), which they believe places them at a competitive disadvantage relative to firms not subject to a similar requirement. Foreign regulators have been working with U.S. regulators to coordinate Basel II implementation for U.S. banks with foreign operations. The proposed standardized approach addresses some concerns non-core banks raised by providing a more risk sensitive approach to calculating regulatory requirements. But other factors likely will reduce differences in capital for banks competing in the United States; for example, the leverage requirement establishes a floor that may exceed the capital required under the advanced and standardized approaches. Many factors have affected the pace of Basel II implementation in the United States and, while the gradual implementation is allowing regulators to consider changes in the rules and reassess banks' risk-management systems, regulators have not yet taken action to address areas of uncertainty that could have competitive implications. For example, the final rule provides regulators with considerable flexibility and leaves open questions such as which banks may be exempted from the advanced approaches. Although the rule provides that core banks can apply for exemptions and regulators should consider these in light of some broad categories, such as asset size or portfolio mix, the rule does not further define the criteria for exemptions. Some industry participants we spoke with said that uncertainties about the implementation of the advanced approaches have been a problem for them. Moreover, regulators have not fully developed plans for a required study of the impacts of Basel II before full implementation. Lack of specificity in criteria, scope, methodology, and timing will affect the quality and extent of information that regulators will have to help assess competitive and other impacts, determine whether there are any material deficiencies requiring future changes in the rules, and determine whether to permit core banks to fully implement Basel II.

Recommendations for Executive Action

  1. Status: Closed - Implemented

    Comments: As a result of the financial crisis that started in 2007, U.S. and international banking regulators reevaluated Basel II and the advanced approaches, in part to revise the regulatory capital structure to increase the resiliency of banks and the banking system. In August 2012, U.S. banking regulators proposed comprehensive revisions to their regulatory capital framework through three concurrent notices of proposed rulemaking. These proposals would revise the agencies? current general risk-based rules, advanced approaches risk-based capital rules, and leverage capital rules. The proposed changes to the advanced approaches rules incorporate applicable provisions of Basel III and other agreements reached by the Basel Committee on Banking Supervision since 2009. Through their reevaluation of Basel II and the advance approaches and proposed rulemakings, the U.S. banking regulators addressed, in effect, the substantive issues we identified in our recommendation.

    Recommendation: To improve the understanding of potential competitive effects of the new capital framework, the heads of the FDIC, Federal Reserve, OCC, and OTS should take steps jointly to plan for the study to determine if major changes need to be made to the advanced approaches or whether banks will be able to fully implement the current rule. In their planning, they should consider such issues as the objectives, scope, methodology, and timing needs for the future evaluation of Basel II. The plan should include how the regulators will evaluate competitive differences between core and non-core banks in the United States, between core banks and consolidated supervised entities, and between U.S.-based banks and banks based in other countries.

    Agency Affected: Federal Deposit Insurance Corporation

  2. Status: Closed - Implemented

    Comments: As a result of the financial crisis that started in 2007, U.S. and international banking regulators reevaluated Basel II and the advanced approaches, in part to revise the regulatory capital structure to increase the resiliency of banks and the banking system. In August 2012, U.S. banking regulators proposed comprehensive revisions to their regulatory capital framework through three concurrent notices of proposed rulemaking. These proposals would revise the agencies? current general risk-based rules, advanced approaches risk-based capital rules, and leverage capital rules. The proposed changes to the advanced approaches rules incorporate applicable provisions of Basel III and other agreements reached by the Basel Committee on Banking Supervision since 2009. Through their reevaluation of Basel II and the advance approaches and proposed rulemakings, the U.S. banking regulators addressed, in effect, the substantive issues we identified in our recommendation.

    Recommendation: To improve the understanding of potential competitive effects of the new capital framework, the heads of the FDIC, Federal Reserve, OCC, and OTS should take steps jointly to plan for the study to determine if major changes need to be made to the advanced approaches or whether banks will be able to fully implement the current rule. In their planning, they should consider such issues as the objectives, scope, methodology, and timing needs for the future evaluation of Basel II. The plan should include how the regulators will evaluate competitive differences between core and non-core banks in the United States, between core banks and consolidated supervised entities, and between U.S.-based banks and banks based in other countries.

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

  3. Status: Closed - Implemented

    Comments: As a result of the financial crisis that started in 2007, U.S. and international banking regulators reevaluated Basel II and the advanced approaches, in part to revise the regulatory capital structure to increase the resiliency of banks and the banking system. In August 2012, U.S. banking regulators proposed comprehensive revisions to their regulatory capital framework through three concurrent notices of proposed rulemaking. These proposals would revise the agencies? current general risk-based rules, advanced approaches risk-based capital rules, and leverage capital rules. The proposed changes to the advanced approaches rules incorporate applicable provisions of Basel III and other agreements reached by the Basel Committee on Banking Supervision since 2009. Through their reevaluation of Basel II and the advance approaches and proposed rulemakings, the U.S. banking regulators addressed, in effect, the substantive issues we identified in our recommendation.

    Recommendation: To improve the understanding of potential competitive effects of the new capital framework, the heads of the FDIC, Federal Reserve, OCC, and OTS should take steps jointly to plan for the study to determine if major changes need to be made to the advanced approaches or whether banks will be able to fully implement the current rule. In their planning, they should consider such issues as the objectives, scope, methodology, and timing needs for the future evaluation of Basel II. The plan should include how the regulators will evaluate competitive differences between core and non-core banks in the United States, between core banks and consolidated supervised entities, and between U.S.-based banks and banks based in other countries.

    Agency Affected: Federal Reserve System

  4. Status: Closed - Implemented

    Comments: In August 2012, the Federal Reserve (includes the holding company function of the former OTS), OCC (includes the depository institution function of the former OTS), and FDIC issued a notice of proposed rulemaking on Basel III, which addresses some of the issues raised in Basel II. The new rules clarify any ambiguity surrounding aspects of Basell II involving the use of regulatory flexibility under the advanced approaches rule and the exercise of exemptions for core banks from the advanced approach. Specifically, the rulemaking addresses our recommendation because it does not include the option of a primary regulator being able to exempt certain depositories or holding companies that would otherwise qualify from the advanced approaches.

    Recommendation: To further limit any potential negative effects, where possible, the heads of the FDIC, Federal Reserve, the Office of the Comptroller of the Currency (OCC), and the Office of Thrift Supervision (OTS) should move to minimize the uncertainty surrounding certain aspects of Basel II. Specifically, regulators should clarify how they will use certain regulatory flexibility under the advanced approaches rule, particularly with regard to how they will exercise exemptions for core banks from the advanced approaches requirement and the extent to which core banks will be allowed to adopt the standardized approach.

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

  5. Status: Closed - Implemented

    Comments: In August 2012, the Federal Reserve (includes the holding company function of the former OTS), OCC (includes the depository institution function of the former OTS), and FDIC issued a notice of proposed rulemaking on Basel III, which addresses some of the issues raised in Basel II. The new rules clarify any ambiguity surrounding aspects of Basell II involving the use of regulatory flexibility under the advanced approaches rule and the exercise of exemptions for core banks from the advanced approach. Specifically, the rulemaking addresses our recommendation because it does not include the option of a primary regulator being able to exempt certain depositories or holding companies that would otherwise qualify from the advanced approaches.

    Recommendation: To further limit any potential negative effects, where possible, the heads of the FDIC, Federal Reserve, the Office of the Comptroller of the Currency (OCC), and the Office of Thrift Supervision (OTS) should move to minimize the uncertainty surrounding certain aspects of Basel II. Specifically, regulators should clarify how they will use certain regulatory flexibility under the advanced approaches rule, particularly with regard to how they will exercise exemptions for core banks from the advanced approaches requirement and the extent to which core banks will be allowed to adopt the standardized approach.

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

  6. Status: Closed - Implemented

    Comments: In August 2012, the Federal Reserve (includes the holding company function of the former OTS), OCC (includes the depository institution function of the former OTS), and FDIC issued a notice of proposed rulemaking on Basel III, which addresses some of the issues raised in Basel II. The new rules clarify any ambiguity surrounding aspects of Basell II involving the use of regulatory flexibility under the advanced approaches rule and the exercise of exemptions for core banks from the advanced approach. Specifically, the rulemaking addresses our recommendation because it does not include the option of a primary regulator being able to exempt certain depositories or holding companies that would otherwise qualify from the advanced approaches.

    Recommendation: To further limit any potential negative effects, where possible, the heads of the FDIC, Federal Reserve, the Office of the Comptroller of the Currency (OCC), and the Office of Thrift Supervision (OTS) should move to minimize the uncertainty surrounding certain aspects of Basel II. Specifically, regulators should clarify how they will use certain regulatory flexibility under the advanced approaches rule, particularly with regard to how they will exercise exemptions for core banks from the advanced approaches requirement and the extent to which core banks will be allowed to adopt the standardized approach.

    Agency Affected: Federal Reserve System

  7. Status: Closed - Implemented

    Comments: In August 2012, the Federal Reserve (includes the holding company function of the former OTS), OCC (includes the depository institution function of the former OTS), and FDIC issued a notice of proposed rulemaking on Basel III, which addresses some of the issues raised in Basel II. The new rules clarify any ambiguity surrounding aspects of Basell II involving the use of regulatory flexibility under the advanced approaches rule and the exercise of exemptions for core banks from the advanced approach. Specifically, the rulemaking addresses our recommendation because it does not include the option of a primary regulator being able to exempt certain depositories or holding companies that would otherwise qualify from the advanced approaches.

    Recommendation: To further limit any potential negative effects, where possible, the heads of the FDIC, Federal Reserve, the Office of the Comptroller of the Currency (OCC), and the Office of Thrift Supervision (OTS) should move to minimize the uncertainty surrounding certain aspects of Basel II. Specifically, regulators should clarify how they will use certain regulatory flexibility under the advanced approaches rule, particularly with regard to how they will exercise exemptions for core banks from the advanced approaches requirement and the extent to which core banks will be allowed to adopt the standardized approach.

    Agency Affected: Federal Deposit Insurance Corporation

  8. Status: Closed - Implemented

    Comments: As a result of the financial crisis that started in 2007, U.S. and international banking regulators reevaluated Basel II and the advanced approaches, in part to revise the regulatory capital structure to increase the resiliency of banks and the banking system. In August 2012, U.S. banking regulators proposed comprehensive revisions to their regulatory capital framework through three concurrent notices of proposed rulemaking. These proposals would revise the agencies? current general risk-based rules, advanced approaches risk-based capital rules, and leverage capital rules. The proposed changes to the advanced approaches rules incorporate applicable provisions of Basel III and other agreements reached by the Basel Committee on Banking Supervision since 2009. Through their reevaluation of Basel II and the advance approaches and proposed rulemakings, the U.S. banking regulators addressed, in effect, the substantive issues we identified in our recommendation.

    Recommendation: To improve the understanding of potential competitive effects of the new capital framework, the heads of the FDIC, Federal Reserve, OCC, and OTS should take steps jointly to plan for the study to determine if major changes need to be made to the advanced approaches or whether banks will be able to fully implement the current rule. In their planning, they should consider such issues as the objectives, scope, methodology, and timing needs for the future evaluation of Basel II. The plan should include how the regulators will evaluate competitive differences between core and non-core banks in the United States, between core banks and consolidated supervised entities, and between U.S.-based banks and banks based in other countries.

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

 

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