Risk-Based Capital: Bank Regulators Need to Improve Transparency 
and Overcome Impediments to Finalizing the Proposed Basel II	 
Framework (15-FEB-07, GAO-07-253).				 
                                                                 
Concerned about the potential impacts of the proposed risk-based 
capital rules, known as Basel II, Congress mandated that GAO	 
study U.S. implementation efforts. This report examines (1) the  
transition to Basel II and the proposed changes in the United	 
States, (2) the potential impact on the banking system and	 
regulatory required capital, and (3) how banks and regulators are
preparing for Basel II and the challenges they face. To meet	 
these objectives, GAO analyzed documents related to Basel II and 
interviewed various regulators and officials from banks that will
be required to follow the new rules.				 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-07-253 					        
    ACCNO:   A65970						        
  TITLE:     Risk-Based Capital: Bank Regulators Need to Improve      
Transparency and Overcome Impediments to Finalizing the Proposed 
Basel II Framework						 
     DATE:   02/15/2007 
  SUBJECT:   Bank examination					 
	     Bank management					 
	     Banking law					 
	     Banking regulation 				 
	     Federal regulations				 
	     Federal reserve banks				 
	     Internal controls					 
	     Policy evaluation					 
	     Program management 				 
	     Regulatory agencies				 
	     Risk management					 
	     Standards						 
	     Program goals or objectives			 
	     Program implementation				 

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GAO-07-253

   

     * [1]Results in Brief
     * [2]Background

          * [3]U.S. Regulators Responsible for Implementing Basel II
          * [4]Existing Regulatory Capital Framework

     * [5]The Transition to Basel II Has Been Driven by Limitations of

          * [6]Basel I Is a Simple Framework with Broad Risk Categories Tha
          * [7]Basel I Does Not Reflect Financial Innovations and Risk Mana

     * [8]Federal Regulators Are Proposing a Regulatory Capital Framew

          * [9]Basel II Is an International Framework Based on Shared Regul
          * [10]U.S. Regulators Propose to Apply Basel II Only to Large and/
          * [11]U.S. Regulators Have Revised Time Frames for Implementation
          * [12]U.S. Regulators Proposed Basel IA and Plan to Retain Basel I
          * [13]U.S. Regulators Plan to Retain the Leverage Requirement and
          * [14]The U.S. Proposal Differs in Other Ways from the Internation

     * [15]Basel II Is Expected to Improve Risk Management and Enhance

          * [16]Basel II Preparations Have Contributed to Improved Risk Mana
          * [17]Basel II Models Could Improve the Risk Sensitivity of Capita

               * [18]More Risk-Sensitive Capital Requirements Could Improve
                 Safet
               * [19]A-IRB Approach for Credit Risk Has Strengths and
                 Weaknesses
               * [20]AMA for Operational Risk Also Has Strengths and
                 Weaknesses
               * [21]Using Bank Models for Regulatory Capital Purposes
                 Increases

          * [22]Changes in Capital Requirements Could Affect Competition amo
          * [23]The Impact of Basel II on the Level of Bank Capital Is Uncer

               * [24]Quantitative Impact Study Raised Concerns about Large
                 Drops
               * [25]The Parallel Run, Transitional Floors and Leverage Ratio
                 Wou
               * [26]Basel II Required Capital Could Vary over the Business
                 Cycle
               * [27]Impact of Basel II on Total Capital Held Is Uncertain
                 Becaus

     * [28]Core Banks Are Incorporating Basel II into Ongoing Efforts t

          * [29]Core Banks Are Working to Integrate Basel II into Existing E
          * [30]Core Banks Are Investing in Information Technology, Such as
          * [31]Core Banks Reported That They Were Training Employees and Hi
          * [32]Core Banks Reported Having Incurred Significant Monetary Cos
          * [33]Core Banks Face Challenges, Including the Lack of a Final Ru

     * [34]U.S. Regulators Are Integrating Preparations for Basel II in

          * [35]Regulators Have Been Building on Experience Overseeing Risk
          * [36]Regulators Plan to Integrate Basel II into Their Existing Su
          * [37]Regulators Are Taking Steps toward Eventual Qualification of
          * [38]Hiring and Training Supervisory Staff Is an Important Part o
          * [39]Regulators Are Coordinating Domestically and Internationally
          * [40]Regulators Face Impediments in Finalizing the Rule That if L

               * [41]Regulators' Differing Perspectives and Goals Fuel
                 Ambiguity
               * [42]Lack of Transparency and Ongoing Ambiguity Contribute to
                 Que
               * [43]Questions about Reliability of Bank Data Remain an Issue
               * [44]Questions about Pillar 3 Disclosure Requirements Remain

     * [45]Conclusions
     * [46]Recommendations
     * [47]Agency Comments and Our Evaluation

          * [48]Pillar 1: Minimum Capital Requirements

               * [49]Credit Risk
               * [50]Operational Risk
               * [51]Market Risk

          * [52]Pillar 2: Supervisory Review
          * [53]Pillar 3: Market Discipline in the Form of Increased Disclos

     * [54]GAO Contacts
     * [55]Staff Acknowledgments
     * [56]GAO's Mission
     * [57]Obtaining Copies of GAO Reports and Testimony

          * [58]Order by Mail or Phone

     * [59]To Report Fraud, Waste, and Abuse in Federal Programs
     * [60]Congressional Relations
     * [61]Public Affairs

Report to Congressional Committees

United States Government Accountability Office

GAO

February 2007

RISK-BASED CAPITAL

Bank Regulators Need to Improve Transparency and Overcome Impediments to
Finalizing the Proposed Basel II Framework

GAO-07-253

Contents

Letter 1

Results in Brief 3
Background 9
The Transition to Basel II Has Been Driven by Limitations of Basel I and
Advances in Risk Management at Large Banking Organizations 14
Federal Regulators Are Proposing a Regulatory Capital Framework that
Differs from the International Basel II Accord in Several Respects 19
Basel II Is Expected to Improve Risk Management and Enhance Capital
Allocation, While Proposed Safeguards Would Help to Prevent Large Capital
Reductions during a Temporary Transition Period 36
Core Banks Are Incorporating Basel II into Ongoing Efforts to Improve Risk
Management, but Challenges Remain 53
U.S. Regulators Are Integrating Preparations for Basel II into Their
Current Supervisory Process but Face a Number of Impediments 59
Conclusions 74
Recommendations 77
Agency Comments and Our Evaluation 79
Appendix I Scope and Methodology 83
Appendix II U.S. and International Transition to Basel II 86
Appendix III Basel II Descriptive Overview 88
Appendix IV Comments from the Board of Governors of the Federal Reserve
System 93
Appendix V Comments from the Office of the Comptroller of the Currency 96
Appendix VI Comments from the Federal Deposit Insurance Corporation and
the Office of Thrift Supervision 98
Appendix VII Comments from the Department of the Treasury 100
Appendix VIII GAO Contacts and Staff Acknowledgments 102
Related GAO Products 103

Tables

Table 1: Major Types of Banking Risks 9
Table 2: U.S. Basel I Credit Risk Categories 15
Table 3: Differences in U.S.-Proposed Implementation of Basel II and
International Accord 28

Figures

Figure 1: The Three Pillars of Basel II 21
Figure 2: Banks that Meet U.S.-Proposed Criteria for Mandatory Adoption of
Basel II 24
Figure 3: Sensitivity to Credit Risk for Mortgages under Basel I and Basel
IA 30
Figure 4: U.S. Regulatory Capital Requirements 33
Figure 5: Leverage Ratio vs. Basel II Credit Risk Required Capital for
Externally Rated Corporate Exposures, by Rating 48
Figure 6: Leverage Ratio vs. Basel II Credit Risk Required Capital for
Mortgages, by Probability of Default 50
Figure 7: Computation of Capital Requirements for Wholesale and Retail
Credit Risk under Basel II 89

Abbreviations

A-IRB Advanced Internal Ratings-Based Approach
AMA Advanced Measurement Approaches
ANPR advance notice of proposed rulemaking
EAD exposure at default
FDIC Federal Deposit Insurance Corporation
LDA loss distribution approach
LGD loss given default
LTV loan-to-value
MRA Market Risk Amendment
NPR Notice of Proposed Rulemaking
OCC Office of the Comptroller of the Currency
OTS Office of Thrift Supervision
PCA prompt corrective action
PD probability of default
QIS-4 Fourth Quantitative Impact Study
SEC Securities and Exchange Commission
VAR value-at-risk

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United States Government Accountability Office

Washington, DC 20548

February 15, 2007

The Honorable Christopher Dodd
Chairman
The Honorable Richard Shelby
Ranking Member
Committee on Banking, Housing, and Urban Affairs
United States Senate

The Honorable Barney Frank
Chairman
The Honorable Spencer Bachus
Ranking Member
Committee on Financial Services
House of Representatives

For nearly a decade, federal banking regulators have been considering
revisions to risk-based capital rules that could have far-reaching
consequences for the safety, soundness, and efficiency of the U.S. banking
system.^1 The original risk-based capital rules, known as Basel I, were
adopted by the Basel Committee on Banking Supervision in 1988 and
implemented in the United States in 1989.^2 The proposed changes, known as
Basel II, are based on an internationally adopted framework developed by
the Basel Committee. Basel II aims to align minimum capital requirements
with enhanced risk measurement techniques and to encourage banks to
develop a more disciplined approach to risk management. In the United
States, Basel II rules are intended to apply primarily to the largest and
most internationally active banking organizations. U.S. regulators expect
about 11 banking organizations (core banks), which account for close to
half of U.S. banking assets, to be required to implement Basel II. As
such, regulators must take care to ensure that Basel II functions as
intended to help preserve the safety and soundness of the banking system
and mitigate the risk of losses to the federal deposit insurance fund.

^1Capital is generally defined as a firm's long-term source of funding,
contributed largely by a firm's equity stockholders and its own returns in
the form of retained earnings. One important function of capital is to
absorb losses. The federal banking regulators are the Federal Reserve
System (Federal Reserve), Federal Deposit Insurance Corporation (FDIC),
Office of the Comptroller of the Currency (OCC), and Office of Thrift
Supervision (OTS).

^2The Basel Committee on Banking Supervision (Basel Committee) seeks to
improve the quality of banking supervision worldwide, in part by
developing broad supervisory standards. The Basel Committee consists of
central bank and regulatory officials from 13 member countries: Belgium,
Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain,
Sweden, Switzerland, United Kingdom, and United States. The Basel
Committee's supervisory standards are also often adopted by nonmember
countries.

However, in moving toward the proposed Basel II framework, a number of
serious concerns have been raised by regulatory officials, banks,
academics, and congressional and industry stakeholders. First,
considerable uncertainty remains about the appropriate level of minimum
required capital and the potential impact of the proposed rules on minimum
required risk-based capital levels. Second, the proposed rules depend in
part on the reliability of banks' internal models, and some observers have
expressed concerns about using banks' internal models for establishing
regulatory capital requirements. Third, the increased complexity of
regulatory capital calculations undertaken by banks heightens the
challenge of effective oversight by banking regulators. Fourth, the U.S.
proposed rules differ in some respects from those of other countries,
raising concerns about possible competitive effects of different rules
between domestic and foreign banking organizations. Concerns have also
been raised about domestic competitive inequities between banks that adopt
Basel II and those that do not.

In light of these concerns, Congress has held several oversight hearings
that have provided valuable information on regulatory objectives, actions,
and potential pitfalls throughout the ongoing rule-making process. As part
of this effort, Congress mandated that we review the implementation of
Basel II in the United States.^3 To date, federal regulators have
requested public comment on a Basel II Advance Notice of Proposed
Rulemaking (ANPR) and Notice of Proposed Rulemaking (NPR). They also have
proposed additional changes, known as Basel IA, to establish simpler
revisions to the regulatory capital framework for banks not subject to
Basel II.^4 However, regulators do not expect to issue final rules until
later in 2007. Because the rule-making process is not complete, this
report can address only certain aspects of the implementation process to
date. Specifically, this report examines the following:

^3Federal Deposit Insurance Reform Conforming Amendments Act of 2005, Pub.
L. No 109-173 S 6(e) (Feb. 15, 2006).

^4The Basel II NPR and Basel IA NPR were published in the Federal Register
on September 25, 2006, and December 26, 2006, respectively. The comment
periods for both NPRs will close on March 26, 2007.

           1. developments leading to the transition to Basel II,
           2. the proposed changes to the U.S. regulatory capital framework,
           3. the potential implications of Basel II's quantitative
           approaches and their potential impact on required capital,
           4. banks' preparations and related challenges, and
           5. U.S. regulators' preparations and related challenges.

To meet our objectives, we reviewed the Basel II international accord, the
U.S. proposed rules for Basel II and Basel IA, draft supervisory guidance,
and related materials. We interviewed officials at the federal bank
regulatory agencies to obtain their views. We also interviewed officials
at each of the banks that, under the proposed rule, would be required to
adopt Basel II; a sample of banks that may opt into Basel II (based in
part on size and primary regulator); a state bank regulator and an
association of state bank supervisors; two bank trade associations; and
two credit rating agencies. To understand how regulators oversee risk
management processes at core banks and how the regulators are planning to
incorporate Basel II into their examinations, we interviewed bank
examiners and reviewed examination reports. We also compared the proposed
capital requirements for different assets to demonstrate how related
capital requirements may change, depending on the business cycle and the
estimated level of risk of holding certain assets. We conducted our work
from April 2006 to January 2007 in accordance with generally accepted
government auditing standards. More information on our scope and
methodology appears in appendix I.

Results in Brief

The motivation to revise risk-based capital requirements in the United
States and internationally has been driven by the limitations of Basel I,
especially for large, complex banking organizations, and by advances in
risk management at these organizations. Regulatory officials generally
agree that while Basel I continues to be an adequate capital framework for
most banks, several limitations have rendered it increasingly inadequate
for supervising the capital adequacy of the nation's largest, most complex
banks. For example, Basel I's simple risk weighting approach does not
adequately differentiate between assets that have different risk levels,
offers only a limited recognition of credit risk mitigation techniques,
and does not explicitly address all risks faced by banking organizations.
In addition, significant financial innovations have occurred since Basel I
was established in 1988 to the point where a bank's regulatory capital
ratios may not always be useful indicators of its risk profile. Many large
banks have also developed advanced risk measurement techniques--including
economic capital models--which regulators have sought to encourage both as
an element of strong risk management and because such techniques may
provide useful input to the supervisory process. By more closely aligning
regulatory capital methodologies with banks' internal economic capital
methodologies, Basel II aims to encourage large banks to develop and
maintain a more disciplined approach to risk management.

While Basel II is an international accord based on shared regulatory
objectives, U.S. regulators are proposing a regulatory capital framework
that differs from the international accord in several ways. As recognized
in the international accord, the United States and other adopting
countries have used different degrees of national discretion in developing
their own national rules to implement Basel II. The U.S.-proposed changes
would result in three risk-based capital regimes--Basel II, Basel IA, and
Basel I--largely based on a banking organization's size and complexity.
While the Basel II international accord allows for the option of choosing
from among several risk measurement approaches, U.S. regulators have
proposed to limit the scope of Basel II to the advanced approaches and to
require it only for the largest and/or most internationally active banks.
These advanced approaches depend in part on a bank's own internal models.
However, regulators have requested public comments on simpler approaches
for determining minimum required capital--such as the "standardized
approach" in the international accord and the U.S. Basel IA rule--as
possible options for Basel II banks.^5 U.S. regulators also have delayed
implementation of the changes to the regulatory capital framework in
response to concerns raised by a quantitative impact study about the
potential adverse impact of Basel II on regulatory capital. They also have
proposed prudential safeguards beyond those in the international accord,
such as more conservative limits on permissible reductions in required
capital during the transition period for Basel II banks. For banks not
subject to Basel II, U.S. regulators have proposed Basel IA, which
consists of simpler revisions to Basel I, to address potential domestic
competitive inequities among banks. U.S. regulators also plan to retain
Basel I as an option for banks not required to adopt Basel II. Finally,
regulators plan to retain the existing leverage ratio and prompt
corrective action requirements for all banks.^6

5The standardized approach for credit risk creates several additional risk
categories but does not rely on banks' internal models for estimating risk
parameters used to calculate risk-based capital requirements.

The new capital framework could improve bank risk management and make the
allocation of capital more risk sensitive, but the impact of Basel II on
minimum capital requirements and the actual amount of capital held by
banks is uncertain. The advanced Basel II risk-modeling approaches have
the potential to better align capital with risk, such that banks would
face minimum capital requirements more sensitive to their underlying
risks. However, the advanced approaches themselves are not without risks,
and realizing the benefits of these approaches will depend on (1) the
adequacy of bank quality assurance processes and supervisory review
surrounding the development and maintenance of models, (2) the sufficiency
of credit default and operational loss event data used as inputs to the
regulatory and bank models that determine capital requirements, and (3)
regulators' attention to the appropriate level of risk-based capital.
Possible differences in regulatory capital requirements across banks
subject to different risk-based capital regimes have raised some banks'
concerns about competition between large and small banks domestically, and
between large banks headquartered in the United States and foreign banking
organizations. While initial estimates of the potential impact of Basel II
showed large drops in minimum required risk-based capital, a considerable
amount of uncertainty remains about the potential impact of Basel II on
the level of regulatory capital requirements and the degree of variability
in these requirements over the business cycle. The banking regulators have
committed to broadly maintaining the current level of risk-based
regulatory capital and have proposed safeguards that would limit
regulatory capital reductions during a transition period. Regulators have
also stated that banks under Basel II would continue to be subject to the
leverage ratio, which while making required capital somewhat less risk
sensitive, would also prevent significant reductions in capital. Basel
II's impact on the total amount of capital held by banks, which would
include capital held above the regulatory minimum, is also uncertain,
given banks' internal assessments of capital needs and the amount of
actual capital the market and rating agencies expect them to hold. In
light of the uncertainty concerning the potential impact of Basel II,
these issues will require further and ongoing examination as the banking
regulators continue to finalize the Basel II rule and proceed with the
parallel run and transition period.

^6As discussed later in this report, banks and bank holding companies are
subject to minimum leverage requirements, as measured by a ratio of tier 1
capital to total assets. Prompt corrective action (PCA) is a supervisory
framework for banks that requires regulators to take increasingly
stringent forms of corrective action against banks as their leverage and
risk-based capital ratios decline.

Officials from most core banks with whom we spoke reported that they are
making significant progress in further enhancing their risk management
practices but said that they faced several challenges, including
uncertainty about what the final rule would require. Most officials at
core banks stated that the banks had been working to improve the way they
assessed and managed credit, market, and other types of risks, including
the allocation of capital for these risks, for some years and were largely
integrating their preparations for Basel II into their current efforts.
Some officials saw Basel II as a continuation of the banking industry's
evolving risk management practices and risk-based capital allocation that
regulators had encouraged. Many officials reported that their banks were
investing in information technology and establishing processes to manage
and quantify credit and operational risk, including collecting data on
credit defaults and operational losses, in order to meet the regulatory
requirements proposed for the advanced approaches. To varying extents,
many core banks are training staff and have hired additional staff to
implement Basel II. Furthermore, officials at most core banks said that
they had or would incur significant monetary costs and were allocating
many resources to implement Basel II. However, many officials reported
that their banks faced several challenges in implementing Basel II,
including the lack of a final rule, difficulty obtaining data that met the
minimum requirements for the advanced approaches for all asset portfolios
and data on operational losses, and difficulty aligning their existing
systems and processes with the proposed rule. Overall, core bank officials
with whom we spoke viewed Basel II as an improvement over Basel I, and
officials from noncore banks that were considering adopting Basel II
stated that they believed the new regulatory capital framework would
further improve their risk management practices.

Likewise, U.S. regulators are integrating preparations for Basel II into
their current supervisory process, but a number of issues remain to be
resolved as regulators finalize the rule. In preparation for Basel II
implementation, bank regulatory officials said they had been integrating
plans for Basel II's additional supervisory requirements into their
existing oversight processes and supervisory reviews of banks' risk
management. Regulators are also preparing for the process of qualifying
banks to move to Basel II; coordinating with other U.S. and international
regulators; hiring additional staff with needed quantitative skills; and
training current supervisory staff, including examiners. However,
regulators face a number of impediments in their efforts to agree on a
final rule for the transition to Basel II. The uncertainty about Basel
II's potential impact and different regulatory perspectives made reaching
agreement on the NPR difficult, as is likely to be the case for the final
rule. Regulators have yet to resolve some of the uncertainty and increase
the transparency of their thinking by providing more specific information
about certain outstanding issues, such as the following:

           o how they will treat portfolios that may lack adequate data to
           meet regulatory requirements for the advanced approaches,
           o how they will calculate reductions in aggregate minimum
           regulatory capital and what would happen if a reduction exceeds a
           proposed 10-percent trigger, and
           o what criteria they will use to determine the appropriate average
           level of required capital and appropriate cyclical variation in
           minimum regulatory capital.

           Moreover, the process could benefit from greater transparency
           going forward--for example, by the regulators providing additional
           information to facilitate understanding how they will assess the
           Basel II results during the transition years and how they will
           report on any modifications to the rule during that period. If
           these issues are not addressed, the ongoing ambiguity and lack of
           transparency could result in continued uncertainty about the
           appropriateness of Basel II as a regulatory capital framework.

           With the use of safeguards during the transition period, it is
           appropriate for U.S. banking regulators to proceed with finalizing
           Basel II and proceed with the parallel run and transition period.
           To help reduce the uncertainty about the potential impact of Basel
           II, improve transparency, and address impediments that regulators
           face in transitioning to Basel II, we are making several
           recommendations to the heads of the Federal Reserve System
           (Federal Reserve), Federal Deposit Insurance Corporation (FDIC),
           the Office of the Comptroller of the Currency (OCC), and the
           Office of Thrift Supervision (OTS):

                        o As part of the process leading to the proposed
                        parallel run and transition period, regulators need
                        to clarify certain issues in the proposed final rule,
                        including how they will treat portfolios that may
                        lack adequate data to meet regulatory standards for
                        the advanced approaches, how they will calculate the
                        10-percent reduction in aggregate minimum regulatory
                        capital and respond if this reduction is triggered,
                        and the criteria regulators will use to determine the
                        appropriate average level of required capital and the
                        appropriate level of cyclical variation in minimum
                        required capital.

                        o Regulators should issue a new NPR before finalizing
                        the Basel II rule, if the final rule differs
                        materially from the NPR or if a U.S. standardized
                        approach is an option in the final rule.

                        o Regulators should also periodically publicly report
                        on the progress and results of the proposed parallel
                        run and transition period along with any needed
                        regulatory alignments.

                        o Finally, regulators need to reevaluate, at the end
                        of the last transition period, whether the advanced
                        approaches of Basel II can and should be relied on to
                        set appropriate regulatory required capital in the
                        long term. Based on the information obtained during
                        the transition, this reevaluation should include a
                        range of options, including consideration of
                        additional minor modifications to U.S. Basel II as
                        well as whether more fundamental changes are
                        warranted to set appropriate required regulatory
                        capital levels.

           We received written comments on a draft of this report from the
           Federal Reserve, OCC, FDIC and OTS in a joint letter, and the
           Department of the Treasury. These letters are reprinted in
           appendixes IV through VII. The banking agencies and Securities and
           Exchange Commission (SEC) also provided technical comments, which
           we incorporated in the report where appropriate. The Federal
           Reserve and OCC concurred with our recognition of Basel I's
           limitations for large and/or internationally active banks and
           agreed with our conclusion that the regulators should finalize the
           Basel II rule and proceed with the parallel run and transition
           period. OCC said its position has been to move forward with strong
           safeguards in place and assess the need for adjustment during the
           transition period before removing any temporary safeguards. OCC,
           and FDIC and OTS in their joint letter, noted that the U.S.
           proposals leave two safeguards that are not temporary in
           place--the leverage ratio and prompt corrective action
           framework--and that these underscore the agencies' commitment to
           maintaining a safe and sound banking industry. The Federal Reserve
           commented that it and the other regulators had attempted to be as
           transparent as possible in the rule-making process consistent with
           the letter and spirit of the Administrative Procedure Act, and OCC
           commented that it will ensure that the rule-making process remains
           compliant with the act. FDIC and OTS said they believe serious
           consideration of a U.S. version of the Basel II standardized
           approach should be considered as an option for all U.S. banks.

           The Federal Reserve said it concurred with our recommendations and
           would seek to implement them. OCC, FDIC, and OTS said they will
           consider our recommendations as part of their overall review of
           the comments received on the NPR. Treasury expressed concern with
           our recommendation on the possible issuance of a new NPR, saying
           that the overlapping comment periods for Basel II and IA should
           give commenters the ability to opine on implementation issues and
           options. We realize that an additional NPR would further delay the
           Basel II process; however, under certain circumstances an
           additional NPR would be a necessary step to provide more
           transparency to the process and to ensure that the full
           implications of the final rule are fully considered. In response
           to comments on this recommendation from the Federal Reserve, OCC,
           and Treasury, we have clarified the wording of our recommendation
           to more clearly state the need for a new NPR if the regulators
           intend to issue a final rule that is materially different from the
           NPR or if they intend to provide a U.S. standardized approach.
			  
			  Background

           The business of banking involves taking and managing a variety of
           risks. Major risks facing banking institutions include those
           listed in table 1.

           Table 1: Major Types of Banking Risks
			  
			  Risk               Definition                                              
Credit risk        The potential for loss resulting from the failure of a  
                      borrower or counterparty to perform on an obligation.   
Market risk        The potential for loss resulting from movements in      
                      market prices, including interest rates, commodity      
                      prices, stock prices, and foreign exchange rates.       
Interest rate risk A type of market risk that involves the potential for   
                      loss due to adverse movements in interest rates.^a      
Operational risk   The risk of loss resulting from inadequate or failed    
                      internal processes, people, and systems or from         
                      external events.                                        
Liquidity risk     The risk that a bank will be unable to meet its         
                      obligations when they come due, because of an inability 
                      to liquidate assets or obtain adequate funding.         
Concentration risk The risk arising from any single exposure or group of   
                      exposures with the potential to produce losses large    
                      enough to threaten a bank's health or ability to        
                      maintain its core operations.                           
Reputational risk  The potential for loss arising from negative publicity  
                      regarding an institution's business practices.          
Compliance risk    The potential for loss arising from violations of laws  
                      or regulations or nonconformance with internal policies 
                      or ethical standards.                                   
Strategic risk     The potential for loss arising from adverse business    
                      decisions or improper implementation of decisions.      

           Source: GAO.

           aAs discussed later in this report, current and proposed
           risk-based capital rules require banks with significant trading
           activity to hold capital for market risk from their trading
           activities. However, the current and proposed rules do not
           explicitly require capital for interest rate risk arising from
           nontrading activities.

           Changes in the banking industry and financial markets have
           increased the complexity of banking risks. Banking assets have
           become more concentrated among a small number of very large,
           complex banking organizations that operate across a wide range of
           financial products and geographic markets. Due to these
           organizations' scale and roles in payment and settlement systems
           and in derivatives markets, a significant weakness in any one of
           these entities could have severe consequences for the safety and
           soundness of the banking system and broader economy. As a result,
           federal banking regulators have adopted a risk-focused approach to
           supervision that emphasizes continuous monitoring and assessment
           of how banking organizations manage and control risks. Faced with
           such risks, banks must take protective measures to ensure that
           they remain solvent. For example, banks are required to maintain
           an allowance for loan and lease losses to absorb estimated credit
           losses. Banks must also hold capital to absorb unexpected losses.
           Capital is generally defined as a firm's long-term source of
           funding, contributed largely by a firm's equity stockholders and
           its own returns in the form of retained earnings. In addition to
           absorbing losses, capital performs several other important
           functions: it promotes public confidence, helps restrict excessive
           asset growth, and provides protection to depositors and the
           federal deposit insurance fund.

           Capital adequacy is fundamental to the safety and soundness of the
           banking system, and a bank's capital position can affect its
           competitiveness in several ways. Strong capital enhances a bank's
           access to liquidity on favorable terms and ensures that it has the
           financial flexibility to respond to market opportunities. However,
           holding capital imposes costs on banks, because equity is a more
           costly form of financing than debt. Capital adequacy regulation
           seeks to offset banks' disincentives to hold capital, which result
           in part from access to federal deposit insurance. In addition,
           capital adequacy requirements for large banks are especially
           important because of the systemic risks these banks can pose to
           the banking system. Regulators require banks to maintain certain
           minimum capital requirements and generally expect banks to hold
           capital above these minimums, commensurate with their risk
           exposure. However, requiring banks to hold more capital may reduce
           the availability of bank credit and reduce returns on equity to
           shareholders. In addition, capital requirements that are too high
           relative to a bank's risk profile may create an incentive for a
           bank to hold more high-risk assets, in order to earn a
           market-determined return on capital. Banking regulators attempt to
           balance safety and soundness concerns with the costs of holding
           higher capital.
			  
			  U.S. Regulators Responsible for Implementing Basel II

           Four federal banking regulators supervise the nation's banks and
           thrifts, and each serves as primary federal regulator over certain
           types of institutions:

           o OCC supervises national (i.e., federally chartered) banks. Many
           of the nation's largest banks are federally chartered.
           o The Federal Reserve supervises bank holding companies, including
           financial holding companies, as well as state chartered banks that
           are members of the Federal Reserve System (state member banks).
           Many of the largest banking organizations are part of holding
           company structures--companies that hold stock in one or more
           subsidiaries--and the Federal Reserve supervises bank holding
           company activities.
           o FDIC serves as the deposit insurer for all banks and thrifts and
           has backup supervisory authority for all banks it insures. It is
           also the primary federal regulator of state chartered banks that
           are not members of the Federal Reserve System (state nonmember
           banks).
           o OTS regulates all federally insured thrifts, regardless of
           charter type, and their holding companies.^7

           Under the dual federal and state banking system, state chartered
           banks are supervised by state regulatory agencies in addition to a
           primary federal regulator. In addition to these banking
           regulators, SEC supervises broker-dealers. In 2004, SEC
           established a voluntary, alternative net capital rule for
           broker-dealers whose ultimate holding company consents to
           groupwide supervision as a consolidated supervised entity. The
           rule requires consolidated supervised entities to compute and
           report capital adequacy measures consistent with Basel standards.
			  
			  Existing Regulatory Capital Framework

           The U.S. regulatory capital framework includes both risk-based and
           leverage minimum capital requirements. Both banks and bank holding
           companies are subject to minimum leverage standards, measured as a
           ratio of tier 1 capital to total assets.^8 The minimum leverage
           requirement is between 3 and 4 percent, depending on the type of
           institution and a regulatory assessment of the strength of its
           management and controls.^9 Leverage ratios are a commonly used
           financial measure of risk. Greater financial leverage, as measured
           by higher proportions of debt relative to equity (or lower
           proportions of capital relative to assets), increases the
           riskiness of a firm. During the 1980s, regulators became concerned
           that simple capital-to-assets leverage measures required too much
           capital for less risky assets and not enough for riskier assets.
           Another concern was that such measures did not require capital for
           growing portfolios of off-balance sheet items. In response to
           these concerns, regulators from the United States and other
           countries adopted Basel I, an international framework for
           risk-based capital that required minimum risk-based capital ratios
           of 4 percent for tier 1 capital to risk-weighted assets and 8
           percent for total capital to risk-weighted assets. By 1992, U.S.
           regulators had fully implemented Basel I; and in 1996, they and
           supervisors from other Basel Committee member countries amended
           the framework to include explicit capital requirements for market
           risk from trading activity. The use of a leverage requirement was
           continued after the introduction of risk-based capital
           requirements as a cushion against risks not explicitly covered in
           the risk-based capital requirements. The greater level of capital
           required by the risk-based or leverage capital calculation is the
           binding overall minimum requirement on an institution.

           Furthermore, the Federal Deposit Insurance Corporation Improvement
           Act of 1991 created a new supervisory framework known as prompt
           corrective action (PCA) that links supervisory actions closely to
           a bank's capital ratios. PCA, which applies only to banks, not
           bank holding companies, has become a primary regulatory influence
           over bank capital levels. PCA requires regulators to take
           increasingly stringent forms of corrective action against banks as
           their leverage and risk-based capital ratios decline. The purpose
           is to ensure that timely regulatory action is taken to address
           problems at financially troubled banks in order to prevent bank
           failure or minimize resulting losses.^10 There is a strong
           incentive for banks to qualify as "well-capitalized," which is the
           highest capital category and exceeds the minimum capital
           requirements, because banks deemed less than well-capitalized have
           restrictions or conditions on certain activities and may also be
           subject to mandatory or discretionary supervisory actions.
           Regulatory officials noted that the PCA well-capitalized standards
           are the de facto minimum regulatory capital requirements for banks
           and that virtually all banks maintain capital levels that meet the
           well-capitalized criteria. As shown later in this report in figure
           4, the required capital ratios for the well-capitalized category
           are: (1) a total risk-based capital ratio of 10 percent or
           greater, (2) a tier 1 risk-based capital ratio of 6 percent or
           greater, and (3) a leverage ratio of 5 percent or greater.^11
			  
			  The Transition to Basel II Has Been Driven by Limitations of
			  Basel I and Advances in Risk Management at Large Banking
			  Organizations

           Regulatory officials generally agree that while Basel I continues
           to be an adequate capital framework for most banks, it has become
           increasingly inadequate for supervising the capital adequacy of
           the nation's largest, most complex banking organizations. Many of
           these banks have developed advanced risk measurement techniques
           that have created a growing gap between the regulatory capital
           framework and banks' internal economic capital allocation methods.
           Regulators have sought to encourage the use of such methods as an
           element of strong risk management and because such methods may
           provide useful input to the supervisory process. Basel II is
           intended to address the shortcomings of Basel I and further
           encourage banks to develop and maintain a disciplined approach to
           risk management.
			  
			  Basel I Is a Simple Framework with Broad Risk Categories That Is
			  Inadequate for Large Banking Organizations

           When established internationally in 1988, Basel I represented a
           major step forward in linking capital to risks taken by banking
           organizations, strengthening banks' capital positions, and
           reducing competitive inequality among international banks.
           Regulatory officials have noted that Basel I continues to be an
           adequate capital framework for most banks, but its limitations
           make it increasingly inadequate for the largest and most
           internationally active banks. As implemented in the United States,
           Basel I consists of five broad credit risk categories, or risk
           weights (table 2).^12 Banks must hold total capital equal to at
           least 8 percent of the total value of their risk-weighted assets
           and tier 1 capital of at least 4 percent. All assets are assigned
           a risk weight according to the credit risk of the obligor and the
           nature of any qualifying collateral or guarantee, where relevant.
           Off-balance sheet items, such as credit derivatives and loan
           commitments, are converted into credit equivalent amounts and also
           assigned risk weights. The risk categories are broadly intended to
           assign higher risk weights to--and require banks to hold more
           capital for--higher risk assets.

           Table 2: U.S. Basel I Credit Risk Categories
			  
Risk weight Major assets                                                   
0%          Cash; claims on or guaranteed by central banks of Organization 
               for Economic Cooperation and Development countries; claims on  
               or guaranteed by Organization for Economic Cooperation and     
               Development central governments and U.S. government agencies.  
               The zero weight reflects the lack of credit risk associated    
               with such positions.                                           
20%         Claims on banks in Organization for Economic Cooperation and   
               Development countries, obligations of government-sponsored     
               enterprises, or cash items in the process of collection.       
50%         Most one-to-four family residential mortgages; certain         
               privately issued mortgage-backed securities and municipal      
               revenue bonds.                                                 
100%        Represents the presumed bulk of the assets of commercial       
               banks. It includes commercial loans, claims on                 
               non-Organization for Economic Cooperation and Development      
               central governments, real assets, certain one-to-four family   
               residential mortgages not meeting prudent underwriting         
               standards, and some multifamily residential mortgages.         
200%        Asset-backed and mortgage-backed securities and other          
               on-balance sheet positions in asset securitizations that are   
               rated one category below investment grade.                     

           Source: GAO analysis of federal regulations. See, e.g., 12 C.F.R.
           Part 3, App. A (OCC).

           However, Basel I's risk-weighting approach does not measure an
           asset's level of risk with a high degree of accuracy, and the few
           broad categories available do not adequately distinguish among
           assets within a category that have varying levels of risk. For
           example, although commercial loans can vary widely in their levels
           of credit risk, Basel I assigns the same 100 percent risk weight
           to all these loans. Such limitations create incentives for banks
           to engage in regulatory capital arbitrage--behavior in which banks
           structure their activities to take advantage of limitations in the
           regulatory capital framework. By doing so, banks may be able to
           increase their risk exposure without making a commensurate
           increase in their capital requirements. For example, because Basel
           I does not recognize differences in credit quality among assets in
           the same category, banks may have incentives to take on high-risk,
           low-quality assets within each broad risk category. As a result,
           the Basel I regulatory capital measures may not accurately reflect
           banks' risk profiles, which erodes the principle of risk-based
           capital adequacy that the Basel Accord was designed to promote.

           In addition, Basel I recognizes the important role of credit risk
           mitigation activities only to a limited extent. By reducing the
           credit risk of banks' exposures, techniques such as the use of
           collateral, guarantees, and credit derivatives play a significant
           role in sound risk management. However, many of these techniques
           are not recognized for regulatory capital purposes. For example,
           the U.S. Basel I framework recognizes collateral and guarantees in
           only a limited range of cases.^13 It does not recognize many other
           forms of collateral and guarantees, such as investment grade
           corporate debt securities as collateral or guarantees by
           externally rated corporate entities. In addition, the Basel
           Committee acknowledged that Basel I may have discouraged the
           development of specific forms of credit risk mitigation by placing
           restrictions on both the type of hedges acceptable for achieving
           capital reduction and the amount of capital relief. As a result,
           regulators have indicated that Basel II should provide for a
           better recognition of credit risk mitigation techniques than Basel
           I.

           Furthermore, Basel I does not address all major risks faced by
           banking organizations, resulting in required capital that may not
           fully address the entirety of banks' risk profiles. Basel I
           originally focused on credit risk, a major source of risk for most
           banks, and was amended in 1996 to include market risk from trading
           activity. However, banks face many other significant
           risks--including interest rate, operational, liquidity,
           reputational, and strategic risks--which could cause unexpected
           losses for which banks should hold capital. For example, many
           banks have assumed increased operational risk profiles in recent
           years, and at some banks operational risk is the dominant risk.^14
           Because minimum required capital under Basel I does not depend
           directly on these other types of risks, U.S. regulators use the
           supervisory review process to ensure that each bank holds capital
           above these minimums, at a level that is commensurate with its
           entire risk profile. In recognition of Basel I's limited risk
           focus, Basel II aims for a more comprehensive approach by adding
           an explicit capital charge for operational risk and by using
           supervisory review (already a part of U.S. regulators' practices)
           to address all other risks.

           Basel I Does Not Reflect Financial Innovations and Risk Management
			  Practices at Large Banking Organizations
			  
			  The rapid rate of innovation in financial markets and the growing
           complexity of financial transactions have reduced the relevance of
           the Basel I risk framework, especially for large banking
           organizations. Banks are developing new types of financial
           transactions that do not fit well into the risk weights and credit
           conversion factors in the current standards. For example, there
           has been significant growth in securitization activity, which
           banks engaged in partly as regulatory arbitrage opportunities.^15
           In order to respond to emerging risks associated with the growth
           in derivatives, securitization, and other off-balance sheet
           transactions, federal regulators have amended the risk-based
           capital framework numerous times since implementing Basel I in
           1992. Some of these revisions have been international efforts,
           while others are specific to the United States. For example, in
           1996, the United States and other Basel Committee members adopted
           the Market Risk Amendment, which requires capital for market risk
           exposures arising from banks' trading activities.^16 By contrast,
           federal regulators amended the U.S. framework in 2001 to better
           address risk for asset securitizations.^17 These changes, while
           consistent with early proposals of Basel II, were not adopted by
           other countries at the time. The finalized international Basel II
           accord, which other countries are now adopting, incorporates many
           of these changes.

           Despite these amendments to the current framework, the simple
           risk-weighting approach of Basel I has not kept pace with more
           advanced risk measurement approaches at large banking
           organizations. By the late 1990s, some large banking organizations
           had begun developing economic capital models, which use
           quantitative methods to estimate the amount of capital required to
           support various elements of an organization's risks. Banks use
           economic capital models as tools to inform their management
           activities, including measuring risk-adjusted performance, setting
           pricing and limits on loans and other products, and allocating
           capital among various business lines and risks. Economic capital
           models measure risks by estimating the probability of potential
           losses over a specified period and up to a defined confidence
           level using historical loss data. This method has the potential
           for more meaningful risk measurement than the current regulatory
           framework, which differentiates risk only to a limited extent,
           mostly based on asset type rather than on an asset's underlying
           risk characteristics. Recognizing the potential of such advanced
           risk measurement techniques to inform the regulatory capital
           framework, Basel II introduces "advanced approaches" that share a
           conceptual framework that is similar to banks' economic capital
           models. With these advanced approaches, regulators aim not only to
           increase the risk sensitivity of regulatory measures of risk but
           also to encourage the advancement of banks' internal risk
           management practices.

           Although the advanced approaches of Basel II aim to more closely
           align regulatory and economic capital, the two differ in
           significant ways, including in their fundamental purpose, scope,
           and consideration of certain assumptions. Given these differences,
           regulatory and economic capital are not intended to be equivalent.
           Instead, regulators expect that the systems and processes that a
           bank uses for regulatory capital purposes should be consistent
           with those used for internal risk management purposes. Regulatory
           and economic capital approaches both share a similar objective: to
           relate potential losses to a bank's capital in order to ensure it
           can continue to operate. However, economic capital is defined by
           bank management for internal business purposes, without regard for
           the external risks the bank's performance poses on the banking
           system or broader economy. By contrast, regulatory capital
           requirements must set standards for solvency that support the
           safety and soundness of the overall banking system. In addition,
           while the precise definition and measurement of economic capital
           can differ across banks, regulatory capital is designed to apply
           consistent standards and definitions to all banks. Economic
           capital also typically includes a benefit from portfolio
           diversification, while the calculation of credit risk in Basel II
           fails to reflect differences in diversification benefits across
           banks and over time. Also, certain key assumptions may differ,
           such as the time horizon, confidence level or solvency standard,
           and data definitions. For example, the probability of default can
           be measured at a point in time (for economic capital) or as a
           long-run average measured through the economic cycle (for Basel
           II). Moreover, economic capital models may explicitly measure a
           broader range of risks, while regulatory capital as proposed in
           Basel II will explicitly measure only credit, operational, and
           where relevant, market risks.
			  
			  Federal Regulators Are Proposing a Regulatory Capital Framework
			  that Differs from the International Basel II Accord in Several
			  Respects

           While Basel II is an international framework based on shared
           regulatory objectives, it is subject to national implementation.
           In the United States, federal regulators have proposed a series of
           changes that would result in multiple risk-based capital
           regimes--Basel II, Basel IA, and Basel I--largely based on the
           banking organization's size and complexity.^18 U.S. regulators
           proposed requiring only the Basel II advanced approaches for
           credit and operational risk for a small number of large and/or
           internationally active banking organizations, but regulators are
           currently seeking comment on allowing simpler risk measurement
           approaches for these organizations. The U.S.-proposed changes to
           implement Basel II differ from the international Basel II accord
           in several ways: the U.S. proposal has a more limited scope,
           contains additional prudential safeguards, retains key aspects of
           the existing regulatory capital framework, and contains certain
           technical differences.
			  
			  Basel II Is an International Framework Based on Shared Regulatory
			  Objectives but Subject to National Implementation

           The Basel II international accord seeks to establish a more
           risk-sensitive regulatory capital framework that is sufficiently
           consistent internationally but that also takes into account
           individual countries' existing regulatory and accounting systems.
           The international accord allows for a limited degree of national
           discretion in the application of the approaches for calculating
           minimum capital requirements, in order to adapt the standards to
           different conditions of national markets. Since the international
           accord was issued in 2004, individual countries have been
           implementing national rules based on the principles and detailed
           framework that it sets forth, and each country--including the
           United States--has used some measure of national discretion within
           its jurisdiction. The Basel Committee noted that as a result,
           regulators from different countries will need to make substantial
           efforts to ensure sufficient consistency in the application of the
           framework across jurisdictions. Furthermore, the Basel Committee
           emphasized that the international accord sets forth only minimum
           requirements, which countries may choose to supplement with added
           measures to address such concerns as potential uncertainties about
           the accuracy of the capital rule's risk measurement approaches. As
           detailed later in this report, the U.S.-proposed rules include
           such supplemental measures, including certain requirements that
           already exist in the current U.S. regulatory capital framework.

           Basel II aims for a more comprehensive approach to addressing
           risks, based on three pillars: (1) minimum capital requirements,
           (2) supervisory review, and (3) market discipline in the form of
           increased public disclosure. As shown in figure 1, Pillar 1
           establishes several approaches (of increasing complexity) to
           measuring risk. The advanced approach for credit risk (known as
           the advanced internal ratings-based approach, or A-IRB) uses risk
           parameters determined by a bank's internal systems for calculating
           minimum regulatory capital. The A-IRB will increase both the risk
           sensitivity and the complexity of such calculations. Under the
           advanced approach for operational risk (known as the advanced
           measurement approaches or AMA), a bank is to use its internal
           operational risk management systems and processes to assess its
           need for capital to cover operational risk. This method provides
           banks with substantial flexibility and does not prescribe specific
           methodologies or assumptions, although it does specify several
           qualitative and quantitative standards. Pillar 2 explicitly
           recognizes the role of supervisory review, which includes
           assessment of capital adequacy relative to a bank's overall risk
           profile and early supervisory intervention that are already part
           of U.S. regulatory practice. Pillar 3 establishes disclosure
           requirements that aim to inform market participants about banks'
           capital adequacy in a consistent framework that enhances
           comparability. Appendix III describes the Basel II framework in
           further detail.

^7In this report, the term "bank" refers generally to insured depository
institutions (banks and thrifts) as well as bank holding companies. Where
the distinction is significant, the term "bank holding company" refers to
the insured institution's ultimate holding company.

^8Tier 1 capital is considered most stable and readily available for
supporting a bank's operations. It covers core capital elements, such as
common stockholder's equity and noncumulative perpetual preferred stock.
Tier 2 describes supplementary capital elements and includes loan loss
reserves, subordinated debt, and other instruments. Total capital consists
of both tier 1 and tier 2 capital.

^9Banks holding the highest supervisory rating have a minimum leverage
ratio of 3 percent; all other banks must meet a leverage ratio of at least
4 percent. Bank holding companies that have adopted the Market Risk
Amendment or hold the highest supervisory rating are subject to a 3
percent minimum leverage ratio; all other bank holding companies must meet
a 4 percent minimum leverage ratio.

^10See GAO, Deposit Insurance: Assessment of Regulators' Use of Prompt
Corrective Action Provisions and FDIC's New Deposit Insurance System,
[62]GAO-07-242 (Washington, D.C.: Feb. 15, 2007), which responds to a
legislative mandate that GAO review federal banking regulators'
administration of the prompt corrective action program (P. L. 109-173,
Federal Deposit Insurance Reform Conforming Amendments Act of 2005,
Section 6(a), Feb. 15, 2006).

^11See, e.g., 12 C.F.R. S 6.4(b)(1) (OCC).

^12In addition to the risk weights in table 2, a dollar-for-dollar capital
charge applies for certain recourse obligations. See 66 Fed. Reg. 59620
(Nov. 29, 2001).

^13As implemented in the United States, Basel I assigns reduced risk
weights to exposures collateralized by cash on deposit; securities issued
or guaranteed by central governments of Organization for Economic
Cooperation and Development countries, U.S. government agencies, and U.S.
government-sponsored enterprises; and securities issued by multilateral
lending institutions. Basel I also has limited recognition of guarantees,
such as those made by Organization for Economic Cooperation and
Development countries, central governments, and certain other entities.
See 12 C.F.R. Part 3 (OCC); 12 C.F.R. Parts 208 and 225 (Federal Reserve);
12 C.F.R. Part 325 (FDIC); and 12 C.F.R. Part 567 (OTS).

^14The Basel Committee defines operational risk as the risk of loss
resulting from inadequate or failed internal processes, people, and
systems or from external events, including legal risks, but excluding
strategic and reputational risk. Examples of operational risks include
fraud, legal settlements, systems failures, and business disruptions.

^15Securitization is the process of pooling debt obligations and dividing
that pool into portions (called tranches) that can be sold as securities
in the secondary market. Banks can use securitization for regulatory
arbitrage purposes by, for example, selling high-quality tranches of
pooled credit exposures to third-party investors, while retaining a
disproportionate amount of the lower-quality tranches and therefore, the
underlying credit risk.

^1661 Fed. Reg. 47358 (Sept. 6, 1996).

^1766 Fed. Reg. 59614 (Nov. 29, 2001).

^18See 71 Fed. Reg. 55830 (Sept. 25, 2006) (Basel II NPR); 71 Fed. Reg.
77446 (Dec. 26, 2006) (Basel IA).

Figure 1: The Three Pillars of Basel II

Note: U.S. proposed rules solicit comments generally on permitting core
banks the option of using other credit and operational risk approaches
similar to those provided in the international accord. For credit risk,
the U.S. proposed rules specifically request comments on the suitability
for core banks of the standardized approach under the international accord
or the U.S. Basel IA proposal.

Federal banking regulators have proposed adopting the international accord
and integrating it into the existing U.S. regulatory capital framework,
but the four agencies have faced a number of impediments to explicitly
defining their objectives and balancing among several often competing
priorities. The international accord identifies several broad objectives,
and reaching agreement on these goals has been an important part of
building consensus among U.S. regulators on how to proceed with Basel II.
The international accord's objectives are:

           o Safety and soundness. To further strengthen the soundness and
           stability of the international banking system;

           o Consistency and competitive equity. To maintain sufficient
           consistency that capital adequacy regulation will not be a
           significant source of competitive inequality among internationally
           active banks;
           o Focus on risk management. To promote the adoption of stronger
           risk management practices by the banking industry; and
           o Capital levels. To broadly maintain the aggregate level of
           minimum capital requirements, while also providing incentives to
           adopt the more advanced risk-sensitive approaches of the revised
           framework.

           However, in satisfying these goals, federal regulators have
           struggled to balance incentives (in the form of permissible
           capital reductions) for banks that adopt the advanced risk
           measurement approaches with the objective of broadly maintaining
           the aggregate level of minimum required capital. At the same time,
           regulators seek to ensure that any incentives for these banks do
           not adversely affect the ability of other banks to compete
           domestically. In addition, regulators have sought to balance
           efforts to protect safety and soundness under Basel II with
           efforts to maintain sufficient consistency with the international
           framework. In particular, regulators must ensure that the revised
           U.S. regulatory capital framework does not create excessive
           international competitive inequities for U.S. banking
           organizations. Unless these issues are resolved, they are likely
           to generate ongoing questions about the appropriateness of Basel
           II as a regulatory capital framework.
			  
			  U.S. Regulators Propose to Apply Basel II Only to Large and/or
			  Internationally Active Banks and Are Considering Which Risk
			  Measurement Approaches to Make Available

           As currently proposed in the United States, Basel II would be
           required only for the nation's largest and/or most internationally
           active banking organizations. In addition, while banks in other
           countries may choose from options that include both standardized
           and advanced approaches available in the international accord, the
           current U.S. proposal permits only the advanced approaches for
           credit risk (A-IRB) and operational risk (AMA).^19 In the proposed
           rule, U.S. regulators stated that they proposed to implement only
           the advanced Basel II approaches, which use the most sophisticated
           and risk-sensitive measurement techniques, in order to promote
           further improvements in the risk measurement and management
           practices of large and internationally active banks. Although
           other countries may offer banks the choice of using any of the
           approaches in the international accord, U.S. regulators noted that
           most foreign banks comparable in size and complexity to U.S. core
           banks are adopting some form of the advanced approaches.^20
           Regulators estimate that, according to currently proposed
           criteria, 11 organizations would be required to comply with Basel
           II.^21 Together, these banks (known as core banks) hold about $4.9
           trillion in assets, or about 42 percent of total banking assets in
           the United States (fig. 2). Other banks that are not required to
           adopt the Basel II rule may opt into it with the approval of their
           primary federal regulator, and regulators estimate that about 10
           additional banks are considering doing so.

^19For operational risk, the U.S.-proposed rule permits a bank to propose
an alternative approach to the AMA in limited circumstances, but
regulators expect use of such an alternative approach to occur on a very
limited basis. See 71 Fed. Reg. 55840-41.

^20These foreign banking organizations indicated they may adopt the
foundation internal ratings-based approach for credit risk, which uses
internal models to some extent. However, the United States has proposed to
adopt only the advanced IRB approach.

^21A bank is required to adopt Basel II if it meets the following proposed
criteria: at least $250 billion in assets, or at least $10 billion in
on-balance sheet foreign exposure.

Figure 2: Banks that Meet U.S.-Proposed Criteria for Mandatory Adoption of
Basel II

Note: Banks were identified based on regulatory filings as of December 31,
2005. Assets data shown as of September 30, 2006 for the lead bank (i.e.,
depository institution) in each respective core banking organization.

^aRefers only to the lead U.S. bank subsidiary of a foreign-owned banking
organization.

Beginning in mid-2006, several core banks and industry groups have called
for the U.S.-proposed rules to offer all banks the option of adopting
alternative risk measurement approaches, including a standardized approach
for credit risk such as the one available in the international accord. A
standardized approach for credit risk, which is simpler and less costly to
implement than the Basel II advanced approach (A-IRB), increases risk
sensitivity compared to Basel I by expanding the number of risk weight
categories and more fully recognizing credit risk mitigation. However, it
is not as risk sensitive as the Basel II A-IRB approach, which relies in
part on banks' internal models to estimate inputs into capital
calculations. Bank officials stated that the A-IRB approach, as proposed
in the United States, would yield little opportunity for banks to realize
the benefits of a more risk-sensitive capital framework. Officials from a
few core banks acknowledged that a standardized approach for credit risk
might not adequately address the risks facing large, complex banks.
However, other bank officials said that they would prefer having the
option of using a standardized approach for credit risk, especially if the
U.S.-proposed rule for the advanced approach continued to exhibit certain
differences from the international accord.

Some federal and state regulators have also noted the potential advantages
of allowing a standardized approach for credit risk. For example, FDIC
officials have noted that because the standardized approach establishes a
floor for each risk exposure, it does not provide the same potential for
dramatic reductions in capital requirements and would not pose the same
competitive inequity concerns as the advanced approach. But FDIC officials
also recognized that others have argued that only the advanced approaches
would provide an adequate incentive for strengthening risk measurement
systems at the largest banks. An association of state bank regulators also
called for consideration of the standardized approach in the international
accord, stating that it would be more risk sensitive than the current
framework and simpler to implement and supervise than the advanced
approach. An academic familiar with bank regulation also expressed support
for a standardized approach as an interim solution to allow the regulators
time to further assess the feasibility of the internal ratings based
approach.

In response to these developments, regulators have requested public
comments on whether U.S. banks subject to the advanced approaches should
be permitted to use other credit and operational risk approaches similar
to those provided in the international accord. However, regulators have
not specified how, if at all, they might propose to apply such approaches,
citing the need first to review comments received during the comment
period of the rule-making process, which has been extended to March 26,
2007. Regulators have also noted that to date, banks have not sufficiently
clarified their views on what form a standardized approach for credit risk
should take. Given that the Basel II NPR only asks a question about a
standardized approach and offers no specifics, the banking regulators
indicated that pursuant to the rule-making requirements of the
Administrative Procedure Act they would likely issue a new, targeted NPR
if they were to include the approach as an option for credit risk.^22 This
new proposal would require a definition of the standardized approach in
the United States, its application criteria, and how long banks could opt
to use it. Failure to provide a subsequent NPR if this option were
included in the final rule could result in new questions, issues, and
potential unintended consequences that the regulators may not have
considered.

^225 U.S.C. S 553.

U.S. Regulators Have Revised Time Frames for Implementation and Proposed
Prudential Safeguards

Concerns in the U.S. about the potential adverse impact of Basel II on
regulatory capital requirements have led federal regulators to revise the
time frame for implementation and propose additional prudential
safeguards. Appendix II shows key events in the transition to Basel II and
proposed implementation time frames in the United States and abroad. In
April 2005, U.S. federal regulators announced that a quantitative impact
study (QIS-4) had estimated that Basel II could cause material reductions
in aggregate minimum required risk-based capital and significant
variations in results across institutions and portfolio types. As a
result, they delayed the time frame for issuing the Basel II NPR in order
to further analyze the results of the study. In February 2006, regulators
announced that QIS-4 had estimated reductions in minimum total risk-based
capital requirements of 15.5 percent (mean) and 26.3 percent (median), as
well as reductions in minimum tier 1 risk-based capital requirements of 22
percent (mean) and 31 percent (median), relative to the current Basel
I-based framework. The study also estimated significant reductions in
minimum required capital for almost every portfolio category.^23 In
addition, the study showed that similar loan products at different banks
may have resulted in very different risk-based capital requirements.
However, as discussed later in this report, regulators were unable to
conclude whether the study's estimates were an understatement or
overstatement of the overall level of minimum risk-based capital that
would be required in a fully implemented Basel II. Nevertheless, the
regulators stated that the results observed in QIS-4 would be unacceptable
in an actual capital regime.

While regulators decided to proceed with issuing a proposed rule, delays
in both the rule-making process and the implementation time frame have
created challenges. Regulators stated that a final rule, supplemented with
certain prudential safeguards, would allow them to more reliably observe
the impact of Basel II. Such a controlled environment would prevent
unintended capital reductions and would allow banks to submit compliant
data based on a final rule that would provide greater certainty than data
submitted under a preliminary impact study. For example, regulators
delayed the start of the first available "parallel run" until January
2008, a year later than the international accord, creating challenges for
banks that operate in multiple countries.^24 Regulators also added a third
transition period to the original two transition periods and established
floors on capital reductions for individual institutions during the
transition period that are more conservative than those proposed in the
international accord.^25

23QIS-4 estimated aggregate reductions in minimum required capital for
every wholesale and retail exposure category (except credit cards, for
which minimum required capital would increase significantly) across the 26
banking organizations that participated in the study. The study also
estimated a reduction in minimum required capital for securitization
exposures and a relatively small increase for equity exposures.

Regulators must resolve a number of open questions before issuing the
final rule for Basel II. They have expressed a goal of doing so by June
30, 2007, at least 6 months prior to the start of the first available
parallel run. The regulators have defined more specific objectives in the
U.S.-proposed rule that include the following:

           o Viewing a 10 percent decline in aggregate risk-based capital
           requirements compared to risk-based capital requirements under the
           existing rules as a material reduction warranting modifications to
           the Basel II-based framework;
           o Establishing comparable capital requirements for similar
           portfolios;
           o Domestically, working to mitigate differences in risk-based
           capital requirements between institutions that participate in
           Basel II and those that do not; and
           o Retaining the leverage ratio and prompt corrective action
           requirements.

           Table 3 summarizes some of the key differences between the
           U.S.-proposed rules for Basel II and the international accord.

^24A bank transitioning to Basel II must first satisfactorily complete a
one-year parallel run period in which it calculates regulatory capital
according to both Basel I and Basel II (its actual regulatory capital
requirement would be determined by Basel I).

^25During each transition period (lasting at least 1 year), banks would be
subject to limits on the amount by which a bank's risk-based capital
requirements could decline and would be required to calculate capital
requirements according to both Basel I and Basel II.

Table 3: Differences in U.S.-Proposed Implementation of Basel II and
International Accord

                    United States                  International Accord       
Scope of            o Proposes only the            o Provides all banks    
application         advanced approaches for        with a choice of        
                       credit and operational risk    multiple approaches for 
                       for largest banks.             assessing risks.        
                       o Proposes Basel IA and        o Replaces Basel I.     
                       retains Basel I for all        o First available       
                       other banks.                   parallel run for A-IRB  
                       o First available parallel     and/or AMA in 2007.     
                       run in 2008.                                           
Prudential          o Transitional floors in       o Transitional floors   
safeguards          which required risk-based      in which required       
                       capital cannot go below 95     risk-based capital      
                       percent, 90 percent, and 85    cannot go below 90      
                       percent of Basel I             percent and 80 percent  
                       requirements in three          of Basel I requirements 
                       transition years,              in the first and second 
                       respectively.                  transition years,       
                       o Regulators intend to view    respectively.           
                       a 10 percent or greater        o Supplementary         
                       decline in aggregate           measures are not        
                       risk-based capital             required under the      
                       requirements (compared to      international accord,   
                       Basel I) as a material         but national            
                       reduction warranting           authorities are free to 
                       modifications to the U.S.      adopt them as they see  
                       Basel II framework.            fit.                    
                       o Leverage ratio and prompt                            
                       corrective action are                                  
                       retained.                                              
Significant technical differences
Wholesale        Based on whether:              Based on whether:          
definition of                                                              
default             o the bank places any          o the bank considers an 
                       exposure to the obligor on     obligor unlikely to pay 
                       nonaccrual status,             in full without         
                       o the bank incurs full or      recourse to bank        
                       partial charge-offs on any     actions, or             
                       exposure to the obligor, or    o an obligor's payment  
                       o the bank incurs a            on principal or         
                       credit-related loss of 5       interest is more than   
                       percent or more on the sale    90 days past due.       
                       of any exposure to the         o Includes nonaccrual   
                       obligor or transfer of any     status and material     
                       exposure to the obligor to     credit-related loss on  
                       the held-for-sale,             sale as elements        
                       available-for-sale, trading    indicating unlikeliness 
                       account, or other reporting    to pay. However, the    
                       category.                      accord does not specify 
                                                      the threshold of 5      
                                                      percent for             
                                                      credit-related losses   
                                                      upon sale or transfer,  
                                                      and other countries'    
                                                      definitions do not      
                                                      generally include       
                                                      nonaccrual status.      
Retail           Occurs when an exposure        Occurs when an exposure    
definition of    reaches 120 or 180 days past   reaches a past due         
default          due, depending on exposure     threshold between 90 and   
                    type, or when the bank incurs  180 days, set by the       
                    a full or partial charge-off   national supervisor, or    
                    or write-down on principal for when the bank considers an 
                    credit-related reasons.        obligor unlikely to pay in 
                                                   full without recourse to   
                                                   bank actions.              
Small- and       Does not include an adjustment Includes such an           
medium-sized     that would result in a lower   adjustment.                
business lending capital requirement for loans                             
                    to small and medium-sized                                 
                    enterprises compared to other                             
                    business loans under the                                  
                    framework.                                                
Loss given          o A bank may use its own       o Requires banks to     
default (LGD)       LGD estimates upon             estimate losses from    
                       obtaining supervisory          default that would      
                       approval, which is based in    occur during economic   
                       part on whether the            downturn conditions,    
                       estimates are reliable and     which may result in     
                       sufficiently reflective of     higher regulatory       
                       economic downturn              required capital for    
                       conditions.                    some exposures under    
                       o A bank that does not         the framework.          
                       qualify to use its own         o Does not identify an  
                       internal LGD estimates must    explicit supervisory    
                       instead compute LGD using a    formula for estimating  
                       supervisory formula that       LGD when a bank's       
                       some bank officials have       internal LGD estimates  
                       described as overly            do not meet minimum     
                       conservative.                  requirements.           
                                                      o Instead, if a bank is 
                                                      unable to estimate LGD  
                                                      for any material        
                                                      portfolio, it would not 
                                                      qualify for the A-IRB   
                                                      approach.               

Source: GAO analysis.

U.S. Regulators Proposed Basel IA and Plan to Retain Basel I for All Other Banks

Regulators have proposed revising and retaining key aspects of Basel I,
which would result in multiple risk-based capital regimes--Basel II, Basel
IA, and Basel I. The regime that each bank uses will be largely based on
its size and complexity. Federal regulators had initially limited the
scope of Basel II to a small number of large and/or internationally active
institutions and had planned to retain Basel I unchanged for all other
institutions, in order to reduce the regulatory burden for these banks. In
response to concerns voiced by small banks about potential competitive
inequities between them and banks adopting Basel II, regulators proposed
Basel IA.^26 Regulatory and bank officials acknowledge that Basel IA may
help mitigate potential competitive inequities, although the extent of
this impact is still to be seen. Basel IA is a risk-weighting approach
that provides greater risk sensitivity than the current Basel I framework
and is less risk sensitive and less complex than the Basel II advanced
approaches. The Basel IA proposal discusses various modifications that
would increase the number of risk-weight categories relative to Basel I;
permit greater use of external credit ratings, if available, as an
indicator of credit risk; expand the range of eligible collateral and
guarantors used to mitigate credit risk; and use loan-to-value (LTV)
ratios to determine risk weights for most residential mortgages.^27
Specifically, Basel IA proposes six risk-weight categories based on LTV
ratios that would replace Basel I's single risk category for most
mortgages.^28 As a result, minimum capital requirements for mortgages
under Basel IA would be more sensitive to risk than they would be under
Basel I. As shown in figure 3, Basel I would generally require the same
amount of capital regardless of the risk level (LTV ratio) of the
mortgage, but Basel IA would generally increase required capital for
higher risk loans and decrease required capital for lower risk loans.
Nevertheless, Basel IA would not be as sensitive to credit risk as the
Basel II A-IRB approach, nor would it rely on banks' internal models to
determine minimum capital requirements. Under the Basel II A-IRB approach,
risk parameter estimates take into account a wider variety of information,
such as probability of default, loss given default, and exposure at
default.

^2671 Fed. Reg. 77446 (Dec. 26, 2006).

^27LTV ratios are a measure of credit risk for mortgages and are commonly
used in the underwriting process. A higher LTV ratio indicates a higher
level of risk.

Figure 3: Sensitivity to Credit Risk for Mortgages under Basel I and Basel
IA

^28Under U.S. Basel I, most first-lien, one-to-four family mortgages meet
certain required criteria (i.e., they meet prudent underwriting standards
and are not 90 days or more past due or in nonaccrual status) to receive a
50 percent risk weight. Those mortgages not meeting the criteria receive a
100 percent risk weight.

Federal regulators have recently requested comment on whether Basel IA
might be an appropriate option for banks subject to Basel II as an
alternative to the advanced approaches. As discussed earlier, in the
September 2006 Basel II NPR regulators requested comment on whether, and
for what length of time, a standardized approach for credit risk similar
to the approach in the international accord should be provided as an
option for core banks. Subsequently, in the Basel IA NPR released in
December 2006, the regulators requested comment on whether the Basel IA
proposal or the standardized approach in the international Basel II accord
would be an appropriate credit risk measurement approach for Basel II
banking organizations and whether operational risk should be addressed
using one of the three Basel II approaches.^29 In many respects, the Basel
IA proposal is similar to the Basel II standardized approach for credit
risk. Both approaches create several additional risk categories and for
the most part do not rely on banks' internal models for calculating
risk-based capital. Unlike Basel IA, the standardized approach has only a
single risk-weight category for most mortgage loans. Compared with the
advanced approach, the standardized approach offers less risk sensitivity
but also less complexity, and it does not provide capital incentives for
large banks to further improve their risk management practices. Regulators
also asked in the Basel IA proposal how, if Basel IA is an option for
Basel II banking organizations, they can be encouraged to enhance their
risk management practices or financial disclosures if provided options
other than the advanced approaches. Lack of sufficient resolution on these
significant questions may lead to continued uncertainty about the proposed
changes to the U.S. regulatory capital framework.

Given the large number of U.S. banks of different sizes, including
thousands of small banks, regulators also plan to retain Basel I. Any bank
not required to adopt Basel II would have the option of either adopting
Basel IA, upon notifying its primary regulator, or remaining under Basel
I. Regulatory officials have noted that Basel I would still be an adequate
capital regime for most banks but that it is becoming increasingly
inadequate for the largest and most complex banks. Regulators have stated
that some small banks tend to hold capital well in excess of current
regulatory minimums. Regulators indicated, based on comment letters
received, that due to the compliance burden associated with moving to
Basel IA, some small banks that are highly capitalized may choose to
remain under Basel I.

^2971 Fed. Reg. 77463.

U.S. Regulators Plan to Retain the Leverage Requirement and Apply Existing
Prompt Corrective Action Measures

While the U.S.-proposed Basel II and Basel IA rules address revisions to
risk-based regulatory capital, regulators also plan to retain the existing
leverage requirements and prompt corrective action (PCA) measures. Federal
regulators have committed to retaining a minimum leverage requirement for
all banks, regardless of whether they use Basel II, IA, or I to calculate
their risk-based required capital.^30 The leverage requirement, a simple
ratio of tier 1 capital to on-balance sheet assets, is a U.S.-specific
measure, while risk-based requirements are generally defined based on the
international Basel accords. U.S. regulators stated that risk-based and
leverage requirements generally serve complementary functions, in which
the leverage ratio can be viewed as offsetting potential weaknesses of the
risk-based ratios, while the risk-based ratios offset weaknesses of the
leverage ratio. Risk-based requirements are intended to be more sensitive
to assets of varying levels of risk and to address risks of off-balance
sheet activities. However, the complexity of risk-based capital
calculations will increase significantly under the advanced approaches of
Basel II as these calculations depend on banks' estimates of risks and
supervisory formulas that are based on certain assumptions. By contrast, a
leverage ratio is easy to calculate and verify. Regulatory officials also
noted that the leverage requirement can be considered to cover areas that
risk-based requirements do not currently address, such as interest rate
risk, concentration risk, and "model risk" (i.e., risk that the model
assumptions or underlying data could be unreliable). While U.S. regulators
support the use of a leverage requirement, some have noted that the
leverage ratio, as currently formulated, may impede the risk sensitivity
of the proposed changes to risk-based requirements.^31

30A leverage limit is required unless a federal banking agency rescinds it
upon determining (with the concurrence of the other federal banking
agencies) that the measure no longer is an appropriate means for carrying
out the purpose of PCA. 12 U.S.C. S 1831o(c)(1)(B)(ii).

^31For example, OTS notes that, if Basel II is adopted as proposed, the
capital of institutions with concentrations of low-risk assets could be
constrained by a leverage requirement at a capital level well above that
suggested by the risk reflected by a bank's internal model that meets
supervisory qualification criteria. Conversely, the leverage requirement
may not impose any meaningful constraint on relatively higher-risk
institutions (in particular, since the leverage ratio as currently
formulated does not address off-balance sheet risks). As a result, OTS
notes that low credit risk lenders may have a regulatory capital arbitrage
incentive to pursue riskier lending.

In addition, under the PCA framework in the United States, banks tend to
hold both risk-based and leverage capital at significantly higher levels
than the international regulatory minimums. As figure 4 shows, the PCA
thresholds for "well-capitalized" status exceed the international Basel
minimums, which are considered under PCA as "adequately capitalized."
According to banking regulators, failure to maintain well-capitalized
status can have significant consequences, such as higher deposit insurance
premiums. As a result, most U.S. banks maintain regulatory capital at
levels that achieve well-capitalized status. In connection with the
U.S.-proposed Basel II framework, PCA will play a significant role in
ensuring that Basel II banks maintain sufficient capital.

Figure 4: U.S. Regulatory Capital Requirements

aSelected capital categories as defined in PCA, which applies to banks
(i.e., insured depository institutions), but not bank holding companies.

bThe well-capitalized designation for bank holding companies under
Regulation Y has equivalent risk-based minimums as those under the
well-capitalized PCA designation for banks, but it does not have a minimum
leverage requirement.

cFor the risk-based capital ratios, the adequately capitalized minimums
are equivalent to the internationally adopted Basel minimums and apply to
both banks and bank holding companies.

dA minimum leverage requirement of 3 percent applies to (1) banks that
receive the highest supervisory rating and (2) bank holding companies that
have adopted the Market Risk Amendment or that hold the highest
supervisory rating. All other banks and bank holding companies are subject
to a 4 percent minimum leverage requirement.

The U.S. Proposal Differs in Other Ways from the International Accord

The Basel II NPR contains several other deviations from the international
accord that have resulted in uncertainty and concerns about international
consistency. For example, the proposed definitions of default for
wholesale and retail exposures in the United States differ from those used
in other jurisdictions. Differences in such fundamental definitions could
have significant effects on the implementation costs of banks operating in
multiple jurisdictions, possibly requiring banks to develop multiple data
systems and processes. Furthermore, in contrast to the international
accord, the U.S. proposal does not include an adjustment that would result
in required capital for loans to small- and medium-sized businesses being
lower than would be required for other business loans under the framework.
Regulators noted that some misunderstanding may exist among banks on
aspects of the proposed rule, such as the estimation of loss given default
(LGD), a key risk input, under economic downturn conditions. The
regulators proposed a supervisory formula for banks that do not qualify
for use of their own LGD estimates, but it was not intended as a
requirement for those banks that do qualify for use of their own LGD
estimates. A number of other differences exist, and regulatory officials
noted the need to take a comprehensive view of these differences, that in
some areas the proposed U.S. requirements are less conservative than the
international accord, and in other areas the requirements are more
conservative. Notwithstanding these differences, other international
differences in regulatory and accounting standards also have significant
consequences for the comparability of capital ratios and the associated
costs of implementing Basel II.

In addition, SEC has established a holding company supervision regime for
certain securities firms that requires computation of groupwide capital
adequacy measures and is separate from the federal banking regulators'
proposed Basel II rule, raising some concerns about competitiveness
between large commercial and investment banks subject to different capital
rules. SEC's voluntary, alternative net capital rule, approved in 2004,
allows certain broker-dealers to use internally developed mathematical
models to calculate market and derivatives-related credit risk.^32 In
order for a broker-dealer to apply the rule, its ultimate holding company
(collectively, the "consolidated supervised entity") must calculate and
report capital adequacy measures that are broadly consistent with Basel
standards and consent to groupwide supervision by SEC.^33 SEC issued the
rule in part as a response to a requirement by the European Union that
non-European Union financial institutions be subject to consolidated
supervision at the groupwide level in order to conduct business in Europe
without establishing a separate European holding company. Five investment
bank holding companies have elected to be treated as consolidated
supervised entities. While the rule does not prescribe the use of the
Basel II advanced approach for credit risk, consolidated supervised
entities have with one exception elected to apply this approach.^34
According to SEC officials, because the timetable imposed by the European
requirements necessitated the adoption of holding company capital
requirements by consolidated supervised entities prior to issuance by U.S.
banking regulators of guidance on Basel II, SEC has used the 2004
international Basel II accord as its guide for Basel II implementation.
SEC officials stated that they would review the changes in the banking
regulators' final rule and that they planned to implement Basel II for
investment banks in a way that was generally consistent with the Federal
Reserve's interpretation of Basel II as applied to financial holding
companies.

^32SEC, Alternative Net Capital Requirements for Broker-Dealers That Are
Part of Consolidated Supervised Entities, 69 Fed. Reg. 34428 (June 21,
2004).

^33Holding companies that already have a principal regulator (e.g., bank
or financial holding companies regulated by the Federal Reserve) would be
examined by their principal regulator, rather than SEC.

^34According to SEC, one firm, faced with less than 6 months between
publication of SEC rules and the European Union deadline, opted to
implement Basel I as an interim measure. That firm plans to adopt the
Basel II advanced approach for credit risk in the first quarter of 2007.

Basel II Is Expected to Improve Risk Management and Enhance Capital Allocation,
While Proposed Safeguards Would Help to Prevent Large Capital Reductions during
a Temporary Transition Period

The longer-term impact of Basel II on minimum regulatory capital
requirements and the safety and soundness of the banking system is largely
unknown, but its implementation could have a variety of consequences for
the banking system. First, bank and regulatory officials generally agree
that the movement toward Basel II has prompted the largest U.S. banking
organizations to make improvements in their risk measurement and risk
management systems. Second, the advanced Basel II risk modeling approaches
have the potential to better align capital with risk, such that banks
would face minimum capital requirements more sensitive to their underlying
risks. However, the advanced approaches are not themselves without risks
and realizing the benefits of these approaches will depend in part on the
sufficiency of credit default and operational loss event data used as
inputs to the regulatory and bank models that determine required capital.
Third, while initial estimates of the potential impact of Basel II showed
large drops in minimum required capital, the impact of Basel II on minimum
required capital is uncertain, and U.S. regulators have proposed
safeguards to prevent the large reductions in required capital during a
transition. Fourth, possible changes in regulatory capital requirements
have also raised some banks' concerns about competition between large and
small banks domestically, and between large banks headquartered in the
United States and foreign banking organizations. Finally, Basel II's
impact on the amount of capital banks' actually hold is also uncertain
because regulatory requirements are just one of several factors that banks
weigh in deciding how much capital to hold. In light of the uncertainty
concerning the potential impact of Basel II, these issues will require
further and ongoing examination as the banking regulators continue to
finalize the Basel II rule and proceed with the parallel run and
transition period.

Basel II Preparations Have Contributed to Improved Risk Management at
Participating Banks

Bank and regulatory officials generally agree that, due to the systems
required for the use of the advanced approaches, Basel II has already
prompted some large banks to improve their risk measurement and management
systems. For example, officials at one bank said that the more detailed
categorizing of risks under the advanced approaches would offer
information about a portfolio that banks could use to identify and plan
for potential problems. Other officials said that Basel II would improve
their collection and use of data so that they could aggregate and better
understand information about their risk profile across all their
portfolios. Some officials noted that Basel II would help to formalize
processes for identifying and addressing operational risk. In preparation
for Basel II implementation, many banks have improved data collection and
invested resources in quantifying and modeling operational risk. Although
they felt it still had many gaps, officials from several core banks said
that Basel II also brought regulatory requirements closer to the ways in
which they have been addressing economic risk internally. Many of these
officials believe that the transition to Basel II should help the banks
continue to more quickly improve their risk management practices.

Officials from some banks that were considering adopting Basel II cited
several factors that made the new framework attractive. Officials from
some banks acknowledged that over the long run Basel II would make the
regulatory capital framework more risk sensitive and improve bank's risk
management and internal controls, resulting in stronger banks. Officials
from one bank stated that over the long term, Basel II would equip them
with the tools to better differentiate and price risks and allocate
capital, placing the bank in a stronger position to compete with larger
banks. Officials from a few banks said that as a result of acquisitions or
business growth, their institutions would grow and become more complex,
requiring more sophisticated risk measurement and management tools. These
officials also shared the view that Basel II would further improve their
collection and use of data and other information. Officials from one bank
believed that such information would allow banks to make better decisions
during emergency situations. Finally, officials at some banks said that
their foreign parent companies were required to implement the new
framework, facilitating their adoption of Basel II in the United States.

Regulatory officials also believed that the systems required for the
advanced approaches would allow banks to better understand and measure
risk, and they suggested that the improvements in risk management at these
banks was one of the primary benefits of Basel II. For example, Federal
Reserve officials noted that the proposed rule mandates that the largest
U.S. banks adopt the advanced approaches of Basel II because these
approaches would strongly encourage improved risk measurement and
management practices. Regulatory officials stated that the requirement to
model operational risk has created significant interest in the discipline
and has motivated some banks to collect operational loss data. Another
positive risk management effect of Basel II preparation, according to some
regulatory officials, is improved data collection that will be useful for
internal economic capital purposes as well as for calculating regulatory
capital.

Basel II Models Could Improve the Risk Sensitivity of Capital Requirements but
Also Have Limitations

The bank and regulatory models associated with the Basel II advanced
approaches have the advantage of making capital requirements more
sensitive to some underlying risks, but also have a number of limitations.
This improved risk sensitivity could improve the safety and soundness of
the banking system. However, the use of bank models that influence capital
requirements requires increased reliance on risk assessments provided by
bank officials, though these assessments are subject to both internal and
supervisory review. The A-IRB approach incorporates historical estimates
of credit losses to determine required capital but is based on simplifying
assumptions provided by regulators about the sources of credit risk. Its
effectiveness will depend on the quality and sufficiency of data on credit
losses. With sufficient controls on the modeling process, and relevant
historical data, the A-IRB approach should generate capital requirements
more reflective of actual credit risk than the broader risk categories of
Basel I. The AMA approach offers a number of channels for risk
sensitivity, though the operational risk capital requirements are
sensitive to the potentially varied statistical assumptions and data banks
would use to estimate the magnitude of severe operational loss events.
Finally, while banks' models have been used for internal purposes, they
are relatively unproven for regulatory capital purposes. The use of these
models also raises concerns about their ability to estimate losses from
low-frequency catastrophic events, which also increases the importance of
supervisory review as well as regulators' attention to the appropriate
level of risk-based capital.

  More Risk-Sensitive Capital Requirements Could Improve Safety and Soundness

For a given amount of capital, more risk-sensitive capital requirements
could improve the safety and soundness of the banking system through a
number of channels--each of which more closely aligns required capital
with associated risks--and provide a required level of capital more likely
to absorb unexpected losses. First, holding assets with higher risk under
Basel II would require banks to hold more capital relative to lower risk
assets. For example, while Basel I requires the same amount of capital for
many high-risk and low-risk mortgages, those mortgage loans on average
expected to have greater credit losses under Basel II would require more
capital than would be required for other mortgage loans. Second, banks
with higher risk credit portfolios or greater exposure to operational risk
would be required to hold relatively more capital than banks with lower
risk profiles. For example, a bank with a speculative bond portfolio, or
one with a business line more susceptible to fraud, could face relatively
higher capital requirements in those areas. Third, because credit quality
varies over the business cycle, banks could be required to hold more
capital for some assets as economic conditions are expected to
deteriorate. As a result, banks would have a relatively larger capital
requirement when credit losses from default are more likely. Finally,
although more risk-sensitive capital requirements can help enhance safety
and soundness, the level of regulatory capital must also be sufficient to
account for broader risks to the economy and safety and soundness of the
banking system, which will require ongoing regulatory scrutiny.

  A-IRB Approach for Credit Risk Has Strengths and Weaknesses

Assuming sufficient controls on the quantification and modeling process,
and relevant historical data, the A-IRB approach should generate capital
requirements more reflective of actual credit risk than the broad Basel I
risk categories; however, the formulas provided by regulators for
calculating capital requirements for credit risk have both strengths and
weaknesses. The A-IRB formulas generate a capital requirement that depends
on risk characteristics of the asset, estimated by the bank, such as the
probability of default (PD) and LGD, thus making required capital more
sensitive to the underlying risk of the asset. This improved risk
sensitivity would help ensure that banks are required to hold relatively
more capital against riskier assets more likely to generate unanticipated
credit losses and hold less required capital against less risky assets.
However, the appropriateness of the capital requirements generated by the
A-IRB approach depends on the accuracy of parameter estimates, such as PD
and LGD, which depend in part on the quality and comprehensiveness of the
historical data that underlie the estimates. For portfolios with data that
cover short time horizons or incomplete economic cycles, the capital
required under the A-IRB approach will not necessarily accurately reflect
the risk of credit losses from the asset because the more limited history
may not be representative. However, for portfolios with data covering
longer time horizons that include adverse economic conditions, the A-IRB
approach is anticipated to generate a capital requirement better aligned
with the underlying risk of the asset than the broad risk categories of
Basel I.

The authors of a Basel Committee working paper have noted significant
challenges related to estimation of loss severity and exposure at default
in particular, and highlight the importance of building consistent data
sets at banks.^35 For new or innovative financial products, bank officials
described a number of strategies for estimating risk parameters, including
simulating how the borrower would behave under a variety of economic
conditions, comparing the product to similar products for which the banks
already had data, using expert judgment, and making conservative
adjustments to estimates. Officials at several banks told us these sorts
of products were typically not material portions of their credit
portfolio, and therefore would not materially affect their capital
requirements under Basel II. None of the bank officials with whom we spoke
had received formal feedback or guidance from regulators clarifying the
treatment of portfolios that did not have a historical track record,
though one official explained that similar strategies to those described
above had already been endorsed by regulators for market risk
calculations.

^35"Studies on the Validation of Internal Rating Systems," Basel Committee
on Banking Supervision Working Paper, no. 14, May 2005.

For large corporate borrowers, bonds or loans with lower external ratings
would generally be assigned a higher probability of default, resulting in
relatively higher required capital. In addition, estimates of LGD for
small business loans, for example, will be sensitive to collateral that
the borrower provides, with greater collateral reducing the losses to the
lender if the borrower defaults, and hence required capital. However, the
A-IRB formulas are based on certain simplifying assumptions that provide
only limited recognition of diversification and concentration in credit
risk, among other limitations. Other criticisms include inappropriate
values for the regulator-provided asset correlations with the overall
economy, and the assumption that credit risk at a given bank is driven by
a single, economy-wide risk-factor with simplified statistical properties.
More generally, some researchers believe that the A-IRB approach does not
reflect best practices in banking but instead reflects a negotiated
compromise that attempts to balance competing goals, including improved
risk sensitivity and simplicity.^36 In essence, the A-IRB approach is an
attempt to convert historical data on credit defaults into worst-case
scenario credit losses, assuming that this scenario can be captured by
statistical assumptions about the distribution of losses. These severe
scenarios are inherently difficult to estimate, because of their rarity,
but their magnitude will determine the level of resources banks will need
to weather similar events. Regulators acknowledge the assumptions of the
A-IRB approach represent simplifications of very complex real-world
phenomena, meant to approximate such severe scenarios.

  AMA for Operational Risk Also Has Strengths and Weaknesses

The Basel II NPR is less prescriptive on the calculation of capital
requirements for operational risk, the AMA. Nevertheless, banks must
incorporate a number of elements, and regulators have prescribed a level
of confidence for bank models that is equivalent to requiring a capital
level for operational risk that would have a one in one thousand chance of
being exceeded by operational losses in a given year, provided the
underlying assumptions were correct. The elements that banks must
incorporate are internal operational loss event data, external operational
loss event data, results of scenario analyses, and assessments of the
bank's business environment and internal controls.^37 One rationale for
the flexibility afforded under the AMA approach is that operational risk
modeling is a new and evolving discipline.

^36Hugh Thomas and Zhiqiang Wang, "Interpreting the Internal Ratings-Based
Capital Requirements in Basel II," Journal of Banking Regulation, vol. 6,
no. 3 (2005).

According to some regulatory officials, Basel II banks are all currently
exploring the loss distribution approach (LDA) to estimating their
exposure to operational risk. Under one possible way to implement a LDA, a
bank would use internal and external operational loss data to separately
estimate the range of possible frequencies and magnitudes of operational
losses. The bank would then combine this information with expert-designed
scenarios to better anticipate very infrequent, yet very severe
operational loss events. Finally, the bank is required to incorporate
information regarding the strength of its internal controls, and risks of
its particular business environment into its estimates of potential
losses. Banks may also be able to use insurance or other risk mitigants
aimed at covering operational losses to reduce their operational risk
required capital by up to 20 percent. This approach offers a number of
channels for risk sensitivity and also provides incentives to mitigate
operational risk. First, internal operational loss data are by nature
specific to individual banks, so they are expected to reflect the types of
losses that have historically affected the bank. Second, because the AMA
requires that banks incorporate an assessment of the strength of internal
controls, expert-designed scenarios could reflect where internal controls,
or lack of them, are likely to mitigate or exacerbate potential
operational losses. Third, because banks would, to a limited extent, be
able to reduce their capital requirements by insuring against some
operational losses, the AMA could provide additional incentives for banks
to purchase such insurance or other risk mitigants.

There are several methodological challenges with respect to quantifying
operational risk. For example, the operational risk capital charge will be
strongly influenced by infrequent but very large operational losses.
Because of their rarity, the magnitude and likelihood of these losses is
difficult to estimate. Some banks have joined industry groups to share
data or have purchased data from external sources to supplement internal
data. Nevertheless, the estimated operational risk exposure will be
sensitive to the potentially varied statistical assumptions and data
sources chosen by the bank. The lack of data on severe operational losses
also increases reliance on scenario analysis. While scenario analysis can
be useful in offering a forward-looking perspective not captured by
internal data, the Basel Committee has noted that the rigor applied to
scenario development varies greatly from bank to bank.

^37Scenario analysis is defined in the Basel II NPR as a "systematic
process of obtaining expert opinions from business managers and risk
management experts to derive reasoned assessments of the likelihood and
loss impact of plausible high-severity operational losses that may occur
at a bank." 71 Fed. Reg. 55852, 55920.

  Using Bank Models for Regulatory Capital Purposes Increases Importance of
  Validation and Supervisory Review of Bank Models

Required capital levels under Basel II will depend in part on a bank's own
assessment of the risks to which it is exposed, and these assessments are
to be subject to both independent internal scrutiny and supervisory
review. The use of these assessments has the advantage of making
regulatory capital more sensitive to risks but also requires bank
supervisors to increase their reliance on the risk assessments of bank
officials. As discussed previously, models similar in some ways to the
ones that would be used for Basel II have been used by banks for internal
risk management purposes but, with the exception of market risk, have not
been used to calculate minimum regulatory capital requirements. To address
this issue, regulators have put several safeguards in place to provide
greater confidence in bank estimates, especially the requirement that the
models that the bank would use to implement Basel II must be validated on
an ongoing basis. That is, these models must have an independent internal
evaluation for conceptual soundness and real-world performance, among
other areas. The model validations can also be reviewed by bank examiners
and quantitative specialists at the discretion of the regulators, and the
integrity of the process surrounding model validation is also subject to
regulatory review. The adequacy of the supervisory review process will be
particularly important to ensure prudent estimates of risk, and hence,
required capital.

Changes in Capital Requirements Could Affect Competition among Banks

Possible changes in regulatory capital requirements have raised concerns
about competition between large and small banks domestically; between
large banks headquartered in the United States and foreign banks; and
commercial and investment banks in the United States, though the effect of
Basel II on bank competition remains uncertain. The competitive landscape
for banks headquartered in the United States will change in 2007 as some
foreign banks implement Basel II, which has raised concerns among core
banks. For example, some core banks are concerned that the leverage ratio,
to which foreign banks based in industrialized countries are generally not
subject, may impose higher capital requirements than Basel II for banks
with relatively low-risk credit portfolios. U.S. banks competing in
foreign jurisdictions would be subject to foreign regulatory requirements,
as well as a 3 percent leverage ratio at the holding company level. U.S.
banks have also expressed concern about other aspects of the U.S. Basel II
rules that could impose higher costs than foreign Basel II rules.^38

Controversial initial estimates of the capital levels that would be
required under the A-IRB approach suggested that credit risk capital
required for many broad asset classes could fall relative to Basel I. In
particular, OCC has noted that because of the low credit risk associated
with collateralized mortgage lending, that Basel II may lead to
substantial reductions in credit-risk capital for residential mortgages.
Because mortgage lending is an area where the largest U.S. banks compete
with smaller banks, some regulators and smaller banks were concerned that
those banks not subject to Basel II would be at a disadvantage. Regulators
proposed Basel IA in part to mitigate potential competitive disparities
between large and small banks, and the proposal features some additional
risk sensitivity for mortgages and lower capital requirements than Basel I
for some lower risk mortgages. OCC has noted that another potential avenue
for competitive effects between smaller banks and Basel II banks is small
business lending. One study of lending to small and medium enterprises
found only relatively minor competitive effects between community banks
and Basel II banks, because community banks and large banks make different
kinds of small business loans. However, there were potentially significant
adverse competitive effects on large banks that do not adopt Basel II in
the United States.^39 While this study is a comparison of the A-IRB
approach and Basel I, regulators state in the Basel IA NPR that they are
exploring options for an additional, lower risk-category for certain small
business loans (the equivalent to a 25 percent reduction in capital
requirements for those loans). Even with Basel IA as an option, FDIC
officials have highlighted concerns about potential competitive
disadvantages for banks that do not adopt Basel II based on lower
estimated capital requirements in the QIS-4 as compared with the Basel IA
ANPR. Retaining the leverage ratio for all U.S. banks will likely be
important to addressing some of these competitiveness concerns.

^38The Basel Committee has stated both that a limited amount of national
discretion can be used to adapt the Basel II standards to different
conditions of national markets, and that national authorities are free to
put in place supplementary measures of capital adequacy.

^39Allen N. Berger, "Potential Competitive Effects of Basel II on Banks in
SME Credit Markets in the United States," Journal of Financial Services
Research, vol. 29, no. 1 (2006).

Finally, banking organization officials have also raised the concern that
they will face disadvantages relative to domestic competitors that will
not be subject to the U.S. version of Basel II, such as some large
investment banks regulated by SEC at the holding company level
(consolidated supervised entities), which are permitted to use the
international Basel II framework. SEC officials with whom we spoke
generally did not believe that the differences between the NPR and SEC's
rule would raise material competitiveness issues, mostly because
investment banks did not currently engage in significant middle market and
retail lending. The officials said they would review the changes to the
banking regulators' final rule and planned to implement Basel II for
investment banks in a way that was generally consistent with the Federal
Reserve's interpretation of Basel II, as applied to financial holding
companies, and would consider changes that went beyond the Basel
agreement. SEC officials stated they did not anticipate the need to
propose another rule to incorporate any such changes.

The Impact of Basel II on the Level of Bank Capital Is Uncertain, but Proposed
Safeguards Would Limit Capital Reductions during a Transition Period

While initial estimates of the impact of Basel II showed large drops in
minimum required capital, a considerable amount of uncertainty remains
about the potential impact of Basel II on the level of regulatory capital
requirements and the degree of variability in these requirements over the
business cycle in the long term. The banking regulators have committed to
broadly maintain the level of risk-based capital requirements and proposed
safeguards that would limit capital reductions during a transition period.

  Quantitative Impact Study Raised Concerns about Large Drops in Required
  Capital

The QIS-4 showed, on average, large drops in minimum required risk-based
capital for participating banks, and there are a number of factors
affecting capital requirements that could make the potential impact of
Basel II, as currently proposed, vary in either direction from the QIS-4
results. First, the Basel Committee has instituted a "scaling factor" that
was not included in the QIS-4 results, currently 1.06, equivalent to a 6
percent increase, which would raise capital requirements for credit risk
relative to QIS-4.^40 The U.S. regulators, who have included this increase
in the NPR, view 1.06 as a placeholder, and have stated that they will
revisit the scaling factor along with other calibration issues identified
during the parallel run and transitional floor periods. U.S. regulators
have also committed to broadly maintain the overall level of risk-based
capital requirements (i.e., capital neutrality) with some incentives for
the advanced approaches in the NPR, though they have not defined precisely
how they plan to achieve this goal. Large reductions in minimum required
capital could reduce safety and soundness because banks would generally
hold too little capital in the absence of capital regulation. Second, the
regulators have noted a number of factors that could have biased the QIS-4
estimates in either direction. For example, the limited use of downturn
LGDs, meant to capture economic losses from default in a stressed or
recessionary economic environment, might have caused required capital to
be understated during QIS-4, while the lack of incorporation of credit
risk mitigation may have overstated required capital. Officials at some
banks noted more recently that, based on their estimates, they did not
expect large deviations from their QIS-4 results--with respect to the
level of total minimum capital requirements--given similar economic
conditions. Finally, the greater sensitivity of the A-IRB approach to
economic conditions and the good economic environment during QIS-4 was an
important factor in explaining lower estimates of required capital, and
less favorable economic conditions could produce greater required capital.

^40A bank's credit risk-weighted assets would be multiplied by the scaling
factor, which would yield an increase in minimum required capital for
credit risk of 6 percent.

The QIS-4 results featured variations in capital requirements across
portfolios and also identical assets. Regulators offered several possible
explanations for this variation, but some regulatory officials believed
that the variation raised questions about the reliability of bank models
for determining regulatory capital. One result of the QIS-4 was a
variation in capital requirements for the same broad class of assets.
However, portfolios for a given type of exposure can vary significantly
from bank to bank. For example, one bank may specialize in prime credit
card borrowers, while another may specialize in less credit worthy credit
card borrowers. The former would therefore be required to hold less
capital for its credit card risks under a risk-sensitive system such as
Basel II. FDIC officials have expressed particular concern regarding
variation in capital requirements for identical assets across banks based
on a test constructed by regulators as part of the QIS-4. In a functioning
capital regime, this variation would imply different capital treatment
across banks for the same degree of risk, which, if significant, would run
counter to both the goals of capital adequacy and competitive equity. The
regulators emphasized that the QIS-4 was conducted on a "best efforts"
basis without the benefit of either a definitive set of proposals or
meaningful supervisory review of the institutions' systems.^41
Nevertheless, QIS-4 raised a number of questions that have significantly
changed the way U.S. regulators are planning to implement Basel II.

  The Parallel Run, Transitional Floors and Leverage Ratio Would Help Prevent
  Large Declines in Required Capital during a Transition Period

As proposed in the United States, Basel II would initially have a less
significant impact on minimum required capital because the parallel run
and transitional floors would prevent large reductions in capital
requirements during a transition. The parallel run would allow regulators
to observe how Basel II would affect minimum capital requirements; and
regulators would see how the banks' models perform, as banks would
calculate required capital under both Basel I and Basel II, while meeting
the Basel I requirement. The NPR notes that regulators plan to share
information related to banks' reported risk-based capital ratios with each
other for calibration and other analytical purposes. Banks would be
qualified to transition to Basel II only after four consecutive calendar
quarters during which the bank complies with all of the qualification
requirements to the satisfaction of its primary federal supervisor. During
at least three transitional years, permissible risk-based capital
reductions at a qualified bank would rise by 5 percent per year relative
to minimum capital requirements calculated using Basel I. Regulators have
also stated that banks under Basel II would continue to be subject to the
leverage ratio--a capital requirement that is calculated as a percentage
of assets, independent of risk--which could also prevent significant
reductions in required capital.

As mentioned previously, regulatory officials have suggested a number of
advantages to the leverage ratio--a common financial measure of
risk--although as it is currently formulated, it also has some drawbacks.
The advantages of the leverage ratio include that it is easy to calculate
and that it can compensate for the limitations of the risk-based minimum
requirements, including coverage of only market, credit, and operational
risk, and the possibility that risks could be quantified incorrectly.
However, the leverage ratio could be the higher capital requirement for
some banks at some times, especially those with low risk profiles. This
would dampen some of the risk sensitivity of Basel II for low-risk banks
and assets, possibly leading to disincentives for banks to hold low-risk
portfolios. Furthermore, some banks were concerned that the leverage ratio
requirement, along with certain safeguards, defied the purpose of moving
to a conceptually more risk-sensitive capital allocation framework. These
banks believed that the leverage requirement and some safeguards could
prevent banks' regulatory capital levels from reflecting actual risk
levels. As a result, the banks would not benefit from the capital
reductions associated with taking on less risk, or managing it more
effectively. As seen in figure 5, the leverage capital requirement for the
lowest risk externally rated corporate exposures could exceed the Basel II
credit risk requirement, making the leverage ratio the relevant
requirement. Both figures 5 and 6 compare the minimum leverage ratio
requirement (a tier 1 capital requirement) with the Basel II credit risk
capital requirement (a total capital requirement that must be met with at
least half tier 1 capital, but can also include tier 2 capital). If the
figures compared only tier 1 capital, the Basel II credit risk capital
requirements would be half as high, which would mean that the leverage
ratio would exceed the Basel II tier 1 capital Basel requirement for a
broader range of assets, and thus be the relevant constraint.^42

41For example, Basel II banks will have to qualify before moving to the
advanced approaches, and, as mentioned above, validate models used to
calculate A-IRB credit risk parameters. During the transition period, the
parallel run and transitional floors also guard against precipitous
reductions in capital requirements.

^42As noted previously, the proposed Basel II minimum risk-based capital
requirements are that banks hold 4 percent of risk-weighted assets as tier
1 capital and 8 percent of risk-weighted assets as total qualifying
capital. 71 Fed. Reg. 55921.

Figure 5: Leverage Ratio vs. Basel II Credit Risk Required Capital for
Externally Rated Corporate Exposures, by Rating

Note: Estimates in the figure assume a LGD of 31.6 percent (mean LGD for
corporate, bank, and sovereign exposures from QIS-4), a downturn LGD of
37.07 percent (calculated using the supervisory formula from the Basel II
NPR) and a maturity of 5 years. Default probabilities, from Moody's, are
0.03 percent for AAA (the lower bound in the Basel II NPR), 0.08 percent
for Aa and A, 0.3 percent for Baa, 1.43 percent for Ba, 4.48 percent for
B, and 19.09 percent for C. The leverage requirement is measured in tier 1
capital, and the Basel II credit risk requirement is measured in total
capital. The estimates do not include any increase in the operational risk
capital requirement that could come from holding additional assets.

OTS has noted that because of the low credit risk associated with
residential mortgage-related assets, relative to other assets held by
banks, the risk-insensitive leverage ratio may be more binding for
mandatory and opt-in thrifts, thus the proposed rule may cause these
institutions to incur much the same implementation costs as banks with
riskier assets, but with reduced benefits. Similar to the lowest risk
externally rated corporate exposures, as seen in figure 6, the leverage
capital requirement for many lower risk mortgages, such as those with a
lower probability of default, could exceed the Basel II credit risk
requirement. Also, the U.S. leverage requirement does not include
off-balance sheet exposures, which include many securitizations and
derivatives, resulting in an incomplete picture of capital adequacy.^43 As
a result, the retention of the leverage ratio under Basel II may still
provide a regulatory disincentive to hold low-risk assets on the balance
sheet.^44

43In contrast, Fannie Mae and Freddie Mac, regulated by the Office of
Federal Housing Enterprise Oversight, must meet a leverage capital
requirement that includes both on-balance sheet assets as well as
off-balance sheet obligations, along with a risk-based capital
requirement. 12 C.F.R. S 1750.4.

^44The Federal Reserve has noted that if this takes place, the
disincentive does not present a regulatory capital problem from a
prudential perspective so long as appropriate risk-based capital charges
are levied against all assets that are retained by a bank.

Figure 6: Leverage Ratio vs. Basel II Credit Risk Required Capital for
Mortgages, by Probability of Default

Note: According to one estimate, a borrower with a LTV ratio of 80 percent
(equivalent to a 20 percent down payment) and a credit score of 740 has a
0.15 percent annual probability of default. For the same down payment,
credit scores of 700, 660, and 620 are associated with default
probabilities of 0.2, 0.31, and 0.51 percent, respectively. Estimates in
the figure assume a LGD of 17.7 percent (mean LGD for mortgage exposures,
other than home equity lines of credit, from QIS-4) and a downturn LGD of
24.28 percent (calculated using the supervisory formula from the Basel II
NPR). The leverage requirement is measured in tier 1 capital, and the
Basel II credit risk requirement is measured in total capital. The
estimates do not include any increase in the operational risk capital
requirement that could come from holding additional assets.

  Basel II Required Capital Could Vary over the Business Cycle

To supplement the results from QIS-4, some banks simulated their
portfolios under alternative economic conditions and estimated that
capital requirements for consumer and business credit exposures could vary
from 20 to 35 percent over the business cycle under Basel II, because

defaults and losses are higher in poor economic times.^45 More generally,
some bank officials said that Basel II is more sensitive than Basel I to
the risk level of their exposures and the health of the economy in which
they were operating. However, federal regulatory officials with whom we
spoke were uncertain about how much capital requirements would or should
vary over the business cycle. FDIC officials with whom we spoke said they
believed it was undesirable for bank capital requirements to fall
substantially during expansions and rise substantially during recessions,
when bank capital may be most difficult to obtain. Because capital
requirements could vary over the business cycle, average (i.e., through
the cycle) capital could be higher or lower than Basel I, depending on how
Basel II is calibrated. In particular, if Basel II were calibrated to be
capital neutral with Basel I during good economic conditions, average
capital requirements could actually rise relative to Basel I.

While minimum capital requirements are expected to vary over the business
cycle, actual capital held by banks could be more stable if banks take
into account more stressed economic scenarios through holding capital
above regulatory minimums. Requiring banks to hold more capital when
borrowers are more likely to default could help ensure that banks have
adequate capital when economic conditions begin to deteriorate. However,
some experts have raised concerns that this could exacerbate already
deteriorating economic conditions by discouraging banks from lending.
Regulatory officials were uncertain of whether minimum required capital
would adjust in advance of changes in economic conditions. However, the
Basel II NPR contains a stress-testing requirement in which banks must
simulate their portfolios in order to understand how economic cycles,
especially downturn conditions, affect risk-based capital requirements.
Adequate stress testing, as in calculating risk parameters, will depend on
banks gathering data from historical recessions that could reflect future
economic downturns, or adjusting existing data to reflect more severe
economic conditions. As part of Pillar 2, according to the NPR, regulators
expect that banks will manage their regulatory capital position so that
they remain at least adequately capitalized during all phases of the
economic cycle.^46 OCC has noted that the stress-testing requirements will
help ensure that institutions anticipate cyclicality in capital
requirements, reducing the potential impact of changes in capital
requirements. In other words, bank capital would be relatively stable over
the business cycle, while the buffer between required capital and actual
capital held would fluctuate through the cycle. Several bank officials
have suggested that this scenario is consistent with banks' desire to
avoid raising additional capital during a downturn.

^45These estimates are generally based on the recessionary period between
2000 and 2002, which was relatively mild by historical standards.

^4671 Fed. Reg. 55855.

  Impact of Basel II on Total Capital Held Is Uncertain Because Banks Hold
  Capital for a Variety of Reasons

Basel II's impact on the capital actually held by banking organizations is
also uncertain, because banks hold capital for a variety of reasons,
including market forces such as meeting the expectations of counterparties
and credit rating agencies. Officials at several banks told us that they
weighed a number of factors when deciding how much capital to hold,
including both minimum and Pillar 2 regulatory requirements; internal
economic capital models; senior management decisions; and market
expectations, which are often exemplified by assessments from credit
rating agencies such as Moody's and Standard and Poor's.^47 The Basel
Committee has identified important obligations for banks as part of Pillar
2 supervision, specifically a process for assessing their overall capital
adequacy in relation to their risk profile and a strategy for maintaining
their capital levels. This process requires banks to demonstrate that
their internal capital targets are well founded and consistent with their
overall risk profile and current operating environment. Banks are to
assess all material risks, including both those risks covered by Pillar 1
minimum requirements as well as other risks that are not addressed, such
as concentration, interest rate, and liquidity risks. One rating agency
expected that banks would hold a larger capital cushion than they
currently do over regulatory requirements under Basel II because of the
uncertainty about the new requirements. Further, a foreign bank supervisor
suggested that the effect of Basel II on actual capital would be less than
the change in minimum required capital, due in part to the expectations of
counterparties and rating agencies.

^47In order for a bank holding company to be eligible to become a
financial holding company, which allows it to engage in securities and
insurance businesses, all its commercial banks must be well-capitalized.
As mentioned previously, well-capitalized banks must meet capital ratios
for risk-based and leverage capital that are above the minimum
requirements.

Core Banks Are Incorporating Basel II into Ongoing Efforts to Improve Risk
Management, but Challenges Remain

Officials at most core banks with whom we spoke reported that their banks
had been working to improve the way they managed and assessed credit,
market, and other types of risks, including the allocation of capital to
cover these risks for some years. According to these officials, the banks
were largely integrating their preparations for Basel II into their
current risk management efforts. Some officials saw Basel II as a
continuation of the banking industry's evolving risk management practices
and risk-based capital allocation practices that regulators had
encouraged. To help meet the regulatory requirements proposed for Basel
II's advanced approaches, many core bank officials reported that their
banks were investing in information technology and establishing processes
to manage and quantify credit and operational risk. To varying extents,
many officials said that the banks had hired additional staff or were
providing different levels of training for current employees. Most
officials said that their banks had incurred or would incur significant
monetary costs and were allocating substantial resources to implement
Basel II. Many officials also reported that their banks faced challenges
in implementing Basel II, including operating without a final rule,
obtaining data that meet the minimum requirements for the A-IRB for all
asset portfolios and data on operational losses, and difficulty aligning
their existing systems and processes with the proposed rules. Officials at
many core banks viewed Basel II as an improvement over Basel I, and some
banks considering adopting Basel II believed that the new regulatory
capital framework would help improve their risk management practices.

Core Banks Are Working to Integrate Basel II into Existing Efforts to Improve
Risk Management and Capital Allocation Practices

Officials at many core banks with whom we spoke pointed out that their
banks had been improving the way they managed and assessed credit, market,
and other types of risks for some time, including allocating capital to
cover these risks. Some officials noted that regulators had encouraged
these efforts and added that many of the steps the banks had taken
foreshadowed proposed Basel II requirements, in part because of regulatory
guidance. For example, a number of core banks noted that the Federal
Reserve's Supervisory Letter 99-18 (SR 99-18) emphasized the need for
banking organizations to make greater efforts to ensure that their capital
reflected their underlying risk positions.^48 The guidance also encouraged
the use of credit-risk rating systems in measuring and managing credit
risk. One official compared the processes that the guidance encouraged for
determining whether or not banks were adequately capitalized to the role
of supervisory oversight under Pillar 2 of Basel II. Officials at another
bank explained that the bank had already set up an internal risk rating
system that was similar to what the officials believe will be required
under the A-IRB. Officials at other banks noted that they were complying
with OCC's supervisory guidance in Bulletin 2000-16 for validating
computer-based financial models, a process similar to that which is
proposed under Basel II.^49

48See Federal Reserve, Assessing Capital Adequacy in Relation to Risk at
Large Banking Organizations and Others with Complex Risk Profiles, SR
99-18 (July 1, 1999).

Officials at many core banks said that their efforts to comply with the
proposed Basel II rules took place within an existing corporate structure
that allocated risk management, review, and reporting responsibilities
among different divisions and business units. For example, officials from
one bank said that their business units follow a common set of
implementation tools and information regarding these projects, which is
consolidated to facilitate managerial oversight. Some banks are
establishing risk governance policies or processes to help in developing
assessments of their risks and are monitoring and reporting these risks.
Officials from one bank noted that policies and processes for determining
risk parameters were being used to assess capital needs. Other banks have
established or are enhancing internal controls for systems related to
Basel II, including data systems.

Core Banks Are Investing in Information Technology, Such as Data Collection, to
Quantify and Manage Risks

Officials at many core banks reported that their banks were investing in
information technology and establishing processes to manage and quantify
credit and operational risk, including collecting data on credit defaults
and operational losses, in order to meet the regulatory requirements
proposed for the advanced approaches. To varying extents, core banks are
making efforts to collect, aggregate, and store data and detailed
information associated with credit defaults that can be used to determine
risk parameters. For example, officials at several banks explained that
they were collecting more comprehensive and detailed information on their
credit defaults or were gathering such information more consistently. Many
banks are automating or upgrading their data collection systems, including
building data repositories that aggregate default information in a
centralized database.

^49See OCC Bulletin, OCC 2000-16 (May 30, 2000).

In preparation for Basel II, some bank officials also reported that their
banks were creating or refining systems to classify and assign internal
ratings showing the risk levels of their credit exposures. Many banks are
also making efforts, to varying extents, to establish an ongoing,
independent process to track, review, and validate the accuracy of the
risk ratings. Many banks are working on statistical models that will
generate risk parameters that can be used to determine the level of
regulatory capital needed to cover their exposures to credit risk,
according to bank officials. For this effort, some banks are using
existing models that are also used to determine internal economic capital.
Many are establishing processes to review and validate the accuracy of
their regulatory and economic capital model inputs using quantitative
methods and expert judgment.

Similarly, officials at many core banks reported that their banks had
built or were in the process of building systems and databases to collect
and store data on operational losses. Officials at some banks noted that
their banks were compiling key risk indicators for potential operational
losses or said that their banks had engaged in benchmarking exercises for
operational risk with federal regulators. Several officials also reported
that their banks were in the process of codifying and enhancing their
internal controls for operational risk, including developing and
documenting relevant policies. Other banks are conducting independent
reviews of the operational risk-control processes that their business
lines are required to follow. As with credit risk, many officials said
that their banks were building or further developing their models to
assess capital needs for potential operational losses, including by
applying scenario analyses.

Core Banks Reported That They Were Training Employees and Hiring Additional
Staff to Implement Basel II

To varying extents, officials at many core banks stated that as part of
their preparations for Basel II they had hired or would hire additional
staff and were providing different levels of training for their staff to
implement Basel II. For example, one bank intends to hire more than 100
new staff who would largely be devoted to building systems to address
credit, operational and market risk, including modifying the bank's
capital models for operational risk. Some officials noted that they were
reallocating human resources within their organizations or drawing on the
expertise of existing staff who were already familiar with the Basel II
requirements. Some banks have devoted or plan to devote more resources to
modeling efforts, such as hiring consultants and validating models.

Bank officials also described training programs and standardized training
procedures that were tailored to projects related to Basel II or to staff
audiences, including (1) providing courses and online information on the
Basel II requirements and (2) educating senior management about the new
systems required under the advanced approaches. Banks have also invested
in or identified the need to focus training in specific areas, such as how
to assign credit-risk ratings to their borrowers, or validate their rating
systems. Other specific training topics reported by bank officials
included calculating capital for wholesale credit exposures, transferring
information from databases into risk models, and effective regulatory
reporting. In addition, banks have invested in training for operational
risk--for example, by promoting awareness for and treating operational
risk in a consistent manner. Some officials also noted that the training
required to implement Basel II was similar to the training they had
developed for their own risk management or economic capital efforts.
Officials from several banks expect to provide additional training as they
continue to implement Basel II or when they better understand what will be
required in the final rule.

Core Banks Reported Having Incurred Significant Monetary Costs in Implementing
Basel II

Officials at many core banks said that they had or would incur significant
monetary costs, and were allocating substantial resources to implement
Basel II. Some banks had developed plans or performed analyses to see what
areas of their implementation efforts required improvement, so that they
could determine the skill sets, staffing levels, systems, and technology
needed to comply with the proposed rules. Many bank officials expected to
make significant investments in building their credit-risk infrastructure,
including developing models to measure risk. Specifically, some officials
noted that they were making greater investments to collect data and build
data warehouses. Officials at several banks added that they expected to
incur ongoing costs as a result of implementing Basel II. For example, one
bank official explained that they had performed a number of analyses to
estimate certain risk parameters and needed to check regularly that the
numbers generated from the analyses were reasonable.

Depending on the final rule, bank officials expect to incur additional
costs. The uncertainty about the final rule has contributed to the expense
of preparing for Basel II, according to the officials, because some banks
have been unable to make timely decisions or have had to adjust their
systems to conform to different stages of the proposed rules for Basel II
specified in the ANPR, and later in the draft NPR. However, officials at
many core banks stated that they might have incurred some of these costs
regardless of Basel II in their efforts to improve their risk management
practices and economic capital systems. For example, officials at one bank
stated that upgrading the bank's technological infrastructure would also
help the bank meet Basel II requirements. Some officials were concerned
that the expenditures and efforts they had made to prepare for Basel II
were far greater than the improvements they expected Basel II to bring to
their risk management practices. But others noted that separating the
direct costs of Basel II from other expenses was difficult, because the
banks had ongoing risk management needs and laws to comply with, such as
the Sarbanes-Oxley Act of 2002.^50 Ultimately, banks' efforts to meet
Basel II requirements have compressed such expenditures into a shorter
time frame.

Core Banks Face Challenges, Including the Lack of a Final Rule and Difficulties
in Obtaining Data and Aligning Existing Systems with the Proposed Rules

Officials at many core banks reported that their banks faced challenges in
implementing Basel II. Key among these challenges is the uncertainty
created by the lack of a final rule. Some officials, for example, stated
that they had prepared for the implementation of Basel II knowing that the
requirements of the rule could change, potentially increasing costs.
Officials at a few banks noted that they might be unable to move forward
with certain implementation efforts, such as hiring or providing specific
training for their staff, without a final rule. If the final rule requires
that banks make significant changes to their current efforts, several
officials said that they might be unprepared for the parallel run that is
scheduled to start in January 2008. Other officials stated that without
the final rule, regulators were unable to provide banks with formal
regulatory guidance or definitive evaluations of their readiness to meet
Basel II requirements, thus making it difficult for banks to obtain
clarification on parts of the proposed rules. However, several officials
found the preliminary feedback they had received from regulators to be
helpful.

Further, officials from many core banks said that they were having
difficulty obtaining data that met the minimum requirements of the A-IRB
for all asset portfolios and data on operational losses. For example, some
banks have not historically collected all of the data required for Basel
II. While bank officials generally said they believed their banks would
meet the data requirements by the start of the parallel run in 2008, many
said that they did not have enough historical data on loan defaults for
credit risk. In some cases, officials said that they did not have enough
data on credit defaults for immaterial portfolios or portfolios with
low-risk, high-quality exposures. In other cases, the officials said that
they needed to collect additional information specified in the regulatory
criteria. For example, officials at a few banks described having to
integrate and reconcile different types of financial and risk data before
they could apply the information to their modeling efforts. Some banks
lacked historical data covering more than one economic cycle and noted
that it was difficult to capture default information reflecting what could
occur during a significantly stressed economic environment. Officials at a
few banks noted that it either took more effort or was a challenge to
collect data from different legacy systems. Similarly, many officials said
that their banks had limited internal data on operational losses,
including instances of severe loss. For both credit and operational risk,
banks are supplementing insufficient internal data with external data
obtained through rating companies or data consortiums. However, several
officials noted that it was difficult to assess the reliability of
external data or to draw analogies from external information that
adequately represented the risks of a bank's portfolio.

^50Pub. L. No. 107-204, 116 Stat. 745 (July 30, 2002).

Core bank officials also said that they were having difficulty aligning
their existing models with the proposed specifications for the A-IRB
approach. For example, some bank officials were concerned that the
proposed safeguards, such as certain limits that constrain how banks could
calculate risk parameters used to determine capital for credit risk,
differed from banks' internal practices or would lead to higher capital
requirements. In calculating capital for credit risk, some banks use
probabilities and definitions of default for their internal economic
capital that are different from the regulatory capital specifications.
Officials from several banks noted that they were collecting separate
information for both types of calculations or maintaining separate models
for calculating economic and regulatory capital. Some officials also noted
that because the U.S. requirements for Basel II differed from those of
other countries--for example, the definitions of default and the
implementation time frames--they were having difficulty using the systems
and models used for the U.S. requirements to meet the capital requirements
of other countries. Others noted that it would be difficult to comply with
different Basel II rules across countries, and some banks were preparing
to implement the standardized approach for credit risk in other countries
because of the delay in finalizing the rules for the advanced approaches
in the United States.

U.S. Regulators Are Integrating Preparations for Basel II into Their Current
Supervisory Process but Face a Number of Impediments

While U.S. regulators have been integrating preparations for Basel II into
their current supervisory processes and building on their experience
overseeing risk management practices of the banks, a number of issues
remain to be resolved as regulators finalize the rule. All the regulators
have some experience overseeing models-based risk management at core
banks. In addition, they plan to integrate Basel II supervisory
requirements into their existing oversight processes and reviews and are
taking steps to prepare for the process of qualifying banks to use the
advanced approaches by reviewing banks' preliminary qualification plans.
Regulators are also hiring and training staff and coordinating with U.S.
and foreign regulators.^51 However, regulators face a number of
impediments in their efforts to agree on a final rule for the transition
to Basel II. Regulators' different perspectives have made reaching
agreement on the NPR difficult, as will likely be the case for the final
rule. Moreover, the process could benefit from greater transparency going
forward, including how regulators will assess the Basel II results during
the transition years and report on any modifications to the rule during
that period. It is also important for regulators to resolve some of the
uncertainty and increase the transparency of their thinking by including
in the final rule more specific information about certain outstanding
issues, such as how regulators will treat portfolios that lack adequate
data to meet regulatory requirements for the advanced approaches, how
regulators will calculate reductions in aggregate minimum regulatory
capital and what would happen if the reduction exceeds a proposed
10-percent trigger, and how worthwhile public disclosure will be under
Pillar 3. If these issues are not addressed, the ongoing ambiguity and
lack of transparency could result in continued uncertainty about the
appropriateness of Basel II as a regulatory capital framework.

Regulators Have Been Building on Experience Overseeing Risk Management

To varying degrees, banking regulators have overseen some aspects of
banking organizations' internal models-based risk management since the
mid-1990s, including economic capital and market risk models similar to
those that will be a part of Basel II. Although this oversight has been
for risk management and--with the exception of certain market risk
models--not for capital-setting purposes, regulators believe this
experience will help them oversee banks in a Basel II environment.
Regulators have also developed regulatory practices that will continue
after the Basel II rule is finalized. These practices include, among
others, creating standards to use in calculating banks' risk-based capital
ratios and reviewing banks' internal controls to determine if they are
sufficient for sound risk management.

^51All four regulators said that their primary focus was on Basel II,
rather than on Basel IA, and that the additional risk categories and other
changes reflected in Basel IA would not be a significant regulatory
oversight effort in comparison to Basel II; therefore, we also focus on
regulators' preparations for Basel II.

In 1996, regulators amended Basel I to incorporate market risks in the
Basel I calculations of required capital.^52 The Market Risk Rule, which
is overseen by the Federal Reserve, OCC, and FDIC for a small number of
institutions, requires banks to use their own internal models to measure
risk. Specifically, it requires banks to measure banks' daily
value-at-risk (VAR) for covered positions--that is, banks must maintain
capital to cover the risks associated with potential fluctuations in
future market prices.^53 A bank's internal model may use any generally
accepted technique to measure VAR, but the regulation requires that the
model be sophisticated and accurate enough for the nature and size of the
covered positions. To adapt banks' internal models for regulatory
purposes, banking regulators developed minimum qualitative and
quantitative requirements for all banks subject to the market risk rule.
Banks use these standards in calculating their VAR estimate for
determining their risk-based capital ratio.^54

The Federal Reserve, OCC, and FDIC also review banks that are subject to
the market risk capital requirements for evidence of sound risk
management, such as an institution's risk control unit that reports
directly to senior management and is independent of the business trading
units. The Market Risk Rule requires banks to conduct periodic
backtesting--for example, by comparing daily VAR estimates generated by
internal models against actual daily trading results to determine how
effectively the VAR measure has identified the boundaries of losses.^55
Banks must use the backtesting results to adjust the multiplication factor
used to determine the bank required capital. Federal Reserve officials
said that the VAR models have performed well, and noted that no banks have
had model backtest results that have required multiplication factors
higher than the minimum prescribed in the Market Risk Rule. The officials
said that such performance was due, in large part, to the continual
improvement of the banks' VAR methodologies and other requirements of the
Market Risk Amendment, including the use of stress testing. Federal
Reserve officials said that regulators actively monitor the rigor and
adequacy of banks' internal VAR models in light of new and emerging
products.

^52The effective date of the Market Risk Rule was January 1, 1997, but the
date for mandatory compliance was January 1, 1998. 61 Fed. Reg. 47357-78.
In September 2006, the banking regulators issued a Notice of Proposed
Rulemaking proposing revisions to the Market Risk Rule to enhance its risk
sensitivity and introduce public disclosure requirements. 71 Fed. Reg.
55958 (Sept. 25, 2006).

^53Covered positions include all positions (both debt and equity) in a
bank's trading account and all foreign exchange and commodity positions,
whether or not they are in the trading account.

^54The qualitative requirements reiterate the basic elements of sound risk
management. According to the final rule, the quantitative requirements are
designed to ensure that an institution has adequate levels of capital and
that capital charges are sufficiently consistent across institutions with
similar exposures. These requirements call for each bank to use common
quantitative standards when using its internal model to generate its
estimate of VAR.

As part of their risk management reviews, the Federal Reserve and OCC have
also overseen some aspects of core banks' economic capital models since
the 1990s. Although that oversight has focused on risk management and not
setting regulatory capital levels, Federal Reserve and OCC officials said
that the experience had helped prepare them for oversight of Basel II
regulatory capital models, as economic capital models and Basel II
regulatory capital models were similar. For example, as discussed earlier,
both measure risks by estimating the probability of potential losses over
a specified time period and up to a defined confidence level, using
historical loss data. According to these regulators, banks are generally
using existing economic capital systems as a starting point to create
their Basel II regulatory systems. Federal Reserve officials noted that
because Basel II would establish common system requirements for regulatory
capital purposes, in areas where banks have varying requirements for their
internal modeling systems, such as how they define default, regulators
will have greater comparability across systems. Further, some regulatory
officials noted that overseeing models to set regulatory capital levels
would involve increased regulatory scrutiny for model validation as well
as greater market discipline, because banks would be required to publicly
disclose aggregated information underlying the calculation of their
risk-weighted assets.

The Federal Reserve and OCC also have existing supervisory guidance that
describes the regulatory approaches for some aspects of their oversight of
internal models, oversight that the regulators say has helped prepare them
for oversight of models in a Basel II environment. Federal Reserve
Supervisory Letter 99-18 (SR 99-18), issued on July 1, 1999, directs
supervisors and examiners to evaluate banks' internal capital management
processes to judge whether these processes meaningfully tie the
identification, monitoring, and evaluation of risk to the determination of
the institution's capital needs. In addition, SR 99-18 requires examiners
to consider the results of sensitivity analyses and stress testing
conducted by the institution and the way these results relate to their
capital plans. According to the letter, banks must be able to demonstrate
that their capital levels are adequate to support their risk exposure, and
examiners are to review the banks' analyses. Finally, SR 99-18 directs
examiners to assess the degree to which an institution has in place, or is
making progress toward implementing, a sound internal process to assess
capital adequacy, including any risk modeling techniques used. Federal
Reserve officials noted that, although challenges continue to exist, banks
in general have made considerable strides in evaluating their internal
capital adequacy and enhancing governance and controls around the process
that produces such estimates. In some cases, work on the internal
assessment of capital adequacy has highlighted the need for institutions
to focus on fundamental risk management issues, such as risk
identification, risk measurement, and internal controls.

^55See, e.g., 12 C.F.R. Part 3, App. B S 4(e) (OCC).

Likewise, OCC Bulletin 2000-16 (2000-16) (May 30, 2000) articulates
procedures for model validation: independent review of the models' logical
and conceptual soundness, comparisons with other models, and comparison of
model predictions and subsequent real-world events. OCC officials and
examiners for two large U.S. banking organizations said they used 2000-16
to assess banks' processes for validating their economic capital models.
One examiner, for example, noted that a review using 2000-16 led to
requiring a bank to improve its documentation surrounding models it had
created. According to another official, it also helped to promote greater
understanding and awareness of the need for model validation to become an
integral part of bank risk measurement and management systems. It further
promoted greater consistency in supervisory assessments of bank model
validation practices.

OTS and FDIC officials said they also have some experience working with
models. OTS, the primary federal regulator of the remaining core Basel II
institution, has policy staff and examination experience in interest rate
risk modeling and validation processes. OTS created and maintains a Net
Portfolio Value model, which allows users to create customized interest
rate risk stress scenarios and incorporate emerging interest rate
exposures and techniques, among other things. OTS officials said this
oversight had helped OTS policy and examiner staff gain experience in
overseeing the use of models and validation processes. OTS officials also
said that they have some recent experience reviewing economic capital
models and validation for risk management purposes, though OTS's
experience in this area has not been as extensive as the Federal Reserve's
or OCC's. Although OTS has not analyzed market risk models, it will do so
should the September 2006 amendments to the Market Risk Rule be adopted as
proposed. FDIC, as noted earlier, will be involved in the Basel II
implementation process as the deposit insurer for all of the Basel II
banks, and FDIC officials said they could be the primary federal regulator
for insured subsidiaries of core Basel II banks or possible opt-in banks.
FDIC officials said that, in addition to its oversight of banks subject to
the Market Risk Amendment, its examiners also have some experience working
with a variety of credit risk and valuation models.

Regulators Plan to Integrate Basel II into Their Existing Supervisory Processes

The regulators plan to incorporate Basel II's additional supervisory
requirements into their existing oversight processes and supervisory
reviews.^56 Regulatory officials said that because they currently oversee
risk modeling and capital adequacy activities, Basel II oversight is
largely an evolution of existing supervisory strategies. The primary
federal regulators' current supervisory processes for core banks were
generally similar--risk-focused approaches that emphasize continuous
monitoring and assessment of how banking organizations manage and control
risks. Consistent with their current approaches, a team of examiners from
the relevant primary regulator will continue to be in charge of the
supervision of Basel II banks (core and opt-in banks), and teams from the
Federal Reserve will continue to oversee all of the Basel II bank holding
companies. Bank-specific examination teams are supported by other
regulatory staff on specific technical issues, such as core credit, credit
quantification, models and methodologies, and operational risk. As part of
their examination process, examiners will continue to assess the banks'
risks, identifying the business activities that pose the greatest risk,
and validate the use and effectiveness of the bank's risk management
practices. Risks may include credit risks, both commercial and retail
(such as a bank's credit rating system), risks involving the bank's
information technology system (such as data warehousing issues), or
corporate governance risks (such as a bank's ability to provide adequate
audit coverage). Officials from two regulators noted that these risk
factors are all part of banks' risk management processes and would have to
be reviewed even in the absence of Basel II.

^56Because only the Federal Reserve, OCC, and OTS will be the primary
federal regulators of the core banks (at current asset levels), this
discussion focuses on the examination procedures for those regulators.
Once Basel II is implemented, FDIC may be the primary federal regulator
for some opt-in banks.

Based on their risk assessment, examiners develop and execute supervisory
plans that set out the timetable and work schedule for the examiners for
the year. The supervisory plans typically would include oversight of
several aspects of risk management that will continue under Basel II. For
example, examiners from two regulators noted they assess how banks
validate their models, by reviewing how banks verify their own modeling
processes (e.g., independent validation, sound governance, and internal
controls), peer benchmarking studies, and comparisons to rating agencies.
These examiners said they may also compare some models, test specific
assumptions, and assess data and internal audit systems and procedures
such as stress testing, use of scorecards (devices used to determine an
obligor's default probability by associating it with a risk rating for the
obligor) and internal ratings for loans. Finally, these examiners noted
they review banks' businesses or products, such as equity derivatives, and
conduct targeted exams that assess specific areas--for instance,
collateral or asset management for credit, market and operational risk.

Regulators Are Taking Steps toward Eventual Qualification of Banks to Use the
Advanced Approaches

Regulatory officials told us that they were taking steps toward eventual
qualification of banks to use the advanced approaches once the final rule
was in place but that this qualification work was preliminary because the
rule was not final. A bank will be qualified when its primary federal
regulator approves it and, after consulting with other relevant
regulators, determines whether the bank's Basel II systems satisfy the
supervisory expectations for these approaches. The NPR states that
regulators will evaluate banks on their advanced internal ratings based
systems for rating risk and estimating risk exposure; regulators will
consider a bank's estimates of key risk characteristics, such as
probability of default and loss given default (a process called
quantification), ongoing model validation, data management and
maintenance, and oversight and control mechanisms.^57 As part of this
evaluation, regulators said the examination teams for each bank would
develop a qualification strategy designed to help the team better
understand the design of the bank's Basel II systems, drawing on existing
supervisory tools and assessing compliance with the forthcoming U.S. rule
and supervisory guidance. Regulatory officials said that the qualification
process would be a series of targeted reviews tailored to each institution
and determined by the results of specialized reviews and the bank's own
independent testing. Regulatory officials also emphasized that
qualification would be an ongoing process and that the final rule would
require banking organizations to meet the qualification requirements on a
continuous basis, subject to supervisory review. In addition, regulators
plan to:

^5771 Fed. Reg. 55830, 55911-12.

           o Continue conducting discovery reviews of banks' Basel II systems
           and processes that will cover areas such as data collection and
           warehousing, wholesale and retail credit models, and the
           definition of default. Like examinations, these reviews assess
           risks and look at parts of a bank's risk management programs; but
           unlike examinations, they cannot include tests for compliance with
           Basel II requirements until a final rule is in place. Federal
           Reserve and OCC examiners told us that the goals of discovery
           reviews conducted before the rule was finalized are to understand
           the conceptual underpinnings of a bank's Basel II systems and
           evaluate the processes and models from a prudent risk management
           standpoint. These examiners said that discovery reviews could not
           result in formal evaluations of banks' Basel II progress because
           there was no final rule yet. But they noted that they would speak
           with banks whose approaches differed from what was currently
           proposed in Basel II.^58 Similarly, some regulatory officials and
           examiners told us that not having a final rule made it difficult
           to gauge the progress that banks were making and prevented them
           from determining what else banks might need to do to be Basel II
           compliant.
           o Conduct reviews of each bank's Basel II implementation plans and
           the progress made in meeting them, called gap analyses, to
           identify additional work that the banks need to do. The NPR
           requires banks' implementation plans to detail the necessary
           elements of rolling out advanced approaches in both credit and
           operational risk. But without a final rule, regulators and banks
           have been working with informal implementation plans and gap
           analyses using previous regulatory guidance. Regulatory officials
           said the preliminary implementation plans were an essential
           feature of the qualification process, as they linked existing
           regulatory guidance with specific implementation activities and
           provided an initial basis for the development of supervisory plans
           related to the qualification process. For example, one examiner's
           review of a bank's gap analysis found that the bank needed to more
           fully define how it planned to estimate key risk characteristics.
           The examiner noted that the bank was proceeding to update its
           implementation plans across the other components of its commercial
           internal ratings-based portfolio. As a result of these efforts,
           regulators have developed gap analysis templates to guide
           examiners.
			  
^58However, such discussions would not be considered a supervisory issue
because banks are not yet required to meet any Basel II requirements.
			  
           o Communicate with banks about Basel II issues. Regulatory
           officials emphasized that they were speaking with bank officials
           about the development of the bank's Basel II systems, including
           methodologies and processes. These discussions will continue until
           after the final rule is issued, and according to regulators,
           facilitate discovery and qualification work.

           Regulatory officials emphasized that, without a final rule, their
           work on qualification was preliminary, although they said it did
           provide useful information about the status of banks'
           implementation efforts. For example, regulators observed that all
           core banks had draft implementation plans and have Basel II
           project management offices. But regulatory officials said that
           core banks varied in their degree of preparation to date,
           specifically, in the quality of their data and risk management
           systems. OCC officials said that some banks are more likely than
           others to make use of the potential 3-year implementation period
           between becoming a core bank and the first transitional floor
           period to fully develop their data and risk management systems.
			  
			  Hiring and Training Supervisory Staff Is an Important Part of
			  Regulatorsï¿½ Basel II Preparations, but Retaining Staff Is a Key
			  Challenge

           U.S. banking regulators have been preparing for Basel II by hiring
           additional supervisory staff, including examiners, with the
           necessary quantitative skills and by providing training specific
           to Basel II. Officials told us that although the skills needed to
           oversee Basel II implementation were similar to the skills needed
           for all risk management oversight, additional quantitative skills
           would be necessary. Regulatory officials emphasized that, like
           their supervisory processes, these hiring and training efforts
           were part of their evolving human capital plans and coincided with
           increased oversight of banks' models-based risk management
           approaches. Therefore, officials said, the specific impact of
           Basel II on human capital efforts was difficult to quantify.
           Regulatory officials stated that they had been building the skill
           sets required to oversee economic capital models as their
           responsibilities in this area increased and added that many of
           these efforts would be under way even in the absence of Basel II.
           And while several regulatory officials noted that they had hired
           some staff specifically for Basel II that they would probably not
           have hired otherwise, they said that not all staff involved in
           Basel II oversight needed to have specialized skills. Generalist
           safety and soundness examiners with traditional skill sets will
           continue to examine banks, including those under Basel II.
           National teams will, however, assist these examiners with the more
           technical aspects of the new capital regime.

           Several regulatory officials noted that having staff with
           specialized skills in quantitative risk management models and
           quantitative analysis would be even more necessary under Basel II,
           while examiners would generally need good skills in credit,
           capital markets, and information technology. Regulatory officials
           said that they had set up national teams of staff with this
           specialized expertise and were providing training to both
           specialist staff as well as generalist examiners. Officials from
           all four regulators emphasized the importance of training to their
           Basel II implementation efforts. According to regulatory
           documentation and officials, supervisory staff have been trained
           in numerous areas, including model validation, internal control
           reviews, economic capital, operational risk, validation of credit
           rating and scoring models, QIS-4, and possible ways that banks
           could try to manipulate their Basel II systems.

           Regulatory officials said that they faced several human capital
           challenges in implementing Basel II. First, several officials said
           that regulators would be challenged by the increased complexity of
           issues requiring examiner judgment under Basel II and the need to
           apply Basel II requirements consistently across banks. For
           example, examiners will need to review the rank ordering of
           ratings for loans in banks' two-dimensional ratings systems
           developed for Basel II and make greater use of debt-rating models
           that will require examiners to review management overrides and
           assess model validation.^59 OCC officials also noted that
           examiners currently have to exercise judgment on increasingly
           complex issues, including validating models and overrides, as
           banks increasingly use models. Federal Reserve officials said the
           key to successfully meeting this challenge will be high-quality
           training and effective supervisory guidance that incorporates
           comments from the industry. Second, several regulators said
           consistently applying Basel II across banks would also be a
           challenge, especially for the AMA approach to operational risk,
           because of the flexibility allowed under the NPR. OCC officials
           said that the forthcoming supervisory guidance and a recent Basel
           Committee paper would help clarify the allowable range of
           practice.^60 Both OCC and the Federal Reserve noted that their
           national teams of quantitative experts should help regulators meet
           the challenge of consistent application across banks. Third,
           regulators said that hiring new personnel had been challenging and
           that retaining and continued training of supervisory staff
           presented ongoing challenges. For instance, increased competition
           for staff with these skills among the regulators themselves and
           between the regulators and industry made hiring and retaining
           staff more challenging. While some regulatory officials had some
           staffing concerns, they also expressed confidence that they could
           fulfill their new regulatory responsibilities from Basel II.
           Several regulatory officials also said that they would continue
           assessing staffing needs as Basel II moved forward and as the
           exact number of Basel II banks became clearer, they would be
           reassessing the ideal number of staff they needed with specialized
           skills.
			  
^59Typically banks have rated loan quality along a single dimension, but
Basel II requires that borrowers be rated in two areas, or dimensions,
default probability and loss severity in the event of default.

^60The NPR says that regulators will jointly issue supervisory guidance
describing agency expectations for wholesale, retail, securitization, and
equity exposures, as well as for operational risk. 71 Fed. Reg. 55842. The
NPR notes that the regulators have previously issued for public comment
draft supervisory guidance on corporate and retail exposures and
operational risk. Id. n. 23. The forthcoming guidance will be designed to
clarify the requirements of the NPR and help provide a consistent and
transparent process to oversee implementation of the advanced approaches.
			  
			  Regulators Are Coordinating Domestically and Internationally, but
			  Lack of a Final Rule Is a Complicating Factor

           Regulators are coordinating their work with other U.S. regulators
           and with those in other countries in order to provide more
           effective and consistent oversight, but the lack of a final rule
           makes this coordination more complicated. The four regulators'
           strategic plans all place priority on this effort, and several
           regulatory officials from these agencies emphasized the importance
           of coordination, given the complexity of Basel II and the
           regulators' varied perspectives. Domestically, regulators use
           several mechanisms to coordinate with their counterparts,
           including an interagency steering group (which also coordinates
           with an association of state bank supervisors), joint supervisory
           work and examinations, interagency training, formal and informal
           examiner meetings, and outreach to banks. While examiners
           generally said that their Basel II coordination efforts were
           effective, the delays in various stages of the rule-making process
           indicate some difficulties at the policy-making level.

           U.S. regulators are also working to coordinate with regulators
           from other Basel II countries. For example, they are participating
           in the Accord Implementation Group, one of a number of subgroups
           that the Basel Committee formed to promote international
           consistency and address other Basel II issues. The United States,
           as a home regulator (a regulator overseeing domestic banks),
           communicates its qualification strategies and processes to host
           regulators (foreign regulators overseeing U.S. banks in their
           countries, or U.S. regulators overseeing foreign banks in the
           United States). For their home responsibilities, U.S. regulators
           coordinate supervisory work based on the Accord Implementation
           Group's home-host principles, including determining whether a
           bank's capital model for a global business is ready for Basel II.
           Home regulators will rely on the work of foreign host regulators
           that approve banks' local models and processes and will share
           appropriate information, such as regulatory memorandums, with host
           regulators. The United States is also a host regulator and as such
           will share appropriate sections of supervisory plans, scopes, and
           product memorandums regarding reviews of local models and
           processes. U.S. regulators are also participating in supervisory
           colleges, or working groups of supervisors that are formed on an
           as-needed basis to share information about and coordinate
           supervision of international banking organizations. One regulatory
           official noted that the colleges have been and will continue to be
           critical to the success of the international Basel II effort.

           U.S. regulators face challenges regarding international
           implementation of Basel II, in part because the United States is
           implementing Basel II one year later than many other countries,
           including countries in the European Union. U.S. regulators are
           working with U.S. and foreign banks and regulators to address the
           implications of this so-called gap year. For example, in several
           instances, U.S. regulators are trying to evaluate the advanced
           systems of foreign banks' U.S. subsidiaries to provide foreign
           regulators with feedback on those systems to be used in foreign
           regulators' evaluations of banks attempting to become Basel II
           compliant in their home countries in 2007, before the United
           States implements Basel II in 2008. Similarly, according to U.S.
           regulatory officials, some U.S. banks operating abroad are
           prevented by their host supervisors from using advanced systems in
           the host jurisdiction before they are allowed to do so at home,
           and some U.S. regulatory officials said they are working with the
           foreign regulators in cases where U.S. banks want or need to use
           advanced approaches in the host jurisdiction prior to a final rule
           in the United States. Further, as stated earlier, countries have a
           limited degree of national discretion, which, in part, requires
           U.S. and foreign regulators to address challenges that
           internationally active banks are experiencing due to differences
           between U.S. rules and those of other countries. U.S. regulators
           are working to find effective mechanisms for cooperation and
           information to resolve these issues, such as the supervisory
           colleges previously discussed. One regulatory official said that
           international home-host efforts could tend to focus on the global
           parent company but added that that regulator's focus was on making
           sure that the allocation of capital within that company was
           appropriate and covered the risk for the bank in the United
           States.
			  
			  Regulators Face Impediments in Finalizing the Rule That if Left
			  Unresolved Could Result in Ongoing Regulatory Ambiguity for Banks
			  and Uncertainty about the Appropriateness of the Basel II
			  Framework

           Although U.S. regulators have committed to working together to
           issue a final rule and use prudential safeguards that would limit
           regulatory capital reductions during a parallel run and transition
           period, they face a number of ongoing impediments in agreeing on a
           final rule to implement Basel II. First, regulators have somewhat
           differing perspectives and goals, which fuels ambiguity and
           contributes to questions about the appropriateness of the Basel II
           framework. Second, a lack of transparency and ongoing ambiguity of
           some items in the NPR may contribute to ongoing questions about
           the appropriateness of Basel II as a framework. Finally,
           regulators will need to address banks' concerns regarding Pillar 3
           disclosure requirements and the need to balance protecting
           proprietary information and providing for public disclosure of
           capital calculations to encourage market discipline.
			  
			  Regulatorsï¿½ Differing Perspectives and Goals Fuel Ambiguity

           Each federal regulator oversees a different set of institutions
           and represents an important regulatory perspective, which has made
           reaching consensus on some issues more difficult than others. U.S.
           regulators generally agree on the broad underlying principles at
           the core of Basel II, including increased risk sensitivity of
           capital requirements and capital neutrality. In a 2004 report, we
           found that although regulators communicate and coordinate, they
           sometimes had difficulty agreeing.^61 As we reported, in November
           2003 members of the House Financial Services Committee warned in a
           letter to the bank regulatory agencies that the discord
           surrounding Basel II had weakened the negotiating position of the
           United States and resulted in an agreement that was less than
           favorable to U.S. financial institutions. However, regulatory
           officials also told us that the final outcome of the Basel II
           negotiations was better than it would have been with a single U.S.
           representative because of the agencies' varying perspectives and
           expertise.
			  
^61GAO, Financial Regulation: Industry Changes Prompt Need to Reconsider
U.S. Regulatory Structure, [66]GAO-05-61 (Washington, D.C.: Oct. 6, 2004).

           These differing regulatory perspectives have contributed to
           difficulty achieving a final rule and agreeing to specific
           operational details as well as contributing in part to delays of
           the Basel II implementation process and ongoing questions and
           unresolved issues. For example, officials from FDIC--the deposit
           insurer and regulator of many smaller banks--while acknowledging
           the limitations of Basel I for the largest banks, have expressed
           concerns regarding required capital levels under Basel II and
           potential competitive inequities between large and small banks in
           the United States, if small banks are required to hold more
           regulatory capital than large banks for some similar risks. FDIC
           officials have also expressed some serious reservations about the
           availability of sufficient data underlying certain aspects of the
           models, as well as the calibration of the models themselves.
           Officials from the Federal Reserve and OCC--as the regulators of
           the vast majority of core banks--while acknowledging the uncertain
           impact on capital requirements and data limitations, have
           highlighted the limitations of Basel I, the advances in risk
           management at large banks, the safeguards in the NPR to ensure
           capital adequacy, and regulator experience in reviewing economic
           capital models. OTS officials, noting the thrift industry's
           mortgage-heavy portfolios, have emphasized the potential
           limitations on risk sensitivity imposed by the leverage ratio.
           Specifically, they noted the potential impact on mortgages
           because, as discussed previously, required capital for
           high-quality mortgages could fall significantly under Basel II
           making the leverage ratio a potential regulatory capital floor for
           some institutions.

           As U.S. regulatory officials work to finalize Basel II, overcoming
           these differences will likely be an ongoing challenge. While
           regulatory officials said that they would work collaboratively to
           address comments on the NPR, how they will reconcile potentially
           differing view points is not clear. Further, while officials have
           said that they will monitor progress and modify the Basel II rule
           as necessary during the transition period to ensure that capital
           requirements are appropriate for credit, operational, and market
           risks, they have not specified how that monitoring will take place
           or under what circumstances regulators will revisit the rule.
           Given these differences, failure to take steps to clarify
           remaining questions and improve the transparency through regular
           public reporting of the process going forward would result in
           ongoing questions and ambiguity about Basel II as a viable
           framework for regulatory capital.
			  
			  Lack of Transparency and Ongoing Ambiguity Contribute to Questions
			  about the Overall Appropriateness of the Basel II

           Although regulators have developed a set of safeguards that reduce
           the chances of significant reductions in required regulatory
           capital during the planned parallel run and transitional period,
           regulatory officials and others remain uncertain about the
           potential impact of the final Basel II framework on the safety and
           soundness of the banking system. Specifically, some regulatory
           officials are concerned about the use of banks' models under Basel
           II because, while these models have been used for internal risk
           assessment and management for years, with the exception of certain
           market risk models, they are relatively unproven as a regulatory
           capital tool. Others are concerned about potential drops in
           required regulatory capital once the parallel run and transition
           period have been completed. Regulatory concerns regarding possible
           large drops in aggregate levels of minimum required risk-based
           capital were reinforced after QIS-4 showed large reductions in
           minimum regulatory required capital for credit risk using inputs
           from the banks' models. As a result, U.S. regulators have
           disagreed on how and how quickly to implement Basel II. And some
           industry observers have questioned whether to proceed at all.

           Further, regulators have requested comments on over 60 questions
           in the NPR. For example, as stated earlier regulators have asked
           for comment on whether banks should have the option of using a
           U.S. version of the standardized approach rather than the advanced
           approach and for how long. However, at the time of this review,
           the NPR did not discuss what form a standardized approach would
           take in the United States or whether it would mirror the
           international Basel Accord. Similarly, regulators have not
           explained how they plan to calculate the 10-percent reduction in
           aggregate minimum regulatory capital compared with Basel I and
           what would happen if the 10-percent reduction was triggered, other
           than it will warrant "modifications to the supervisory risk
           functions or other aspects of this framework." Under one scenario,
           for example, aggregate minimum required capital could potentially
           fall by over 10 percent in an economy in which borrowers were very
           unlikely to default, triggering a reexamination of Basel II by
           federal regulators, according to the NPR. However, this 10-percent
           reduction might not be an indicator of a fundamental flaw in the
           Basel II framework but rather a cyclical movement that could be
           reversed in bad economic times--that is, if Basel II is intended
           to be on average equal to Basel I over the business cycle. But
           this interpretation is only one possible interpretation of capital
           neutrality. Alternatively, a 10-percent reduction could indicate a
           problem if average (i.e., through the cycle) capital requirements
           were falling significantly relative to Basel I capital levels
           during less favorable economic conditions.

           While several officials said that they would prefer not to define
           how the regulators will assess the 10-percent trigger explicitly,
           and instead use their own discretion in maintaining capital
           levels, bank officials have expressed interest in knowing how the
           trigger will function. Moreover, it is unclear what would happen
           if a 10-percent reduction relative to Basel I were triggered. For
           example, would banks have to recalibrate their models, would a
           floor be imposed, or would a multiplier be added, and how would
           economic conditions be factored into the determination process?
           Part of this process will have to include determining appropriate
           levels of aggregate required capital and acceptable cyclical
           variation. However, the NPR does not clearly state the regulators'
           views on these issues or their plans for making such
           determinations. Without additional clarity in the final rule,
           these issues will result in ongoing uncertainty for banks and
           lingering questions about required capital levels and how Basel
           II's implementation in the United States will affect banks'
           regulatory capital levels.
			  
			  Questions about Reliability of Bank Data Remain an Issue

           As mentioned, the appropriateness of the capital requirements
           generated by the Basel II models depends in part on the
           sufficiency of the data inputs used by banks, though views vary
           about some data requirements for their portfolios. For example,
           officials at several core banks had differing views about whether
           the 2001 recession represented a sufficiently stressed economic
           period for calibrating their models. Specifically, officials at
           one bank said that the 2001 recession was a sufficiently stressed
           period to meet data requirements for their portfolios, but
           officials at another bank were uncertain, and officials at a third
           bank stated that 2001 was likely not sufficient. Because the 2001
           recession was relatively mild by historical standards, stressed
           scenarios and parameters based on it could underestimate the risk
           associated with future downturns. Officials at several banks
           stated that they already used or would use internal and external
           data to capture time periods prior to 2001. Officials at several
           banks also told us that a supervisory formula for calculating
           "downturn" loss given default was helpful where they had
           insufficient default data; and many banks had also purchased, or
           planned to purchase, external data covering a longer time period
           to help estimate the effect of downturns on their parameter
           estimates.

           However, to address these data sufficiency challenges and their
           effect on the ability of core banks to use the advanced approaches
           for all portfolios, regulators will have to decide whether and how
           to qualify banks to move to the advanced approaches when adequate
           data to assess the risks of certain portfolios is limited. The
           NPR, for example, requests comment on how to address the limited
           data availability and lack of industry experience with
           incorporating economic downturn conditions into LGD estimates.
           Given the importance of bank data requirements, lack of clarity in
           the final rule could result in ongoing questions about the
           reliability and sufficiency of the results generated by the banks'
           models. For example, without clarification, banks' varying
           interpretations of the rule could result in capital requirements
           that are not comparable or that increase reliance on examiner
           judgment through the supervisory review process (Pillar 2),
           thereby resulting in negotiations about capital adequacy between a
           bank and its regulator.
			  
			  Questions about Pillar 3 Disclosure Requirements Remain

           Finally, regulators will need to resolve banks' concerns regarding
           Pillar 3's disclosure requirements, since officials from some
           banks said that those disclosures could be costly but of
           questionable value. Officials from some core banks raised the
           possibility that they would need to make significant investments
           to meet public disclosure requirements under Pillar 3 but that the
           usefulness of the disclosures was uncertain. Some officials were
           concerned that the information required might be too detailed or
           complex for the markets to understand in a useful way. For
           example, officials at a few banks noted that because banks used
           different methodologies to manage risk, comparing disclosures
           across organizations would be difficult. Similarly, another
           official pointed out that comparing disclosures from banks in
           different countries would also be difficult if the banks were not
           operating under the same rules. Still, other officials were
           concerned that proprietary or strategic business information would
           be made public. However, officials from a few banks noted that the
           disclosures could help the markets better understand a bank's risk
           profile. Regulators will need to determine if the banks' concerns
           merit changes to the disclosure requirements.

			  Conclusions

           Basel I has served regulators and banks well for many years and
           for many smaller institutions, it is expected to continue to do
           so. However, for a group of large, complex banking organizations
           it increasingly fails to adequately align regulatory required
           capital and risks. Basel II represents a fundamental shift in the
           regulatory capital framework by seeking to leverage banks' risk
           management systems and internal models for use in estimating risk
           more precisely than the broad risk buckets used under Basel I,
           thereby helping to strengthen the safety and soundness of the
           banking system. Effective capital adequacy regulation requires
           balancing the costs to business of holding capital and the need to
           provide protection to depositors and the federal deposit insurance
           fund.

           Given the limitations of Basel I, the goal of better aligning
           regulatory capital with risks, and the use of safeguards during
           the parallel run and transition period to ensure that a large drop
           in capital does not occur, we support the regulators' plans to
           continue to finalize the Basel II rule and proceed with the
           parallel run and transition period in order to determine whether
           the Basel II framework can be relied on to adequately capture
           risks for regulatory capital purposes. It is appropriate for the
           regulators to proceed for several reasons.

           o First, it will provide the regulators with critical information
           they currently lack to assess the appropriateness of the Basel II
           framework relative to Basel I.
           o Second, the proposed rules, issued in September 2006, contain
           important safeguards that will help prevent large declines in
           regulatory capital. The safeguards will help mitigate any risk to
           the system by requiring capital to be held based on current Basel
           I rules during the parallel run and allowing only limited
           reductions during each of 3 transition years, which will vary
           depending on when a bank is qualified.
           o Third, maintaining the current leverage ratio and PCA will
           further guard against any large declines in bank capital.
           o Finally, foreign regulators are moving to Basel II creating
           potential competitive disadvantages for U.S. banks vis-`a-vis
           foreign banks.

           While Basel II seeks to establish a closer relationship between
           regulatory capital and risk for the largest and most
           internationally active banking organizations, there are many
           issues that will require ongoing supervision and monitoring,
           including the ability of these banks' models to adequately measure
           risks for regulatory capital purposes and the regulators' ability
           to oversee them. For example, the Basel II models are driven by
           low-frequency catastrophic events that are inherently difficult to
           estimate, which creates challenges for regulators both in
           developing appropriate models and supervising models developed by
           banks. Regulators already face resource constraints in hiring and
           retaining talent that are more binding than the resource
           constraints faced by the banks they regulate and this issue is
           likely to become more significant under Basel II. Yet, it is a
           critical point because under Basel II regulators' judgment will
           likely play an increasingly important role in determining capital
           adequacy. We recognize that these issues and others need to be
           addressed, and moving forward is not without risks. However, as
           mentioned, the proposed safeguards and retention of the leverage
           ratio should help mitigate potential negative effects from moving
           forward while allowing the banks and regulators to gather
           information to assess the appropriateness of the Basel II
           framework.

           As the regulators finalize Basel II, clarification of a number of
           issues would make the final rule more transparent, the impact on
           capital more predictable, and the treatment of portfolios with
           insufficient data more consistent. Specifically, the proposed rule
           is ambiguous on a number of important issues that, if left
           unresolved, could continue to result in regulatory ambiguity for
           banks and concerns for industry observers, including (1) what
           regulators plan to do when banks have limited data available,
           especially for new financial products or portfolios that lack data
           on the impact of a major economic downturn, and how they will
           ensure that portfolios with insufficient data are treated
           prudently and consistently, such as considering options like a
           higher risk-weight or substituting Basel IA or the Basel
           Committee's standardized approach for these portfolios; (2) how
           regulators will calculate the 10-percent aggregate reduction in
           minimum regulatory capital and what would happen if this is
           triggered; and (3) the criteria for determining an appropriate
           average level of aggregate capital and appropriate cyclical
           variation in regulatory capital. Also, to address growing concerns
           from some large banks about Basel II becoming an expensive
           compliance exercise, the regulators have requested comments on
           many technical issues, as well as whether banks should have the
           option of using a U.S. version of the standardized approach.
           However, it is uncertain from the NPR what form a standardized
           approach would take, whether it would mirror the international
           Basel Accord, and how long banks would be able to use it.

           Although the regulators have been operating in accordance with the
           Administrative Procedure Act in their Basel II rule-making
           process, the process could benefit from increased transparency to
           respond to broader questions and concerns about transitioning to
           Basel II in the United States. Specifically, the differing
           perspectives the regulators bring to the Basel II negotiations
           make it difficult for them to explicitly define the criteria they
           plan to use to judge Basel II's success. This difficulty has, in
           turn, resulted in considerable uncertainty about, and some
           opposition to, Basel II among industry and other interested
           parties and stakeholders. As a result, although the regulators
           have indicated that they plan to revise the framework as needed
           during the transition, publicly reporting results of the parallel
           runs and comparisons of Basel II and Basel I results for core
           banks is particularly important given concerns about implementing
           Basel II in the United States. Going forward, public reports could
           be used to provide greater transparency on a number of issues and
           could help allay concerns among banks and industry stakeholders
           about the transition to Basel II. Issues that would benefit from
           greater transparency include (1) the results of coordination and
           communication efforts among SEC and the banking regulators; (2)
           changes to the Basel II rules during the transition period and the
           safeguards, if any, that regulators believe are appropriate in the
           absence of the transitional floors; and (3) updates to supervisory
           guidance incorporating Basel II rule changes. Without added
           transparency, the implementation will continue to generate
           questions and concerns about the adequacy of the proposed
           framework. Moreover, regulators have not articulated whether the
           safeguards will be retained at the end of the parallel run and
           transition period if the new capital framework results in
           significant declines in regulatory required capital or significant
           changes in the regulatory approach.

           Finally, Basel II raises a number of competitiveness concerns that
           warrant further study and review. First, how Basel II will impact
           U.S. banks' competitiveness internationally remains unknown. But
           this issue will continue to be an ongoing concern, especially if
           the U.S. implementation of Basel II results in higher regulatory
           required capital or greater compliance costs for U.S. banks than
           for foreign banks. Second, competitiveness issues also exist
           between U.S. institutions such as investment banks and commercial
           banks. SEC, which has implemented the Basel Accord for
           consolidated supervised entities, plans to revisit its rules based
           on the Federal Reserve's interpretation of Basel II as applied to
           financial holding companies. Finally, Basel II also raises
           competitiveness concerns between large and small U.S. banks. Lower
           capital requirements for some assets could provide large banks
           with a competitive advantage; however, retaining the leverage
           ratio will help maintain the domestic competitive landscape. Going
           forward, regulators will need to monitor the ability of U.S. banks
           to compete internationally and balance their competitiveness with
           the need to protect the public interests. Moreover, the Basel IA
           NPR, as proposed, attempts to mitigate potential competitive
           inequities created by Basel II between large and small U.S. banks
           by leveling the playing field to some degree. However, these
           competitive concerns will continue into the transition period, and
           it is too soon to tell whether these concerns are justified or
           whether they will be adequately addressed by Basel IA.
			  
			  Recommendations

           To help reduce the uncertainty about the impact of Basel II on
           required levels of regulatory capital, improve the transparency of
           the process, and address the impediments regulators face in moving
           to Basel II, we are making the following four recommendations. We
           recommend that, as part of the process leading to the parallel run
           and during the proposed transition period(s), the heads of the
           Federal Reserve, FDIC, OCC and OTS take, at a minimum, the
           following steps:

           o Clarify and reach agreement on certain issues in the final rule,
           including

                        o How to treat portfolios at Basel II banks that may
                        lack the data to meet regulatory standards for the
                        advanced approaches. To ensure that portfolios with
                        insufficient data are treated prudently and
                        consistently, regulators should consider options such
                        as a higher risk-weight, or substituting Basel IA or
                        the Basel Committee's standardized approach for these
                        portfolios.
                        o How to calculate the 10-percent reduction in
                        aggregate minimum regulatory capital and what will
                        happen if the 10-percent reduction is triggered.
                        o What the criteria will be for determining an
                        appropriate average level of required capital and
                        appropriate cyclical variation in minimum required
                        capital.

           o Issue a new NPR before finalizing the Basel II rule, if the
           final rule differs materially from the NPR or if a U.S.
           standardized approach is an option in the final rule. While this
           step may add months to the process, the additional time may help
           provide more transparency and allow banks and stakeholders to
           provide feedback before the rule is finalized.
           o Issue public reports at least annually on the progress and
           results of implementation efforts and any resulting regulatory
           adjustments. This reporting should include an articulation of the
           criteria for judging the attainment of their goals for Basel II
           implementation and for determining its effectiveness for
           regulatory capital-setting purposes. These reports should also
           include analyses of (1) the results of the parallel runs and
           transition periods and a comparison of Basel II and Basel I
           results for the core banks and (2) the effect(s), if any, of Basel
           II or differences between U.S. and international rules on the
           competitiveness of U.S. banks.

           Finally, at the end of the last transition period, we recommend
           that the regulators reevaluate whether the advanced approaches of
           Basel II can and should be relied on to set appropriate regulatory
           capital requirements in the longer term. Depending on the
           information collected during the transition, any reevaluation
           should include a range of options, including consideration of
           additional minor modifications to U.S. Basel II regulations as
           well as whether more fundamental changes are warranted for setting
           appropriate required regulatory capital levels.
			  
			  Agency Comments and Our Evaluation

           We provided the heads of the Federal Reserve, FDIC, OCC, OTS, SEC,
           and the Department of the Treasury with a draft of this report for
           their review and comment. We received written comments from the
           Federal Reserve, OCC, FDIC and OTS in a joint letter, and
           Treasury. These comments are summarized below and reprinted in
           appendixes IV through VII. The banking agencies and SEC also
           provided technical comments that we incorporated in the report
           where appropriate.

           In its comments, the Federal Reserve said it concurred with our
           initial finding that Basel I is particularly inadequate for large
           banking organizations and agreed with our conclusion that the
           regulators should continue their efforts to finalize the U.S.
           Basel II capital rule and proceed with the parallel run and
           transition periods. In commenting on our conclusion that the U.S.
           Basel II process has lacked transparency, the Federal Reserve
           commented that it and the other regulators have attempted to be as
           transparent as possible in their implementation efforts,
           consistent with the letter and spirit of the Administrative
           Procedure Act. However, the Federal Reserve commented that it
           understood that the Basel II proposals contain a considerable
           amount of ambiguity and that it expects to reduce this ambiguity
           as it works with the other regulators to finalize the Basel II
           rule. We agree that the regulators have been operating within the
           parameters of the Administrative Procedure Act in their
           rule-making process, but they have been less transparent with
           regard to broader questions and concerns about transitioning to
           Basel II in the United States. Especially going forward,
           additional public reporting would be useful to provide greater
           transparency on a number of issues and could help allay concerns
           among banks and industry stakeholders about the transition to
           Basel II. In addition, the Federal Reserve concurred with our
           recommendations and said it will seek to implement them.

           Similarly, in its comments, OCC said it appreciated our
           recognition of the limitations of Basel I for large and/or
           internationally active banks and welcomed our conclusion that the
           regulators should finalize the rule and proceed with the parallel
           run and transition period. OCC commented that its position has
           been that the regulators should move forward on Basel II with
           strong safeguards in place during a transition period and assess
           the need for adjustments during this period before removing any
           safeguards. OCC also noted that U.S. proposals leave two existing
           U.S. capital safeguards in place that are not temporary--the
           leverage ratio and the prompt corrective action framework. OCC
           also said it welcomed our recommendations, which it, along with
           the other regulators, will consider as part of the overall review
           of comments received on the NPR. With regard to our recommendation
           on whether a new NPR might be necessary before proceeding to a
           final rule, OCC said it believed that will ultimately depend on
           whether actual changes made to the NPR in the subsequent version
           of the Basel II rule are sufficiently different so as to require
           another round of notice and comment and that it was premature to
           make that determination until all comments had been received and
           evaluated and the regulators decide what changes to make. OCC also
           pointed out that further delay could have ramifications for
           international competition and said it will ensure that the
           rule-making process complies with the letter and spirit of the
           Administrative Procedure Act.

           In their joint letter, FDIC and OTS commented that Basel II
           efforts to improve the risk sensitivity of capital requirements
           for large, complex banks has been rooted in the regulators' shared
           objectives and said that ensuring the achievement of these shared
           objectives will remain of paramount importance to the regulators'
           deliberations and review of comments on the NPR. They also said
           that the regulators share a commitment to maintaining a safe and
           sound banking industry and that retention of the existing leverage
           ratio and prompt corrective action framework, and other safeguards
           in the NPR, underscore that commitment. In addition, they
           commented that, given the considerable costs and complexity of the
           advance approach and its attendant uncertainties and risks, FDIC
           and OTS noted that serious consideration should be given to the
           implementation of a U.S. version of the Basel II standardized
           approach as an option for all U.S. banks. Similar to OCC, FDIC and
           OTS also said they will consider our recommendations as part of
           the overall review of the comments received on the NPR.

           In its comments, Treasury agreed that there are a number of
           significant Basel II implementation challenges and uncertainties
           for the large, complex banking organizations that will be subject
           to Basel II requirements and for federal banking regulators.
           Treasury stated its view that the regulators needed to reach a
           consensus on the major requirements of a final rule soon after the
           NPR comment period closes for Basel II and IA if the United States
           is going to meet the January 2008 goal for Basel II
           implementation. Treasury noted that further delay would add to
           uncertainty and potentially create burdens for domestic and
           foreign banks. Treasury also expressed concern with our
           recommendation to issue a new NPR before finalizing the Basel II
           rule, saying that the overlapping comment period for Basel II and
           Basel IA, which is similar to the standardized approach for credit
           risk in the international Basel Accord, provides commenters the
           ability to opine on implementation and other issues and options.
           We realize that an additional NPR would further delay the Basel II
           process; however, under certain circumstances an additional NPR
           would be a necessary step to provide more transparency to the
           process and to ensure that the final rule is comprehensive and
           that the implications are fully considered. In response to
           comments on this recommendation from the Federal Reserve, OCC, and
           the Treasury, we have clarified the wording of our recommendation
           to more clearly state the need for a new NPR if the regulators
           intend to issue a final rule that is materially different from the
           NPR or if they intend to provide a U.S. standardized approach.

           We are sending copies of this report to interested congressional
           committees, the Chairman of the Federal Reserve Board, Chairman of
           the Federal Deposit Insurance Corporation, the Comptroller of the
           Currency, the Director of the Office of Thrift Supervision, the
           Chairman of the Securities and Exchange Commission, and the
           Secretary of the Treasury. We will also make copies available to
           others on request. In addition, the report will be available at no
           charge on GAO's Web site at http://www.gao.gov .

           If you or your staff have any questions regarding this report,
           please contact Orice M. Williams at (202) 512-5837 or
           [email protected] or Thomas J. McCool at (202) 512-2642 or
           [email protected] . Contact points for our Offices of
           Congressional Relations and Public Affairs may be found on the
           last page of this report. GAO staff who made major contributions
           to this report are listed in appendix VIII.

           Orice M. Williams, Director
			  Financial Markets and Community
           Investment

           Thomas J. McCool, Director
			  Center for Economics
			  
			  Appendix I: Scope and Methodology

           The objectives of this report were to describe (1) the
           developments leading to the transition to Basel II, (2) the
           proposed changes to the U.S. regulatory capital framework, (3) the
           potential implications of Basel II's quantitative approaches and
           their potential impact on required capital, (4) banks'
           preparations and related challenges, and (5) U.S. regulators'
           preparations and related challenges.

           For all our objectives, we reviewed a variety of documents,
           including regulators' statements; congressional testimony; the
           international Basel II Accord (entitled "International Convergence
           of Capital Measurement and Capital Standards: A Revised
           Framework") and other documents from the Basel Committee on
           Banking Supervision, such as the 1988 Basel Capital Accord (Basel
           I); the Basel II and Basel IA Notices of Proposed Rulemaking
           (NPR);^1 the Basel II and Basel IA Advance Notices of Proposed
           Rulemaking (ANPR);^2 literature from the Congressional Research
           Service, bank trade associations, academic articles, and our
           previous reports on banking regulation. We also interviewed senior
           supervisory officials at the Board of Governors of the Federal
           Reserve and the Federal Reserve Bank of New York (Federal
           Reserve), Office of the Comptroller of the Currency (OCC), Federal
           Deposit Insurance Corporation, Office of Thrift Supervision, and
           the Securities and Exchange Commission (SEC). We interviewed a
           former U.S. regulatory official, a foreign banking regulatory
           official, a state regulator and an association of state banking
           regulators. In addition, we interviewed officials from all core
           and a selected group of opt-in banks, two bank trade associations,
           an international banking association, and two credit rating
           agencies. Finally, we attended several conferences held by
           regulators and trade associations that included discussions
           related to Basel II.

           To describe the developments leading to the transition to Basel II
           and the proposed changes to the U.S. capital framework, in
           addition to the foregoing, we reviewed a variety of documents,
           including the Market Risk Amendment and official comments on the
           Basel II and Basel IA ANPRs.^3
			  
^171 Fed. Reg. 55380 (Sept. 25, 2006) (Basel II NPR); 71 Fed. Reg. 77446
(Dec. 26, 2006) (Basel IA).

^268 FR 45900 (Aug. 4, 2003) (Basel II ANPR); 70 FR 61068 (Oct. 20, 2005)
(Basel IA ANPR).

^3In 1996, the United States and other Basel Committee members adopted the
Market Risk Amendment to Basel I, which requires capital for market risk
exposures arising from banks' trading activities.			  

           As noted throughout the report, the rules for Basel II and Basel
           IA in the United States were not yet final when we completed our
           audit work, limiting our ability to assess the potential impact of
           regulatory changes. To describe the potential implications of
           Basel II's quantitative approaches and their potential impact on
           required capital, we used data from the fourth quantitative impact
           study, Moody's Investors Service, and regulatory, bank, and
           academic studies to analyze and illustrate how proposed regulatory
           changes could affect capital requirements for a variety of assets
           under a variety of economic conditions. For example, we combined
           risk parameter estimates from those sources to estimate Basel II
           credit risk capital requirements for externally-rated corporate
           exposures and mortgages and compared those estimates to required
           capital under the leverage ratio. We analyzed the advanced
           internal ratings-based approach to credit risk and advanced
           measurement approaches to operational risk based on the proposed
           rules, academic studies, Basel Committee documents, and our
           interviews with core and opt-in bank officials, and regulators.

           To describe banks' preparations and related challenges, as stated
           previously, we interviewed officials from each of the likely core
           banks. To identify the likely core banks, we used data available
           from public regulatory filings to determine those whose total
           assets and/or foreign exposure met the proposed criteria in the
           Basel II NPR as of December 31, 2005. We also collected
           information through interviews and written data collection
           instruments from a sample of five possible opt-in banks, selected
           on the basis of input from the regulators and bank associations,
           size, and primary federal regulator.

           To describe regulators' preparations and challenges, we reviewed a
           variety of documents as listed above, as well as other documents
           from the federal banking regulators, such as the Federal Reserve's
           Supervisory Letter 99-18 (SR 99-18), OCC's Bulletin 2000-16, the
           Market Risk Rule, and regulators' strategic and annual performance
           plans.^4 At the Federal Reserve and OCC, we also interviewed bank
           examiners for two of the largest U.S. banking organizations and
           reviewed examination reports to understand how regulators oversee
           risk management processes at core banks and how the regulators are
           planning to incorporate Basel II into their examinations and
           oversight processes.
			  
^461 Fed. Reg. 47358 (Sept. 6, 1996).			  

           We conducted our work in Washington, D.C.; Chicago, San Francisco,
           and New York, between April 2006 and January 2007 in accordance
           with generally accepted government auditing standards.
			  
			  Appendix II: U.S. and International Transition to Basel II

           Note: Dates shown for both the international and U.S. parallel run
           and transition periods are for the advanced risk measurement
           approaches.

           aDenotes estimated date.
			  
			  Appendix III: Basel II Descriptive Overview
			  
			  Pillar 1: Minimum Capital Requirements

           Pillar 1 of the U.S. Basel II proposal features explicit minimum
           capital requirements, designed to ensure bank solvency by
           providing a prudent level of capital against unexpected losses for
           credit, operational, and market risk. The advanced approaches,
           which are the only measurement approaches currently proposed in
           the United States, will make capital requirements depend in part
           on a bank's own assessment, based on historical data, of the risks
           to which it is exposed.
			  
			  Credit Risk

           Under the advanced internal ratings-based (A-IRB) approach, banks
           must establish risk rating and segmentation systems to distinguish
           risk levels of their wholesale (most exposures to companies and
           governments) and retail (most exposures to individuals and small
           businesses) exposures, respectively. Banks use the results of
           these rating systems to estimate several risk parameters that are
           inputs to supervisory formulas. Figure 7 illustrates how credit
           risk will be calculated under the Basel II A-IRB. Banks must first
           classify their assets into exposure categories and subcategories
           defined by supervisors: for wholesale exposures those
           subcategories are high-volatility commercial real estate and other
           wholesale; for retail exposures those subcategories are
           residential mortgages, qualifying revolving exposures (e.g.,
           credit cards), and other retail. Banks then estimate the following
           risk parameters, or inputs: the probability a credit exposure will
           default (probability of default or PD), the expected size of the
           exposure at the time of default (exposure at default or EAD),
           economic losses in the event of default (loss given default or
           LGD) in expected and "downturn" (recession) conditions, and, for
           wholesale exposures, the maturity of the exposure (M). In order to
           estimate these inputs, banks must have systems for classifying and
           rating their exposures as well as a data management and
           maintenance system. The conceptual foundation of this proposal is
           that a statistical approach, based on historical data, will
           provide a more appropriate measure of risk, and capital, than a
           simple categorization of asset types, which does not differentiate
           precisely between risks. Regulators provide a formula for each
           exposure category that determines the required capital on the
           basis of these inputs. If all the assumptions in the supervisory
           formula were correct, the resulting capital requirement would
           exceed a bank's credit losses in a given year with 99.9 percent
           probability. That is, credit losses at the bank would exceed the
           capital requirement with a one in one thousand chance in a given
           year, which could result in insolvency if the bank only held
           capital equal to the minimum requirement.

Figure 7: Computation of Capital Requirements for Wholesale and Retail
Credit Risk under Basel II

Notes:

This figure focuses on wholesale and retail nondefaulted exposures, an
important component of the total credit risk calculation. The total credit
risk capital requirement also covers defaulted wholesale and retail
exposures, as well as risk from securitizations and equity exposures. A
bank's qualifying capital is also adjusted, depending on whether its
eligible credit reserves exceed or fall below its expected credit losses.

Banks may incorporate some credit risk mitigation, including guarantees,
collateral, or derivatives, into their estimates of PD or LGD to reflect
their efforts to hedge against unexpected losses.

In contrast to Basel I, required capital by the A-IRB approach, as
previously described, will depend on the risk characteristics of a
particular asset rather than on broad risk weights for entire asset
categories, as in Basel I. For example, mortgage loans vary significantly
in quality, and the capital requirement will depend on the probability of
default, along with the other inputs, while the capital requirement for
most mortgages is fixed under Basel I.

  Operational Risk

To determine minimum required capital for operational risk, banks would be
able to use their own quantitative models of operational risk that
incorporate elements required in the NPR. To qualify to use the advanced
measurement approaches (AMA) for operational risk, a bank must have
operational risk management processes, data and assessment systems, and
quantification systems. The elements that banks must incorporate into
their operational risk data and assessment system are internal operational
loss event data, external operational loss event data, results of scenario
analysis, and assessments of the bank's business environment and internal
controls. Banks meeting the AMA qualifying criteria would use their
internal operational risk quantification system to calculate the
risk-based capital requirement for operational risk, subject to a solvency
standard specified by regulators, to produce a capital buffer for
operational risk designed to be exceeded only once in a thousand years.

  Market Risk

Regulators have allowed certain banks to use their internal models to
determine required capital for market risk since 1996 (known as the Market
Risk Amendment or MRA). Under the MRA, a bank's internal models are used
to estimate the 99th percentile of the bank's market risk loss
distribution over a 10-business-day horizon, in other words a solvency
standard designed to exceed trading losses for 99 out of 100
10-business-day intervals. The bank's market risk capital requirement is
based on this estimate, generally multiplied by a factor of three. The
agencies implemented this multiplication factor to provide a prudential
buffer for market volatility and modeling error. The OCC, Federal Reserve,
and FDIC are proposing to incorporate their existing market risk rules and
are proposing modifications to the market risk rules, to include
modifications to the MRA developed by the Basel Committee, in a separate
NPR issued concurrently with the proposal for credit and operational risk.
OTS is proposing its own market risk rule, including the proposed
modifications, as a part of that separate NPR.

Regulatory officials generally said that changes to the rules for
determining capital adequacy for market risk were relatively modest and
not a significant overhaul. The regulators have described the objectives
of the new market risk rule as including enhancing the sensitivity of
required capital to risks not adequately captured in the current
methodologies of the rule and enhancing the modeling requirements
consistent with advances in risk management since the implementation of
the MRA. In particular, the rule contains an incremental default risk
capital requirement to reflect the growth in traded credit products, such
as credit default swaps, that carry some default risk as well as market
risk.

Pillar 2: Supervisory Review

The Pillar 2 framework for supervisory review is intended to ensure that
banks have adequate capital to support all risks, including those not
addressed in Pillar 1, and to encourage banks to develop and use better
risk management practices. Banks adopting Basel II must have a rigorous
process of assessing capital adequacy that includes strong board and
senior management oversight, comprehensive assessment of risks, rigorous
stress testing and validation programs, and independent review and
oversight. In addition, Pillar 2 requires supervisors to review and
evaluate banks' internal capital adequacy assessments and monitor
compliance with regulatory capital requirements. Under Pillar 2,
supervisors must conduct initial and ongoing qualification of banks for
compliance with minimum capital calculations and disclosure requirements.
Regulators must evaluate banks against established criteria for their (1)
risk rating and segmentation system, (2) quantification process, (3)
ongoing validation, (4) data management and maintenance, and (5) oversight
and control mechanisms. Regulators are to assess a bank's implementation
plan, planning and governance process, and parallel run performance. Under
Pillar 2, regulators should also assess and address risks not captured by
Pillar 1 such as credit concentration risk, interest rate risk, and
liquidity risk.

Importantly, the Pillar 2 of the international Basel II framework is
already largely in place in the United States. For example, Pillar 2
allows supervisors the ability to require banks to hold capital in excess
of the minimum, an authority that federal regulators already possess under
prompt corrective action provisions.

Pillar 3: Market Discipline in the Form of Increased Disclosure

Pillar 3 is designed to encourage market discipline by requiring banks to
disclose additional information and allowing market participants to more
fully evaluate the institutions' risk profiles and capital adequacy. Such
disclosure is particularly appropriate given that Pillar I allows banks
more discretion in determining capital requirements through greater
reliance on internal methodologies. Banks would be required to publicly
disclose both quantitative and qualitative information on a quarterly and
annual basis, respectively. For example, such information would include a
bank's risk-based capital ratios and their capital components, aggregated
information underlying the calculation of their risk-weighted assets, and
the bank's risk assessment processes. In addition, federal regulators
propose to collect, on a confidential basis, more detailed data supporting
the capital calculations. Federal regulators would use this additional
data, among other purposes, to assess the reasonableness and accuracy of a
bank's minimum capital requirements and to understand the causes behind
changes in a bank's risk-based capital requirements. Federal regulators
have proposed detailed reporting schedules to collect both public and
confidential disclosure information.

Appendix IV: Comments from the Board of Governors of the Federal Reserve
System 

Appendix V: Comments from the Office of the Comptroller of the Currency

Appendix VI: Comments from the Federal Deposit Insurance Corporation and
the Office of Thrift Supervision

Appendix VII: Comments from the Department of the Treasury

Appendix VIII: GAO Contacts and Staff Acknowledgments

GAO Contacts

Orice M. Williams (202) 512-5837 or [email protected] Thomas J. McCool
(202) 512-2642 or [email protected]

Staff Acknowledgments

In addition to the contacts named above, Barbara I. Keller (Assistant
Director); Emily Chalmers; Michael Hoffman; Austin Kelly; Clarette Kim;
James McDermott; Suen-Yi Meng; Marc Molino; and Andrew Nelson made key
contributions to this report.

Related GAO Products

Deposit Insurance: Assessment of Regulators' Use of Prompt Corrective
Action Provisions and FDIC's New Deposit Insurance System, [68]GAO-07-242
. Washington, D.C.: February 15, 2007.

Financial Regulation: Industry Changes Prompt Need to Reconsider U.S.
Regulatory Structure, [69]GAO-05-61 . Washington, D.C.: October 6, 2004.

Risk-Focused Bank Examinations: Regulators of Large Banking Organizations
Face Challenges, [70]GAO/GGD-00-48 . Washington, D.C.: January 24, 2000.

Risk-Based Capital: Regulatory and Industry Approaches to Capital and
Risk, [71]GAO/GGD-98-153 . Washington, D.C.: July 20, 1998.

Bank and Thrift Regulation: Implementation of FDICIA's Prompt Regulatory
Action Provisions, [72]GAO/GGD-97-18 . Washington, D.C.: November 21,
1996.

(250291)

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Highlights of [80]GAO-07-253 , a report to Congressional Committees

February 2007

RISK-BASED CAPITAL

Bank Regulators Need to Improve Transparency and Overcome Impediments to
Finalizing the Proposed Basel II Framework

Concerned about the potential impacts of the proposed risk-based capital
rules, known as Basel II, Congress mandated that GAO study U.S.
implementation efforts. This report examines (1) the transition to Basel
II and the proposed changes in the United States, (2) the potential impact
on the banking system and regulatory required capital, and (3) how banks
and regulators are preparing for Basel II and the challenges they face. To
meet these objectives, GAO analyzed documents related to Basel II and
interviewed various regulators and officials from banks that will be
required to follow the new rules.

[81]What GAO Recommends

With safeguards, it is appropriate for U.S. banking regulators to proceed
with finalizing Basel II and begin the transition period. GAO recommends
that they (1) clarify some aspects of the Notice of Proposed Rulemaking
(NPR); (2) issue a new NPR if material differences from the current NPR,
or a U.S. standardized approach option, are planned for the final rule;
(3) issue periodic public reports on progress, results, and any needed
adjustments; and (4) at the end of the transition period, reevaluate the
appropriateness of Basel II as a long-term framework for setting
regulatory capital. The Federal Reserve said it agreed with our
recommendations and the other banking agencies said they will consider
them as part of the rule-making process.

Rapid innovation in financial markets and advances in risk management have
revealed limitations in the existing Basel I risk-based capital framework,
especially for large, complex banks. U.S. banking regulators have proposed
a revised regulatory capital framework that differs from the international
Basel II accord in several ways, including (1) requiring adoption of the
most advanced Basel II approaches and by only the largest and most
internationally active banks; (2) proposing Basel IA, a simpler revision
of Basel I, and retaining Basel I as options for all other banks; and (3)
retaining the leverage requirement and prompt corrective action measures
that exist under the current regulatory capital framework.

While the new capital framework could improve banks' risk management and
make regulatory capital more sensitive to underlying risks, its impact on
minimum capital requirements and the actual amount of capital held by
banks is uncertain. The approaches allowed under Basel II are not without
risks, and realizing the benefits of these approaches while managing the
related risks will depend on the adequacy of both internal and supervisory
reviews. The move to Basel II has also raised competitiveness concerns
between large and small U.S. banks domestically and large U.S. and foreign
banks internationally. The impact of Basel II on the level of required
capital is uncertain, but in response to quantitative impact study results
showing large reductions in minimum required capital, U.S. regulators have
proposed safeguards, such as transitional floors, that along with the
existing leverage ratio would limit regulatory capital reductions during a
multiyear transition period. Finally, the impact on actual capital held by
banks is uncertain because banks hold capital above required minimums for
both internal risk management purposes as well as to address the
expectations of the market.

Banks and regulators are preparing for Basel II without a final rule, but
both face challenges. Bank officials said they were refining their risk
management practices, but uncertainty about final requirements has made it
difficult for them to proceed further. Banks also face challenges in
aligning their existing systems and processes with some of the proposed
requirements. While regulators plan to integrate Basel II into their
current supervisory process, they face impediments. The banking regulators
have differing regulatory perspectives, which has made reaching consensus
on the proposed rule difficult. Banks and other stakeholders continue to
face uncertainty. Among the issues that regulators have yet to resolve are
how the rule will treat bank portfolios that do not meet data
requirements, how they will calculate reductions in aggregate minimum
regulatory capital and what they will do if the reduction exceeds a
proposed 10 percent trigger, and what criteria they will use to determine
the appropriate average level of required capital and cyclical variation.
Increased transparency going forward could reduce ambiguity and respond to
questions and concerns among banks and industry stakeholders about how the
rules will be applied, their ultimate impact on capital, and the
regulators' ability to oversee their implementation.

References

Visible links
  62. http://www.gao.gov/cgi-bin/getrpt?GAO-07-242
  66. http://www.gao.gov/cgi-bin/getrpt?GAO-05-61
  68. http://www.gao.gov/cgi-bin/getrpt?GAO-07-242
  69. http://www.gao.gov/cgi-bin/getrpt?GAO-05-61
  70. http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-00-48
  71. http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-98-153
  72. http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-97-18
  80. http://www.gao.gov/cgi-bin/getrpt?GAO-07-253
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