The Federal Reserve has announced it will permit smaller US financial institutions to implement the standardised approach for Basel II compliance, acknowledging misgivings raised by banks over previous proposals.
The regulator, which has mandated that the largest internationally active US banks must follow the advanced approaches for calculating their credit, market and operational risk exposures under Basel II, 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), smaller and regional 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, to enhance the risk sensitivity of the capital requirement they hold 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 the LTV ratio loan limit of 80%, required to be eligible for underwriting by government-sponsored enterprises Fannie Mae and Freddie Mac, might now have substantially breached that limit, due to the depreciating value of the home against which a lender is mortgaged, increasing the risk profile of the loan, as the mortgage can approach and exceed 100% of the value of the home.
The 321-page NPR – almost the same size as the 347-page Basel II framework itself - also proposes allowing institutions to follow the relatively crude basic indicator approach (BIA) for operational risk capital requirements, 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 to capture their internal risk exposures using internal and external loss data to inform risk models and largely without direction from supervisors. The 15% capital charge levied by the BIA, though potentially onerous, saves smaller institutions the rigmarole of investing 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, as many respondents noted the Basel IA framework to be 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 as international counterparts of a similar size and stature were free to do. It was 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.
Topics: Federal Reserve
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