GAO report: common sense with a twist

The report is neither the harbinger of doom that much of the anti-Basel II lobby was praying for, nor is it a wholehearted endorsement of how the Basel II drama has played out in the US. Instead, it is, for the most part, a rather sensible document and the kind of thing we really need to see more of in the Basel II debate in the US.

I suppose the one disappointment for the industry is the GAO's endorsement of the regulatory capital floors and restrictions on US banks. Some of the nation's biggest financial institutions have lobbied hard to have these removed.

And I could see their point. The "great handshake" of Basel II was that the industry would invest in better systems and people, in exchange for a reduction in regulatory capital. What the US regulators were implementing fell far outside that agreement.

I have had mixed feelings about this element of the US framework, and up until now, have fallen pretty squarely on the side of the banks on the issue of capital floors. But that was until I read the GAO report.

On page 75, it points out that the regulators are having a tough time training, hiring and retaining people, and that this "resource constraint" is likely to get worse, not better, under the Basel II regime.

"Yet," says the report, "it is a critical point because under Basel II, regulators' judgement will likely play an increasingly important role in determining capital adequacy."

Wow, what a confession. Essentially the capital floors have been put in place because the regulators don't have enough of the right sort of people to assess the industry's capital models and make Pillar II judgement calls.

From the industry's point of view, this must be very frustrating. But on the other hand, this problem has been caused by the industry - they keep raiding regulators' stock of talent.

To be blunt, if the regulators can't validate banks' Basel II frameworks properly, then imposing capital floors is probably the right move from a safety and soundness point of view.

For me, one question remains. If the US - a famously dynamic source of human resources talent - can't muster the regulatory staff to validate the frameworks, what hope do other nations have of validating them properly?

And, if the frameworks aren't being thoroughly road-tested, could we be potentially looking at problems with regulatory capital levels in the future if we suffer a global downturn?

Have a good month.