Bank regulation: Basel brush

Date: 29/03/03

American unilateralism over bank capital rules is upsetting Europeans

FOR the past five years, the world's financial regulators have been working on a new set of rules for bank capital, called Basel 2. The idea is to ensure that banks' capital matches the risks they carry: the riskier their loan books, the more capital they should hold. The rules are not due to be applied until January 2007, but if that deadline is to be met, Basel 2 must be practically set in stone by this May.

The Basel Committee on Banking Supervision, which is drawing up the rules, is pleased with the results of its third (and supposedly last) impact study. The study suggests that the complex new risk weightings to be applied to different types of asset will produce appropriate levels of capital for most of the world's banks.

Getting this far has taken a lot of sweat and horse-trading. American bankers and regulators have been at the forefront. American financial institutions have debated the rule changes as keenly as anybody. And Bill McDonough, head of the Federal Reserve Bank of New York, has cracked the whip as chairman of the Basel committee.

Imagine, therefore, the consternation of other committee members on learning how America plans to treat the new rulebook. Some American bankers and legislators are arguing that the proposed capital charge for operational risk - a fundamental part of Basel 2 - needs to be completely rethought. Worse, American regulators intend to apply the new rules to fewer than a dozen of their banks. At a congressional hearing last month, they made it clear that the thousands of other American banks would continue to use the less complex existing rulebook, Basel 1. In fact, Basel 1 is little different from the lowest of Basel 2's three grades of sophistication. Nevertheless, the regulators believe that even this slight change would be a waste of money for America's smaller banks.

Another transatlantic tiff

This is a choker for European regulators, who see Basel 2, like Basel 1, as a global standard to be applied to all banks. Granted, the Federal Reserve has always said that it would apply Basel 2 only to “internationally active” banks. The surprise is that this means so few. It seems that banks as big as State Street, Mellon Financial Corporation, and perhaps even Bank of New York, which all have huge international payments and securities operations, will escape. State Street and Mellon have been lobbying hard, arguing that the Basel 2 charge for operational risk is too formulaic. They say that operational risk - the risk of loss from systems failures, external events, fraud etc - is impossible to quantify. It would be better if supervisors monitored banks' efforts to mitigate these risks and then set a subjective capital charge. But this is anathema to European regulators.

In Europe, a version of Basel 2 is to be incorporated into European Union law and applied to all banks and investment firms, not just internationally active banks. To this end, the European Commission hopes to publish a draft directive in June. No wonder rulemakers in both Basel and Brussels are furious with the Americans.

As things now look, different standards will apply to American and European banks, giving the Americans a theoretically lower cost of making loans. Karen Petrou of Federal Financial Analytics in Washington fears that the American regulators' narrow application will allow some quite big American banks to side-step realistic capital charges, by using the old Basel 1 loopholes. “The whole point of Basel 2 is to get rid of regulatory arbitrage,” she comments.

However, members of the European Parliament (MEPs) might also try to reshape the new rules - just as American congressmen have already tried. Alexander Radwan, a German MEP who will report to the parliament on Basel 2, has several concerns. He thinks that capital charges that are more sensitive to credit risk could curb lending to small companies, a fear previously expressed also by the German government. And he dislikes the idea of bank-supervision rules being drawn up and amended by unelected experts (such as the Basel committee) outside the purview of politicians.

The Europeans also have some bargaining chips, which may yet produce a compromise with the Americans. American banks cannot operate in Europe under non-EU capital rules or supervision unless these are judged to be of “equivalent” standard. American banks may find that Basel 1 will not be deemed equivalent within the EU after 2006, when the commission's promised directive is due to take effect. Moreover, some American investment banks may be caught by another EU directive on financial conglomerates, which comes into force in 2005. They may have to seek out a consolidated supervisor with stronger oversight than their current one, the Securities and Exchange Commission: an EU committee will decide next year.

Alternatively, European regulators could follow the American lead, and simply reduce the scope of Basel 2 in Europe, along American lines. That might not be a bad outcome. Initially, a few big banks conforming to Basel 2 would set a standard to which other banks could aspire. The incentive to aspire would come not from regulatory pressure but from the market, which might judge compliant banks to be safer and better-run.

Nice, but improbable. So much effort has been put into Basel 2, and so many European banks are braced for the future directive, that there is no turning back now. So it looks more likely that American and European banks and their regulators will end up playing by different rules.

American unilateralism over bank capital rules is upsetting Europeans.

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