American unilateralism over bank capital rules is upsetting Europeans
FOR the past five years, the world's financial regulators have been working
on a new set of rules for bank capital, called Basel 2. The idea is to
ensure that banks' capital matches the risks they carry: the riskier their
loan books, the more capital they should hold. The rules are not due to be
applied until January 2007, but if that deadline is to be met, Basel 2 must
be practically set in stone by this May.
The Basel Committee on Banking Supervision, which is drawing up the rules,
is pleased with the results of its third (and supposedly last) impact
study. The study suggests that the complex new risk weightings to be
applied to different types of asset will produce appropriate levels of
capital for most of the world's banks.
The Basel Committee on Banking Supervision reports on progress towards the
new accord.
Getting this far has taken a lot of sweat and horse-trading. American
bankers and regulators have been at the forefront. American financial
institutions have debated the rule changes as keenly as anybody. And Bill
McDonough, head of the Federal Reserve Bank of New York, has cracked the
whip as chairman of the Basel committee.
Imagine, therefore, the consternation of other committee members on
learning how America plans to treat the new rulebook. Some American bankers
and legislators are arguing that the proposed capital charge for
operational risk�a fundamental part of Basel 2�needs to be completely
rethought. Worse, American regulators intend to apply the new rules to
fewer than a dozen of their banks. At a congressional hearing last month,
they made it clear that the thousands of other American banks would
continue to use the less complex existing rulebook, Basel 1. In fact, Basel
1 is little different from the lowest of Basel 2's three grades of
sophistication. Nevertheless, the regulators believe that even this slight
change would be a waste of money for America's smaller banks.
Another transatlantic tiff
This is a choker for European regulators, who see Basel 2, like Basel 1, as
a global standard to be applied to all banks. Granted, the Federal Reserve
has always said that it would apply Basel 2 only to �internationally
active� banks. The surprise is that this means so few. It seems that banks
as big as State Street, Mellon Financial Corporation, and perhaps even Bank
of New York, which all have huge international payments and securities
operations, will escape. State Street and Mellon have been lobbying hard,
arguing that the Basel 2 charge for operational risk is too formulaic. They
say that operational risk�the risk of loss from systems failures, external
events, fraud etc�is impossible to quantify. It would be better if
supervisors monitored banks' efforts to mitigate these risks and then set a
subjective capital charge. But this is anathema to European regulators.
In Europe, a version of Basel 2 is to be incorporated into European Union
law and applied to all banks and investment firms, not just internationally
active banks. To this end, the European Commission hopes to publish a draft
directive in June. No wonder rulemakers in both Basel and Brussels are
furious with the Americans.
As things now look, different standards will apply to American and European
banks, giving the Americans a theoretically lower cost of making loans.
Karen Petrou of Federal Financial Analytics in Washington fears that the
American regulators' narrow application will allow some quite big American
banks to side-step realistic capital charges, by using the old Basel 1
loopholes. �The whole point of Basel 2 is to get rid of regulatory
arbitrage,� she comments.
However, members of the European Parliament (MEPs) might also try to
reshape the new rules�just as American congressmen have already tried.
Alexander Radwan, a German MEP who will report to the parliament on Basel
2, has several concerns. He thinks that capital charges that are more
sensitive to credit risk could curb lending to small companies, a fear
previously expressed also by the German government. And he dislikes the
idea of bank-supervision rules being drawn up and amended by unelected
experts (such as the Basel committee) outside the purview of politicians.
The Europeans also have some bargaining chips, which may yet produce a
compromise with the Americans. American banks cannot operate in Europe
under non-EU capital rules or supervision unless these are judged to be of
�equivalent� standard. American banks may find that Basel 1 will not be
deemed equivalent within the EU after 2006, when the commission's promised
directive is due to take effect. Moreover, some American investment banks
may be caught by another EU directive on financial conglomerates, which
comes into force in 2005. They may have to seek out a consolidated
supervisor with stronger oversight than their current one, the Securities
and Exchange Commission: an EU committee will decide next year.
Alternatively, European regulators could follow the American lead, and
simply reduce the scope of Basel 2 in Europe, along American lines. That
might not be a bad outcome. Initially, a few big banks conforming to Basel
2 would set a standard to which other banks could aspire. The incentive to
aspire would come not from regulatory pressure but from the market, which
might judge compliant banks to be safer and better-run.
Nice, but improbable. So much effort has been put into Basel 2, and so many
European banks are braced for the future directive, that there is no
turning back now. So it looks more likely that American and European banks
and their regulators will end up playing by different rules.
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