The US Federal Reserve has announced it will permit smaller US financial institutions to implement the standardised approach under Basel II, acknowledging misgivings raised by banks during previous proposals. The regulator, which has stipulated that the largest internationally active US banks must follow the advanced approaches for calculating their credit, market and operational risk exposures, will allow smaller institutions to pursue the less complex, less costly, but also less risk-sensitive standardised approaches. Under the initiatives floated in the notice of proposed rulemaking (NPR), published on June 26, smaller institutions will have to increase the number of risk-weighted categories to which they assign their credit exposures. Firms will also have to use loan-to-value (LTV) ratios to risk-weight the majority of residential mortgages they hold on their balance sheets, in an attempt to enhance the risk sensitivity of the capital they retain against them. LTV ratios have been of particular concern in the US as house prices have eroded in the past two years. Mortgages that previously conformed to a LTV ratio loan limit of 80% - required to be eligible for underwriting by government-sponsored enterprises Fannie Mae and Freddie Mac - have in some cases breached that limit, due to the depreciating value of homes against which the loans were made. The 321-page NPR also proposes allowing institutions to follow the relatively crude basic indicator approach for operational risk, which mandates banks must hold capital equal to 15% of average annual gross income over the previous three years. Larger banks following the advanced measurement approach for operational risk - by far the most poorly defined of the risk disciplines covered under Basel II - have spent millions developing risk measurement systems using internal and external loss data, largely without direction from supervisors. The 15% capital charge levied by the basic indicator approach saves smaller institutions from having to invest time and resources in similar endeavours, and adheres to industry feedback received after prior consultations. In December 2006, the Fed, in conjunction with other US regulatory authorities, proposed a compromise framework known as Basel IA, incorporating elements of the Basel I framework with portions of the new Accord, in an attempt to lessen the regulatory burden for smaller institutions seeking to become Basel-compliant. Response to the consultation was tepid, with many respondents noting the Basel IA framework was markedly less risk-sensitive than the more basic approaches of Basel II. A number of firms urged the US authorities to simply allow regional banks to pursue the standardised approach. It is a call the new NPR appears to have heeded. The consultation period on the proposed rules runs for 90 days and is expected to close in late September. No timeline has been given for the publication of finalised regulations. Peter Madigan....
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