ANPR maps out US differences on Basel II implementation for banks

WASHINGTON, DC -- US regulators are determined to go their own way when it comes to implementing Basel II, according to the government’s ANPR, published in mid-July.

The document contains many clear signs that US regulators -- including the Federal Reserve, the OCC, the FDIC and the Office of Thrift Supervision -- have deviated from the framework laid out in the Basel Committee on Banking Supervision’s CP3.

To begin with, of course, only about 10 US banks will have to adopt Basel II on a mandatory basis. The ANPR has defined banks that will have to adopt Basel II’s AMA and A-IRB as those with total banking assets of $250 billion or more, or total on-balance sheet foreign exposures of $10 billion or more, as stated in the year-end Country exposure report to US regulatory authorities. According to Federal Reserve statistics and banks’ own data, mandatory banks could include JP Morgan Chase, Bank of America, Citibank, Wachovia, Bank One, Wells Fargo, Fleet Boston, Bank of New York, State Street, and Washington Mutual.

But there are other, major differences between the agreements hashed out in Basel II and the proposed US framework. For starters, there is no such thing as partial use under the ANPR -- a US bank has to be on A-IRB and AMA globally, or on Basel I. Also, US banks will not be able to reduce their capital charge as dramatically as they would under CP3’s regime.

Institutions will continue to be subject to a minimum risk-based capital floor for two years after adoption of the AMA and A-IRB on a stand-alone basis. For the first year, an institution’s calculated risk-weighted assets cannot be less than 90% of risk-weighted assets calculated under the general risk-based capital rules that currently apply in that country. For the second year, the figure is 80%. This means that banks will have to calculate their capital charge under both the existing rules -- the prompt corrective action (PCA) framework -- and the new Basel II system for a minimum of three years. "There is an understanding among Basel Committee members that any country can choose to take a more conservative approach than what is in the Accord, and this is an area where we would probably exercise that right," says one US Federal Reserve official. He adds, "in this bold new world of letting banks set their own capital requirements -- which is what the advanced methodologies effectively allow -- the PCA requirements offer a sense of comfort".

In addition, the US document does not address pillar II at all. "We didn’t propose a specific pillar II framework because we didn’t think it was necessary," says the US regulatory official. "In our view, the way we supervise banks is already consistent with pillar II. Most of what pillar II requires -- bank assessment of capital adequacy, supervisory review, capital in excess of minimum, etc -- is already built into our supervisory framework. If some specific things, such as interest rate risk in the banking book, slip through the cracks, it was probably more because of the tight timeframe [for drafting the document] than anything else."

Another big change is the US’s treatment of expected losses (EL) under operational risk -- regulatory capital will be based on the sum of EL and UL (unexpected losses), and the bar for removing EL from the calculation is much higher than in CP3. In CP3, banks must demonstrate "to the satisfaction of the national supervisor that it has measured and accounted for its EL exposure". But the US ANPR says that when it comes to identifying EL offsets, "the agencies believe this is likely to be difficult given existing supervisory and accounting standards. The agencies have considered both reserving and budgeting as potential mechanisms for EL offsets. The use of reserves may be hampered by accounting standards, while budgeting raises concerns about availability over a one-year time horizon to act as a capital replacement mechanism". However, US regulatory officials say that the Basel Committee is re-examining the EL issue both for credit and op risk, and that some supervisors take the view "there was no precedent for allowing things like budgeting to offset EL, and that the treatment of EL for op risk should be more rigorous and consistent with the treatment of credit risk EL". The supervisor said he expects he will receive a substantial number of comments on this issue.

In another departure from CP3, the US does not plan on allowing capital market solutions to be used to mitigate op risk, although it will allow insurance products under limited circumstances. Says the US regulator, "I think that there may have been some concern that explicitly allowing recognition of capital market instruments could result in a feeding frenzy of hot new products that might not be well understood by protection buyers or sellers, and/or might not perform as expected."

The US document is also substantially more detailed on op risk implementation than any other regulator’s work to date, with the possible exception of the UK’s Financial Services Authority (FSA). And even then, the level of specificity the US regulators include in the document surpasses many of the FSA’s proposals so far. For example, the ANPR says banks need to produce quarterly management reports that address both firm-wide and business line results, and summarise op risk exposure, operational loss experiences, and relevant assessments of business environment and internal control factors. Also, banks will have to have five years’ data for their internal op risk loss database that captures information across all material business lines, events, product types and geographic locations. Says the US regulator, "I’m not sure we wanted to be more strict than CP3, but we wanted to be more clear as to how we were interpreting it, and we also wanted to be clear that, for banks to be able to rely on their own estimates for regulatory capital purposes, the bar would be set high in terms of our expectations."

For pillar III, the US regulators are planning to request that banks publish a guide to their disclosures on their websites. And, banks will be asked to disclose their quantitative risk management information on a quarterly basis, while more qualitative information such as the structure of their risk management operations can be disclosed annually. However, the disclosures for op risk are fairly restrained -- banks will have to describe the AMA they adopt, "including a discussion of relevant internal and external factors considered in the banking organisation’s measurement approach". The bank will also have to disclose its op risk charge before and after any reduction in capital resulting from the use of insurance or other potential risk mitigants.

Comments on the ANPR are due back to US regulatory officials 90 days from formal publication of the document in the Federal Register.

There is currently no timetable for the US QIS, which regulators announced they will perform. The agencies are debating between performing the QIS ahead of the issuance of the notice of proposed rulemaking (NPR), which will follow on from the ANPR in the first quarter of 2004. Another idea is to do the QIS after the more technical NPR has been issued, so that banks have specific guidelines upon which to do their capital calculations. A third option is for the US to recruit other countries into a QIS4 -- even though members of the Basel Committee on Banking Supervision has said there will not be another. Discussions are ongoing, the regulatory official says. OpRisk

Ellen Leander, Stewart Eisenhart

The ANPR can be read at

www.federalreserve.gov/boarddocs/meetings/2003/20030711/attachment.pdf