Timetable chaos

The decision by US regulators last September to delay the implementation of Basel II by a year has caused plenty of uncertainty among banks and overseas regulators.

As the deadline loomed, US senators representing states whose banks have predominantly local operations – that is, most of them – hit the panic button. With the results of the fourth quantitative impact study showing that large banks applying the advanced internal ratings-based (IRB) approach would benefit from significant capital reductions, senators applied pressure on the US regulators, which in turn pulled the plug on the previously agreed timetable to implement Basel II. In the process, they also ruptured international banks' plans to co-ordinate their efforts to implement Basel II on a consolidated group basis (see box 1).

Described as "plain stupid" by one Basel II specialist at a large US bank, the delay raises questions as to how supervisors will approach the home/host issue and validate the models of those internationally active banks applying the advanced IRB approach. Now that banks and supervisors across the globe will be working to different implementation timetables, it is not clear how the aims outlined in the Basel Committee's home/host paper – to avoid wasteful duplication of effort – will be achieved.

A dozen or so of the largest US banks will now implement the advanced IRB approach in January 2009, with the first opportunity for banks to conduct parallel running being January 2008. The rest of the country's banking sector will remain on the 1988 Accord. Banks in Europe, meanwhile, will implement Basel II in accordance with the Capital Requirements Directive, with the standardised and foundation IRB approaches applied from January 2007, and the advanced IRB approach adopted from January 2008 after an extra year of parallel running. Many Asian countries, such as Hong Kong, Singapore and Japan, have also broadly adopted this timetable.

The Basel Committee's home/host paper, published in November last year, outlines a framework for the effective cross-border implementation of Basel II (see box 2). Generally, the home regulator should take the lead in the validation of models, and any questions from the host regulator should be directed to the home supervisor, rather than the bank. The document stresses the need for supervisory validation and approval of banks' models across jurisdictions, and recommends that supervisors improve information sharing to reduce the regulatory burden on banks and to conserve scarce supervisory resources.

Ryozo Himino, the secretary-general of the Basel Committee, explains that the main purpose of the consultative document is to offer guidance on how supervisors and banks can minimise the duplication of work. But he adds there cannot be a blanket prescription for how two supervisors in a given situation should work together.

"Flexibility is the key to effective execution of the document's home/host guidelines. The approaches of the home and host supervisor will differ from case to case, so how that information is shared depends on each situation," says Himino.

Most people agree with the paper's general principles. However, few risk managers or supervisors were able to say how that would work in practice given the differing implementation schedules between Europe/Asia and the US.

"This is a tricky area. Regulators have gone a long way to agreeing their respective responsibilities for validation work, but this is going to be complicated if different regulators are going to be working to different timetables," says Simon Topping, executive director of banking policy at the Hong Kong Monetary Authority, the territory's banking regulator. However, he adds that the US regulators have acknowledged this problem and have undertaken to co-operate with other supervisors in order not to hold up the process.

But even with the co-operation of US regulators, the delay creates a number of potential minefields. For example, what happens if a UK bank with a large US subsidiary wants to implement the advanced IRB approach from January 2008 across all its global operations, either because the bank itself wants to avoid duplication of efforts and costs, or because the home regulator wants to eliminate the potential for regulatory arbitrage by ensuring banks switch to advanced IRB across all its businesses at once? It means the US subsidiary will need to begin implementing advanced IRB systems at least one year before US banks.

However, the US regulator has not yet published its national implementation guidelines. Should the US subsidiary begin preparing for advanced IRB now to allow two years of parallel running, as required by the Basel Committee? If so, it runs the risk of the US regulators making use of the national discretion items within the framework to tweak the calibrations. Seeing as the US regulators delayed the implementation of Basel II because advanced IRB banks saw greater-than- expected reductions in regulatory capital, it suggests the supervisors will make changes to the calibrations of the Accord. Does this then mean US subsidiaries of foreign banks will have to subsequently change their systems to comply with the US requirements?

"We have a large US subsidiary, and we're still looking into how this will affect us," says the head of risk management at one major international bank. "We're not sure if our home regulator will insist that we implement advanced IRB across all our businesses. If they do, it will create a huge amount of extra work for our US office, particularly if the US regulations change."

Equally, what if a US bank decides it wants to adopt Basel II at its European subsidiaries as soon as possible from January 2007, perhaps because of competitive pressures? The home regulator is meant to take the lead in model validation. But if the US Federal Reserve is not formally ready to validate IRB models, the implication is that European supervisors would then have to take the lead in validating models themselves, leading to the duplication of validation efforts by the bank.

"European regulators would have to try and prevail upon the US authorities to bring forward some of the validation work or do it themselves," says one Basel II project director of a London-based investment bank.

Although it's reasonable for individual regulators to want to tweak the Basel II framework to suit the idiosyncrasies of their banking systems, and to insist that banks operating in their jurisdictions comply with their rules, too much divergence would threaten the original aim of the Accord – to create a globally consistent and more risk-sensitive framework for calculating regulatory capital.

One head of risk management at a large New York-based securities house fears that "the general flexibility in the interpretation of capital adequacy standards and their implementation dates will lead to the heterogeneity of standards, which is burdensome, expensive and confusing for all concerned".

However, the FSA is keen to play down the difficulties caused by the US delay. Paul Sharma, head of the UK regulator's prudential, risk and accounting department, says the US decision to delay is quite distinct from the issues discussed in the home/host consultation paper. "In practice, supervisors tend to co-operate more than they are obliged to because they tend to do very similar things. US regulators have always given their co- operation to European regulators. The lack of simultaneity in IRB model implementation may mean there will be some duplication of effort. But even so, there will be some parallel running of the old and the new capital Accords in both cases," he says. Sharma adds that it is legitimate for any jurisdiction to delay implementation of Basel II if it is not satisfied with the calibrations.

Nicholas Silitch, Bank of New York's head of the Basel II project office, acknowledges the concerns of US supervisors, but he warns that the delay, if combined with watering down of the Basel II calibrations, could affect US banks. "A conservative US-specific calibration would create an uneven playing field that would result in liquid high-grade exposures – funded and unfunded – flowing from large US banks to non-US banks and global securities markets. This regulatory capital arbitrage would impair the ability of US banks to compete globally."

The US decision to postpone

In September 2005, the four federal agencies responsible for regulating US banks jointly announced they would postpone the implementation of Basel II by one year. The banks' first opportunity for a parallel run will now be in January 2008, with a three-year transition period during which floors on minimum regulatory capital levels will be put in place. The floors are intended to be "simpler in design and more conservative in effect than those set forth in Basel II", the regulators say. A 95% floor will run in 2009, 90% in 2010 and 85% in 2011.

The decision to delay followed the fourth quantitative impact study early last year, which showed a larger than expected drop in regulatory capital for those banks implementing the advanced IRB approach, prompting smaller banks to complain they would be at a competitive disadvantage.

While Susan Schmidt-Bies, a member of the board of governors of the Federal Reserve, has publicly said the decision to delay was the outcome of "successful inter-agency co-operation", observers say the Fed never had any intention of delaying, and that the decision was only taken after a wrangle between the Federal Reserve and the Federal Deposits Insurance Corporation (FDIC), which oversees deposits and tends to represent the interests of smaller banks.

Critics say that dividing responsibility for banking supervision between four agencies – the Federal Reserve Board, FDIC, the Office of the Comptroller of the Currency (OCC) and the Office of Thrift Supervision – creates conflict and slows the decision-making process.

"The real problem is that we shouldn't have all these different regulators for the large banks," says one Basel II specialist at a US bank. "The regulator that oversees deposits should be the same regulator that oversees the safety and soundness of the banks. The FDIC has a very narrow perspective – why shouldn't it be concerned with issues such as liquidity, volatility and long-term outlooks? If the Fed, FDIC and OCC were merged into one agency, life would be much better."

He continues: "Outside New York and North Carolina, other senators represent states with small banks. The FDIC, which was left out of the process several years ago, had their noses put out of joint. That was a huge mistake by the Fed. The FDIC got the small banks to believe they were disadvantaged and the Fed and the OCC got hauled in front of Congress."

Both the Federal Reserve and FDIC declined to comment.

2. The Basel Committee's home/host paper

The Basel Committee's Core Principles Liaison Group, in association with the Accord Implementation Group, published a consultative document in November 2005 aimed at enhancing home/host supervisory information sharing guidelines. Available on the Bank for International Settlements' website (www.bis.org), its purpose is to aid the effective cross-border implementation of Basel II, with the ultimate goal of reducing the regulatory burden on banks and conserving supervisory resources.

The paper sets out some general principles and gives some practical examples to help banking supervisors with implementation. For example, the home supervisor "is responsible for the oversight of the implementation of Basel II for a banking group on a consolidated basis", but acknowledges that "host supervisors' knowledge of local market conditions can be an essential input into the home supervisor's assessment of the banking group".

The type of information to be shared may include reviews of local Basel II systems and processes and of local risk management processes, such as loan rating methodologies. Equally, host supervisors may have legitimate concerns about the home supervision of a bank's Basel II implementation, which "should be communicated separately to the home supervisor".

The reaction to the paper has been positive, but many bankers also raise doubts as to how the paper will be interpreted by supervisors across the globe. "There is a capital regime that is very much geared towards the way global banks operate. However, the regime needs to be forced through regulatory and supervisory mechanisms that are very jurisdictional," says Andrew Cross, Basel II programme director at Credit Suisse in London.

Another Basel project manager goes further, pointing out the proposals "will have to navigate the many egos out there, as there are some developing country host regulators that can be parochial in their mindset and don't give any thought to the practicalities of consolidated supervision".


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