Basel II creates myriad problems for US investment banks

Basel II is causing substantial problems for US investment banks whose overseas subsidiaries may receive harsh treatment under the new capital regime and whose home regulator, the Securities and Exchange Commission (SEC), says it is unsure when it will release guidance on its own plans to implement Basel II within the US.

European regulators, such as the UK’s Financial Services Authority, have already made it clear they will consider US investment banks, such as Morgan Stanley, Goldman Sachs and Merrill Lynch, as falling under the Basel II umbrella. "Any EU-authorised institution will have to apply EU rules laid out in legislation. If for any reason the institution does not apply a Basel II standard in its home jurisdiction, that is a matter for them, but the EU entity will be required to do it," said an FSA official.

This means US investment banks will be asked by regulators to apply either the standardised approach or the advanced measurement approach (AMA) for operational risk to their subsidiaries throughout Europe.

Unfortunately for them, core investment banking businesses are not treated kindly by the betas under the standardised approach, which industry observers say will probably be used as an unofficial benchmark by regulators validating AMA models.

Corporate finance, and trading and sales have 18% betas assigned to them under the standardised approach, compared with 15% for commercial banking and 12% for retail banking and brokerage.

"An investment bank will sit and think, ‘I’m really quite good at corporate finance, trading and sales. On the other hand I have no particular skills in residential mortgages. My analysis of these risks is the other way around,’" said Katharine Seal, a director at the London Investment Banking Association in London. "The investment bank would, almost certainly, be right to assess its strengths and weaknesses this way. But no-one asked the investment banking specialists whether their hierarchy of risks matched the Basel template. They are a different sort of animal, but they are not the target audience for Basel and so parallelism with Basel on this issue is not ideal and it’s not risk-sensitive."

Seal said the US SEC did not have a seat on the Basel Committee during the new Accord’s negotiations, so the regulator has been effectively out of the loop. As the SEC does not regulate on a consolidated basis, the difficulties are exacerbated, she said. Its officials are often unaware of regulatory challenges that investment banks are facing abroad.