RegionsNorth AmericaImplementation Of Basel 2: Implications For U.S. Banks

Implementation Of Basel 2: Implications For U.S. Banks

Implementation Of Basel 2 In The U.S.: Implications For U.S. Banks

In August 2003 the four U.S. federal banking regulators (the Federal Reserve, the OCC, the FDIC, and the OTS) took their first steps in the implementation process for Basel 2 with the publication of an advanced notice of public rulemaking (ANPR) based on the Basel Committee’s CP3. Since then, numerous concerns have been voiced in the U.S. by the different regulators, by members of the U.S. Congress and by many banks themselves, over the potential impact that Basel 2 could have on the U.S. banking system. This perhaps culminated in December when the FDIC published a controversial report suggesting that under Basel 2 the risk-based capital requirements for US banks could decline by 30 percent or more.

Bismarck once said “Laws are like sausages, it is better not to see them being made.” Although this judgment may be overly cynical, we certainly believe that observers of the process need to have strong stomachs. Notwithstanding the current controversies, we believe that ultimately the U.S. will adopt Basel 2 and most of the largest U.S. banks (perhaps a dozen or so initially, and a couple of dozen more over time) will comply with it.

The U.S. regulators all support the fundamental principles underlying Basel 2, and recognize the need to reduce the opportunities for regulatory capital arbitrage under the current capital rules. Ultimately we believe their current differences will be ironed out. And while there are some valid questions about the implications Basel 2 may have on competition, we think that the debate on competitive effects has been overblown, and also ignores the fact that most of these competitive challenges already exist today. While there could still be some further delay in the implementation of Basel 2, we don’t think such delay will cause the entire accord to unravel.

Stronger Risk Culture And Better Disclosures

Moody’s has commented a number of times on Basel 2, most recently in October 2003 after the Basel Committee’s Madrid meeting where it affirmed its commitment to the accord. Our opinion remains the same -Basel 2 will be a net positive for the banking industry. In the U.S., where the regulatory philosophy already closely follows the Pillar 2 framework the accord prescribes, the main effect of Basel 2 will be an improvement in the risk measurement, management, and controls at many banks, and for the risk culture of the banking industry as a whole.

A handful of the largest U.S. banks have already made considerable progress down this path, but over time many more banks should follow. Even among those U.S. banks that never opt-in to Basel 2, we believe many will likely still end up adopting at least some of its precepts and practices, either as a competitive response or through the urging of their regulators. We also expect Pillar 3 will drive further improvements in public disclosure among U.S. banks, benefiting fixed income investors.

Steep Declines In Capital Levels Unlikely

As Basel 2’s impact on the capital levels at U.S. banks, we do not expect to see the kind of declines suggested by the FDIC’s report. There are several reasons for this. First and foremost, the Basel Committee confirmed again in January its objective to maintain broadly the aggregate level of regulatory capital in the banking system. The Committee said it will review the calibration of capital requirements in May and again prior to the final implementation date. The U.S. regulators have also said they will conduct another Quantitative Impact Study (QIS) which, depending upon the results, could lead to some recalibration of risk weight functions. We believe that if either the Committee’s analysis or the U.S. QIS reveals a substantial decline in required capital levels, then there will be a recalibration so that the broad objective of capital preservation is still achieved.

Second, the U.S. regulators have indicated that the prompt corrective action guidelines (PCA) will remain in place, including the leverage ratio. This puts a floor on any U.S. bank’s ability to reduce its capital levels even if its risk-based capital requirements decline substantially.

While some have claimed that PCA will put U.S. banks at a competitive disadvantage to foreign banks under Basel 2, we think Pillar 2 lessens this risk. Pillar 2 says that internationally active banks should operate above the Pillar 1 minimum. To meet the principles of Pillar 2, each country’s supervisor will have to adopt formal or informal tools that serve much the same function as the PCA, i.e. they will demand higher capital levels depending upon the magnitude of a bank’s exposure to other risks, such as interest rate risk or credit concentration risk. Indeed, regulators in several markets outside the U.S. – the United Kingdom, Switzerland, Italy, etc. – already utilize such tools. While each country is free to choose how they will meet the principles of Pillar 2, the Committee expects that information on these different approaches will be shared among supervisors to promote consistency in the application of the accord.

Capital Does Not Drive Moody’s Bank Ratings

Moody’s does not believe that a bank’s overall credit strength would be weakened if, as a consequence of Basel 2, its capital ratios dropped by 50 or even 100 basis points. Such a drop would not normally be a rating event for us. Banks are highly leveraged institutions and we rate them as such. There is no automatic direct correlation between our ratings and the level of a bank’s regulatory or even its economic capital.

Far more important in Moody’s analysis is a bank’s capacity to create capital from its recurring earnings. Stable and recurring earnings are the best capital protection for a bank; they are the principal cushion to absorb higher losses. For banks with volatile or weak recurring earnings power, even ample quantities of regulatory capital may be insufficient.

Challenges for Non-Basel 2 Banks

Outside of the U.S., complying with Basel 2 will require the commitment of substantial resources and pose considerable challenges for smaller banks. But even though smaller U.S. banks (and a fair number of medium-sized ones) will not be required to comply with Basel 2, they still face the challenge of competing against Basel 2 banks.

For some products, Basel 2 banks will benefit from lower marginal credit-risk capital requirements, which could encourage more aggressive pricing. This could pose greater competitive challenges for non-Basel 2 banks. But we think this pricing pressure will be at least partially offset by the need for Basel 2 banks to still hold capital for interest rate risk or other risks not included under Pillar 1 but required under Pillar 2. And in many products, all banks already compete against nonbanks without capital requirements or with other competitive advantages.

Second, to the extent that Basel 2 banks possess more sophisticated credit-risk management tools, they may be able to cherry pick non-Basel 2 banks’ better customers within a given product type. But this already occurs to some extent and is likely to continue to pose challenges for smaller, less sophisticated banks regardless of whether Basel 2 is adopted.

We believe that these competitive challenges will pose the greatest threat to those non-Basel 2 banks with weaker franchises or less sophisticated credit-risk management tools. Such weaknesses are already reflected in our ratings of individual banks. And we expect this may fuel additional consolidation in the banking industry. However, we also believe that there will always be room for smaller banks with a well defined niche, a strong service-oriented, relationship-based franchise, that are financially strong with superior management. Customers of such institutions are usually less price sensitive, and these banks’ often benefit from strong positive selection which may even obviate the need for the most sophisticated risk management tools. Our ratings for such banks are typically higher, and we believe such banks will remain very competitive against even the largest Basel 2 banks.

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