US investment banks create myriad problems for Basel II

NEW YORK -- As financial institutions and banking regulators settle down to the challenge of implementing Basel II, a substantial problem has emerged for US investment banks. Not only will their overseas subsidiaries receive harsh treatment at the hands of Basel II, but their home regulator, the SEC, says it is not sure when it will release guidance on its own plans to implement Basel II within the US, leaving firms in the dark.

European regulators, such as the UK’s FSA, have already made it very clear they will consider US investment banks, such as Morgan Stanley, Goldman Sachs and Merrill Lynch, as falling under the Basel II umbrella. Says an FSA official, "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." This means that US investment banks will be asked by regulators to apply either the TSA or the 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 TSA, which industry observers say will probably be used as an unofficial benchmark by regulators validating AMA models. Both corporate finance, trading and sales have 18% betas assigned to them under the TSA, 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,’" says Katharine Seal, a director at the London Investment Banking Association (LIBA) 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."

Indeed, Seal notes that 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. The fact that the SEC does not regulate on a consolidated basis is adding to the difficulties, she says, so often it’s officials are unaware of regulatory challenges that investment banks are facing abroad.

Focus on TSA recalibration

According to a number of sources, the EU Commission and the FSA are set to consider the recalibration of TSA betas for investment banking firms, so betas for US investment banks would take their relative expertise in corporate finance, sales and trading into account. Trade associations admit to having a mixed reaction to this suggestion -- on one hand their investment bank members would be pleased, but commercial banks with such operations would effectively be penalised, by having higher betas than their direct competitors. Says Simon Wills, a director at the British Bankers’ Association in London, "We want to see a resolution within the bounds of competitive equality. Fundamentally, we think it should be same risk, same charge."

Another issue is the fact that the SEC has yet to make its own Basel II plans public -- the agency has not been included in Congressional hearings on the subject, and is not a signatory to the US ANPR. Nor is the agency included in the language of a bill making its way through the US House of Representatives to restructure the Basel II process in the US (see page 24).

"The staff, of course, are aware of Basel II," says an official at the SEC in Washington, DC. "They are looking at the standards that were set out and are developing a position as to how investment banks in the US under our regulatory regime will be dealt with generally, including considering the Basel II standards." Currently US investment banks are regulated under the so-called net capital rule. Under this directive, operational risk is rolled up into the credit risk charge. The SEC will not disclose a timetable for release of this study by its market regulation division, however, beyond saying it would give the public one weeks’ notice of the meeting at which the new rules would be published.

However, global regulators, academics and politicians are keeping a close eye on what the SEC does -- for competitive reasons they’d prefer that US investment banks are subject to the same Basel II framework as other such institutions will be elsewhere. But they also muster other arguments. "I think it’s a real shortcoming of Basel II that nobody thought of the investment banks," said Paul Welfens, a professor at the European Institute for International Economic Relations, at the University of Wuppertal, in Germany. He was speaking at an EU Parliament workshop in Brussels on Basel II and SMEs held in mid-July. "We’ve had scandals in the United States in the late 1990’s, which have led to the stockmarket hype, the over investment, and now what we all suffer from, under investment. If this is not going to be treated in Basel II, it must be on the agenda for Basel III." OpRisk