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entitled 'Risk-Based Capital: Bank Regulators Need to Improve 
Transparency and overcome Impediments to Finalizing the Proposed Basel 
II Framework' which was released on February 15, 2007. 

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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: 

GAO Highlights: 

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

Why GAO Did This Study: 

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. 

What GAO Found: 

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. 

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. 

[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-07-253]. 

To view the full product, including the scope and methodology, click on 
the link above. For more information, contact Orice Williams at 
williamso@gao.gov or Tom McCool at mccoolt@gao.gov. 

[End of section] 

Contents: 

Letter: 

Results in Brief: 

Background: 

The Transition to Basel II Has Been Driven by Limitations of Basel I 
and Advances in Risk Management at Large Banking Organizations: 

Federal Regulators Are Proposing a Regulatory Capital Framework that 
Differs from the International Basel II Accord in Several Respects: 

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: 

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

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

Conclusions: 

Recommendations: 

Agency Comments and Our Evaluation: 

Appendix I: Scope and Methodology: 

Appendix II: U.S. and International Transition to Basel II: 

Appendix III: Basel II Descriptive Overview: 

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: 

Related GAO Products: 

Tables: 

Table 1: Major Types of Banking Risks: 

Table 2: U.S. Basel I Credit Risk Categories: 

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

Figures: 

Figure 1: The Three Pillars of Basel II: 

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

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

Figure 4: U.S. Regulatory Capital Requirements: 

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

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

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

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: 

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.[Footnote 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.[Footnote 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. 

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.[Footnote 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.[Footnote 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: 

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.[Footnote 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.[Footnote 6] 

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. 

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: 

* how they will treat portfolios that may lack adequate data to meet 
regulatory requirements for the advanced approaches, 

* how they will calculate reductions in aggregate minimum regulatory 
capital and what would happen if a reduction exceeds a proposed 10- 
percent trigger, and: 

* 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): 

* 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. 

* 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. 

* 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. 

* 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: Credit risk; 
Definition: The potential for loss resulting from the failure of a 
borrower or counterparty to perform on an obligation. 

Risk: Market risk; 
Definition: The potential for loss resulting from movements in market 
prices, including interest rates, commodity prices, stock prices, and 
foreign exchange rates. 

Risk: Interest rate risk; 
Definition: A type of market risk that involves the potential for loss 
due to adverse movements in interest rates.[A]. 

Risk: Operational risk; 
Definition: The risk of loss resulting from inadequate or failed 
internal processes, people, and systems or from external events. 

Risk: Liquidity risk; 
Definition: 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. 

Risk: Concentration risk; 
Definition: 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. 

Risk: Reputational risk; 
Definition: The potential for loss arising from negative publicity 
regarding an institution's business practices. 

Risk: Compliance risk; 
Definition: The potential for loss arising from violations of laws or 
regulations or nonconformance with internal policies or ethical 
standards. 

Risk: Strategic risk; 
Definition: The potential for loss arising from adverse business 
decisions or improper implementation of decisions. 

Source: GAO. 

[A] As 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. 

[End of table] 

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: 

* OCC supervises national (i.e., federally chartered) banks. Many of 
the nation's largest banks are federally chartered. 

* 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. 

* 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). 

* OTS regulates all federally insured thrifts, regardless of charter 
type, and their holding companies.[Footnote 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.[Footnote 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.[Footnote 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.[Footnote 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.[Footnote 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).[Footnote 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: 0%; 
Major assets: 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. 

Risk weight: 20%; 
Major assets: Claims on banks in Organization for Economic Cooperation 
and Development countries, obligations of government-sponsored 
enterprises, or cash items in the process of collection. 

Risk weight: 50%; 
Major assets: Most one-to-four family residential mortgages; certain 
privately issued mortgage-backed securities and municipal revenue 
bonds. 

Risk weight: 100%; 
Major assets: 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. 

Risk weight: 200%; 
Major assets: 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). 

[End of table] 

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.[Footnote 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.[Footnote 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.[Footnote 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.[Footnote 16] By 
contrast, federal regulators amended the U.S. framework in 2001 to 
better address risk for asset securitizations.[Footnote 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.[Footnote 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. 

Figure 1: The Three Pillars of Basel II: 

[See PDF for image] 

Source: GAO. 

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. 

[End of figure] 

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: 

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

* 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; 

* Focus on risk management. To promote the adoption of stronger risk 
management practices by the banking industry; and: 

* 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).[Footnote 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.[Footnote 20] Regulators estimate that, according 
to currently proposed criteria, 11 organizations would be required to 
comply with Basel II.[Footnote 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. 

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

[See PDF for image] 

Source: GAO analysis of public regulatory filings; FDIC. 

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. 

[A] Refers only to the lead U.S. bank subsidiary of a foreign-owned 
banking organization. 

[End of figure] 

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.[Footnote 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. 

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.[Footnote 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.[Footnote 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.[Footnote 25] 

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: 

* 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; 

* Establishing comparable capital requirements for similar portfolios; 

* Domestically, working to mitigate differences in risk-based capital 
requirements between institutions that participate in Basel II and 
those that do not; and: 

* 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. 

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

Scope of application; 
United States: 
* Proposes only the advanced approaches for credit and operational risk 
for largest banks; 
* Proposes Basel IA and retains Basel I for all other banks; 
* First available parallel run in 2008; 
International Accord: 
* Provides all banks with a choice of multiple approaches for assessing 
risks; 
* Replaces Basel I; 
* First available parallel run for A-IRB and/or AMA in 2007. 

Prudential safeguards; 
United States: 
* Transitional floors in which required risk-based capital cannot go 
below 95 percent, 90 percent, and 85 percent of Basel I requirements in 
three transition years, respectively; 
* Regulators intend to view a 10 percent or greater decline in 
aggregate risk-based capital requirements (compared to Basel I) as a 
material reduction warranting modifications to the U.S. Basel II 
framework; 
* Leverage ratio and prompt corrective action are retained; 
International Accord: 
* Transitional floors in which required risk-based capital cannot go 
below 90 percent and 80 percent of Basel I requirements in the first 
and second transition years, respectively; 
* Supplementary measures are not required under the international 
accord, but national authorities are free to adopt them as they see 
fit. 

Significant technical differences. 

Wholesale definition of default; 
United States: Based on whether: 
* the bank places any exposure to the obligor on nonaccrual status,; 
* the bank incurs full or partial charge-offs on any exposure to the 
obligor, or; 
* the bank incurs a credit-related loss of 5 percent or more on the 
sale of any exposure to the obligor or transfer of any exposure to the 
obligor to the held-for-sale, available-for-sale, trading account, or 
other reporting category; 
International Accord: Based on whether: 
* the bank considers an obligor unlikely to pay in full without 
recourse to bank actions, or; 
* an obligor's payment on principal or interest is more than 90 days 
past due; 
* Includes nonaccrual status and material credit-related loss on sale 
as elements indicating unlikeliness to pay. However, the 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 definition of default; 
United States: Occurs when an exposure reaches 120 or 180 days past 
due, depending on exposure type, or when the bank incurs a full or 
partial charge-off or write-down on principal for credit-related 
reasons; 
International Accord: Occurs when an exposure reaches a past due 
threshold between 90 and 180 days, set by the national supervisor, or 
when the bank considers an obligor unlikely to pay in full without 
recourse to bank actions. 

Small-and medium-sized business lending; 
United States: Does not include an adjustment that would result in a 
lower capital requirement for loans to small and medium-sized 
enterprises compared to other business loans under the framework; 
International Accord: Includes such an adjustment. 

Loss given default (LGD); 
United States: 
* A bank may use its own LGD estimates upon obtaining supervisory 
approval, which is based in part on whether the estimates are reliable 
and sufficiently reflective of economic downturn conditions; 
* A bank that does not qualify to use its own internal LGD estimates 
must instead compute LGD using a supervisory formula that some bank 
officials have described as overly conservative; 
International Accord: 
* Requires banks to estimate losses from default that would occur 
during economic downturn conditions, which may result in higher 
regulatory required capital for some exposures under the framework; 
* Does not identify an explicit supervisory formula for estimating LGD 
when a bank's internal LGD estimates do not meet minimum requirements; 
* 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. 

[End of table] 

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.[Footnote 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.[Footnote 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.[Footnote 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. 

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

[See PDF for image] 

Source: GAO analysis of information from the Basel IA Draft NPR and 
Congressional Research Service. 

[End of figure] 

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.[Footnote 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. 

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.[Footnote 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.[Footnote 31] 

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: 

[See PDF for image] 

Source: GAO. 

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

[B] The 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. 

[C] For 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. 

[D] A 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. 

[End of figure] 

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.[Footnote 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.[Footnote 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.[Footnote 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. 

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.[Footnote 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. 

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.[Footnote 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.[Footnote 37] One rationale for the flexibility afforded under 
the AMA approach is that operational risk modeling is a new and 
evolving discipline. 

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. 

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.[Footnote 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.[Footnote 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. 

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.[Footnote 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. 

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.[Footnote 
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.[Footnote 42] 

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

[See PDF for image] 

Source: GAO analysis of information from the Basel II NPR, Federal 
Reserve System, Moody's Investors Service, and QIS-4 Summary. 

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. 

[End of figure] 

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.[Footnote 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.[Footnote 44] 

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

[See PDF for image] 

Source: GAO analysis of information from the Basel II NPR, Federal 
Reserve System, and QIS-4 summary. 

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. 

[End of figure] 

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.[Footnote 
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.[Footnote 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. 

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.[Footnote 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. 

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.[Footnote 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.[Footnote 49] 

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. 

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.[Footnote 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. 

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.[Footnote 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. 

In 1996, regulators amended Basel I to incorporate market risks in the 
Basel I calculations of required capital.[Footnote 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.[Footnote 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.[Footnote 
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.[Footnote 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. 

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. 

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.[Footnote 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. 

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.[Footnote 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: 

* 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.[Footnote 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. 

* 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. 

* 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 
Regulators' 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.[Footnote 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.[Footnote 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. 

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. 

Regulators' 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.[Footnote 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. 

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. 

* 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. 

* 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. 

* Third, maintaining the current leverage ratio and PCA will further 
guard against any large declines in bank capital. 

* Finally, foreign regulators are moving to Basel II creating potential 
competitive disadvantages for U.S. banks vis-à-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: 

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

- 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. 

- How to calculate the 10-percent reduction in aggregate minimum 
regulatory capital and what will happen if the 10-percent reduction is 
triggered. 

- What the criteria will be for determining an appropriate average 
level of required capital and appropriate cyclical variation in minimum 
required capital. 

* 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. 

* 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 williamso@gao.gov or 
Thomas J. McCool at (202) 512-2642 or mccoolt@gao.gov. 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. 

Signed by: 

Orice M. Williams, Director: 
Financial Markets and Community Investment: 

Signed by: 

Thomas J. McCool, Director: 
Center for Economics: 

[End of section] 

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);[Footnote 62] the Basel II and Basel IA 
Advance Notices of Proposed Rulemaking (ANPR);[Footnote 63] 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.[Footnote 64] 

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.[Footnote 65] 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. 

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. 

[End of section] 

Appendix II: U.S. and International Transition to Basel II: 

[See PDF for Image] 

Source: GAO. 

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

[A] Denotes estimated date. 

[End of figure] 

[End of section] 

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: 

[See PDF for image] 

Source: GAO analysis of information from the Basel II NPR. 

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. 

[End of figure] 

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. 

[End of section] 

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

Board Of Governors Of The Federal Reserve System: 
Washington, D.C. 20551: 

Susan Schmidt Bies: 
Member Of The Board: 

January 26, 2007: 

Ms. Orice M. Williams: 
Director: 
Financial Markets and Community Investment: 
U.S. General Accountability Office: 
Washington, DC 20548: 

Dear Ms. Williams: 

The Federal Reserve appreciates the opportunity to review and comment 
on a draft of the GAO's report on the U.S. implementation of the Basel 
II capital accord (GAO-07-253). 

The Federal Reserve concurs with the report's initial finding that the 
Basel I capital rule is particularly inadequate for large banking 
organizations and increasingly fails to align regulatory capital 
requirements with risk for large and internationally active banking 
organizations. The report usefully discusses several of the principal 
flaws of the Basel I framework for large banking organizations: its 
simple, non-granular risk-bucketing system; its limited recognition of 
credit risk mitigation techniques; its lack of explicit coverage of 
operational risk; and its limitations in reflecting financial market 
innovations (such as securitization and derivatives). In addition, the 
report acknowledges that the Basel I framework has not kept pace with 
the more advanced risk measurement practices at large banking 
organizations. 

The Federal Reserve also agrees with the report's conclusion that the 
agencies should continue their efforts to finalize the U.S. Basel II 
capital rule and proceed with the parallel run and transition period to 
Basel II. As noted in the report, finalization of the U.S. Basel II 
rule would be appropriate for at least the following reasons: (i) the 
parallel run and transition period will generate crucial information 
for the agencies in their future assessments of the strengths and 
weaknesses of the Basel II rule for the U.S. banking system; (ii) Basel-
II transitional floors will prevent each bank's regulatory capital 
requirements from declining precipitously during the transition period; 
and (iii) any further delay in the U.S. implementation of Basel II 
creates potential competitive disadvantages for U.S. banks as compared 
to foreign banks. The report further indicates that small U.S. banking 
organizations have raised concerns that the proposed bifurcated 
implementation of Basel II in the United States may create competitive 
inequities between small and large U.S. banking organizations. The 
agencies have issued a Basel IA proposal for smaller U.S. banking 
organizations to help address these potential competitive inequities. 
Of course, we intend to review and analyze carefully all public 
comments on the outstanding Basel II and Basel IA proposals before 
making any final decisions about the new regulatory capital framework. 

The report also concludes that the U.S. Basel II implementation process 
has lacked transparency or clarity and, as a consequence, there is 
uncertainty about and some opposition to the Basel II framework. The 
Federal Reserve and the other Federal banking agencies have attempted 
to be as transparent and clear as possible in our Basel II 
implementation efforts, consistent with the letter and spirit of the 
Administrative Procedure Act. In the past few years, these efforts have 
included issuing for public comment proposed Basel II wholesale credit 
and operational risk supervisory guidance and an advance notice of 
proposed rulemaking in September 2003; issuing for public comment 
proposed Basel II retail credit supervisory guidance in October 2004; 
issuing two interagency press releases in 2005 on the timeframe and 
scope of our Basel II implementation efforts; issuing public results of 
our 41h Basel II quantitative impact study in February 2006; issuing 
for public comment a Basel II notice of proposed rulemaking (NPR) in 
September 2006 (with an extensive 6-month comment period); and hosting 
numerous meetings with bank trade associations and individual banking 
organizations throughout 2006 to discuss the NPR. The agencies also 
expect to issue all the Basel II supervisory guidance for a second 
round of public comment in the near future. Many of these actions went 
far beyond our obligations under the Administrative Procedure Act to 
provide the public (including the banking industry) with fair notice of 
our rulemaking activities. 

Notwithstanding these significant efforts by the agencies to promote 
the transparency of the U.S. Basel II implementation process, we 
understand that the outstanding Basel II proposals contain a 
considerable amount of ambiguity. The agencies expect to reduce this 
ambiguity substantially as we work to finalize the Basel II rule. 
Moreover, during the transition period, as we acquire additional 
experience with the new regulatory capital framework, we expect to be 
able to further reduce any residual uncertainties that remain in the 
Basel II rule. Of course, there are limits on how specific and concrete 
the agencies can make the Basel II rule. Basel II has been designed to 
be an adaptable regulatory capital framework; as such, many of the 
ultimate requirements of any final Basel II rule will take the form of 
general principles in order to preserve the risk measurement and 
management flexibility of banking organizations. 

In addition, the report makes a number of recommendations to the 
agencies about how to improve the transparency and clarity of the U.S. 
Basel II implementation process going forward. The Federal Reserve 
concurs with these recommendations and will seek to (i) provide 
additional clarity about how the Basel II rule would treat portfolios 
for which a bank does not have sufficient historical performance data 
(or an acceptable and reliable risk parameter quantification 
methodology); (ii) clarify the criteria we will use for determining an 
appropriate average level of required capital, and appropriate cyclical 
variation in required capital, in the U.S. banking system; (iii) issue 
a second Basel II NPR if the agencies decide to permit Basel II banks 
to use a standardized option or if the agencies intend to issue a final 
Basel II rule that would differ substantially from the Basel II NPR; 
(iv) issue periodic public reports on the U.S. Basel II implementation 
process during the parallel run and transition periods; and (v) re-
evaluate, at the end of the transition period, whether the advanced 
approaches of Basel II provide an appropriate regulatory capital 
framework for U.S. banking organizations. Indeed, with respect to the 
final recommendation, we expect to perform such an evaluation not only 
at the end of the transition period but also during the transition 
period. 

Federal Reserve staff has separately provided GAO staff with technical 
and correcting comments on the draft report. We hope that these 
comments were helpful. 

Thank you for your efforts on this important matter. The Federal 
Reserve appreciates the professionalism of, and the careful analysis 
performed by, the GAO's review team. 

Sincerely: 

Signed by: 

Susan Schmidt Bies: 

[End of section] 

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

Comptroller of the Currency: 
Administrator of National Banks: 
Washington, DC 20219: 

January 26, 2007: 

Ms. Orice M. Williams: 
Director, Financial Markets and Community Investment: 
United States Government Accountability Office: 
Washington, DC 20548: 

Dear Ms. Williams: 

We have received and reviewed your draft report titled "Risk-Based 
Capital: Bank Regulators Need to Improve Transparency and Overcome 
Impediments to Finalizing the Proposed Basel II Framework." The report 
fulfills a statutory mandate resulting from concerns about the possible 
effects of updating risk-based capital rules. 

We appreciate the GAO's recognition of the limitations of Basel I for 
large, complex and/or internationally active banks. The OCC believes 
that the continued safety and soundness of our banking system demands 
that we move away from our current simplistic risk-based capital system 
for large, internationally active banks to one that substantially 
enhances risk management and more closely aligns capital with risk. The 
draft report acknowledges the crucial role of Basel II in the 
development and utilization of enhanced risk management systems in our 
largest banks. 

In this context, we very much welcome your straightforward statement in 
the report that GAO "support[s] the regulators' plans to continue to 
finalize the Basel II rules 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." This has been the essence of the OCC's position on Basel II: 
move forward to finalize the rules; begin implementation with strong 
temporary safeguards in place during a transition period; and assess 
the need for adjustments to the framework during that transition period 
before removing the temporary safeguards. Of course, we also note that 
the proposals leave in place two existing U.S. capital safeguards that 
are not temporary and are in addition to the capital required 
internationally by the Basel II framework: the leverage ratio, and the 
additional capital effectively required by the prompt corrective action 
framework (i.e., the additional capital required to be designated "well 
capitalized," as nearly all U.S. banks are). 

The draft report contains various statements and recommendation for the 
banking agencies to consider in the assessment of comments on the Basel 
11 notice of proposed rulemaking (NPR). 

Several of these statements and recommendations concern the approach to 
safeguards and the transition period just described. In particular, the 
draft report: 

* Describes and supports certain of the safeguards contained in the NPR 
that limit potential reductions in regulatory capital during the 
parallel run and transition periods; 
* Recommends that the agencies improve transparency during the 
transition period by issuing public reports on the progress and results 
of implementation; and: 
* Recommends that, before the end of the transition period, the 
agencies undertake an analysis to determine whether changes are needed 
to the Basel II rule. 

In addition, the draft report: 

* Highlights competitive equity issues associated with the U.S. 
rulemakings, including the need for the agencies to ensure that capital 
adequacy regulations not be a significant source of competitive 
inequality, both domestically and among internationally active banks; 
and: 

* Recommends that the agencies clarify and reach agreement on certain 
provisions of the NPR that are ambiguous or unclear. 

We welcome these and the other substantive comments and recommendations 
made in the draft report, which we and the other banking agencies will 
consider as part of the overall review of comments received on the NPR. 

With respect to your comment about whether a new NPR might be necessary 
before proceeding to a final rule, we believe that will ultimately 
depend on the whether the actual changes made to the NPR in the 
subsequent version of the rule are sufficiently different so as to 
require another round of notice and comment. It is of course premature 
to make that determination until all the comments have been received 
and evaluated and the agencies decide what changes will be made. We 
also note that further delay resulting from an additional NPR could 
itself have ramifications for international competition. In any event, 
we will ensure that the rulemaking process remains compliant with both 
the letter and the spirit of the Administrative Procedure Act. 

I appreciate this opportunity to provide the OCC's comments on the 
draft report, and I extend my thanks for the professionalism with which 
you and your staff have conducted this review. Technical comments were 
provided to your analysts separately. 

Sincerely, 

Signed by:  

John C. Duga: 
Comptroller of the Currency: 

[End of section] 

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

Federal Deposit Insurance Corporation: 
Office of Thrift Supervision: 

January 25, 2007: 

Ms. Orice M. Williams Director: 
Financial Markets and Community Investment: 
U.S. Government Accountability Office: 
441 G Street, N.W. 
Washington, D.C. 20548: 

Dear Ms. Williams: 

The Federal Deposit Insurance Corporation and the Office of Thrift 
Supervision appreciate the opportunity to comment on the GAO's draft 
report, Risk-Based Capital: Bank Regulators Need to Improve 
Transparency and Overcome Impediments to Finalizing the Proposed Basel 
II Framework. This letter summarizes our agencies' overall reaction to 
the report. Technical comments on the report have been provided by our 
respective staffs. 

The report rightly notes that the agencies share a number of important 
regulatory objectives. The Basel II effort to improve the risk- 
sensitivity of capital requirements for large, complex banks has been 
rooted in these shared objectives. As summarized in the report, these 
objectives include: 

* To further strengthen the soundness and stability of the 
international banking system; 

* To maintain sufficient consistency that capital adequacy regulation 
will not be a source of competitive inequality among internationally 
active banks; 

* To promote the adoption of stronger risk management practices by the 
banking industry; and: 

* 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. 

As noted in the report, the agencies also share the goal of avoiding 
unintended consequences, such as the creation of a significant 
competitive disadvantage for any class of banks. 

Ensuring the achievement of these shared objectives will remain of 
paramount importance to the agencies' deliberations and review of 
comments on the Notice of Proposed Rulemaking (NPR). While the agencies 
sometimes approach issues from different perspectives, as the report 
notes, we share a commitment to maintaining a safe and sound banking 
industry. The retention of the existing leverage requirements and 
Prompt Corrective Action framework, and other safeguards contained in 
the NPR, underscore that commitment. 

The report notes that the implementation of the advanced approach is 
not without risk, and that its ultimate impact on the safety-and- 
soundness of the U.S. banking system is uncertain. Given the 
considerable costs and complexity of the advanced approach and its 
attendant uncertainties and risks, our agencies believe 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. 
Our decisions in this regard will benefit greatly from the comments we 
receive on this and other issues. 

The report makes a number of recommendations that our agencies will 
consider as part of the overall review of comments received on the NPR. 
Our agencies appreciate the professionalism of the GAO's review team 
and the significant efforts that went into the development of these 
recommendations. 

Sincerely, 

Signed by: 

Sheila C. Bair: 
Chairman: 
Federal Deposit Insurance Corporation: 

Signed by: 

John M. Reich: 
Director: 
Office of Thrift Supervision: 

[End of section] 

Appendix VII: Comments from the Department of the Treasury: 

Department Of The Treasury: 
Washington, D.C. 

Under Secretary: 

January 26. 2007: 

Orice M. Williams: 
Director, Financial Markets and Community Investment: 
United States Government Accountability Office: 
411 G Street, NW: 
Washington, DC 20508: 

Dear Ms. Williams: 

Thank you for providing the United States Department of the Treasury 
the opportunity to comment on the Government Accountability Office's 
(GAO) report entitled "Risk-Based Capital: Bank Regulators Need to 
Improve Transparency and Overcome Impediments to Finalizing the 
Proposed Basel II Framework. " 

In general, the GAO draft report provides a comprehensive overview of 
the Basel II process and U.S. implementation efforts. As the draft 
report noted, the Basel II process is important for encouraging ongoing 
improvements in bank risk management and measurement processes, and in 
making regulatory capital requirements more risk-sensitive for U.S. 
banking institutions.  

We agree that there remain a number of significant Basel II 
implementation challenges and uncertainties for the large complex 
banking organizations subject to Basel II requirements and for the 
federal banking regulators. Despite these challenges, we believe that 
the federal banking regulators should reach a consensus on the major 
requirements of a final rule soon after the Basel II and Basel IA 
comment periods end in late March. Reaching such a consensus and 
providing key implementation information to relevant banking 
institutions as soon as possible thereafter is essential if the U.S. is 
going to meet the January 2008 goal for Basel II implementation. In 
that regard, we note that the U.S. implementation schedule is already 
one year behind other member countries of the international Basel 
Committee on Banking Supervision. Further delay will add to uncertainty 
and potentially create burdens for both domestic and foreign banks. 
While regulators retain appropriate discretion in implementing Basel II 
to ensure that the proper safeguards remain in place, given that other 
countries are moving forward, it is incumbent upon the federal banking 
regulators to also move forward with Basel II implementation. 

Finally, we would note that the GAO draft report recommended that the 
federal banking regulators issue a new notice of proposed rulemaking 
(NPR) before finalizing the Basel II rule given the. number of open- 
ended questions and the potential option of providing the Basel II 
standardized approach to all U.S. banks. We are quite concerned about 
further delaying this important process. We also note that the 
simultaneous proposal of the Basel IA NPR (which is similar to the 
standardized approach to credit risk option in the international 
accord) and the Basel II NPR for notice and comment, provide commenters 
with the ability to opine on implementation and other issues and 
options. In addition, we note that the extended time period toward fall 
implementation of Basel II (a parallel-year run in 2008 and three-year 
transition period) provides ample opportunity for the federal banking 
regulators to fully consider the impact of Basel II and related issues. 

Again, we would like to thank you for this opportunity to provide our 
views an your draft report. Please let us know if you have any 
additional questions. 

Sincerely, 

Signed by: 

Robert K. Steel: 
Under Secretary for Domestic Finance: 

[End of section] 

Appendix VIII: GAO Contacts and Staff Acknowledgments: 

GAO Contacts: 

Orice M. Williams (202) 512-5837 or williamso@gao.gov Thomas J. McCool 
(202) 512-2642 or mccoolt@gao.gov: 

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. 

[End of section] 

Related GAO Products: 

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

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

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

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

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

FOOTNOTES 

[1] 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. 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). 

[2] The 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. 

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

[4] The 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. 

[5] The 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. 

[6] As 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. 

[7] In 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. 

[8] Tier 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. 

[9] Banks 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. 

[10] See GAO, Deposit Insurance: Assessment of Regulators' Use of 
Prompt Corrective Action Provisions and FDIC's New Deposit Insurance 
System, 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). 

[11] See, e.g., 12 C.F.R. § 6.4(b)(1) (OCC). 

[12] In 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). 

[13] As 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). 

[14] The 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. 

[15] Securitization 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. 

[16] 61 Fed. Reg. 47358 (Sept. 6, 1996). 

[17] 66 Fed. Reg. 59614 (Nov. 29, 2001). 

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

[19] For 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. 

[20] These 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. 

[21] A 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. 

[22] 5 U.S.C. § 553. 

[23] QIS-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. 

[24] A 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). 

[25] During 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. 

[26] 71 Fed. Reg. 77446 (Dec. 26, 2006). 

[27] LTV 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. 

[28] Under 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. 

[29] 71 Fed. Reg. 77463. 

[30] A 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. § 1831o(c)(1)(B)(ii). 

[31] For 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. 

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

[33] Holding 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. 

[34] According 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. 

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

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

[37] Scenario 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. 

[38] The 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. 

[39] Allen 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). 

[40] A 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. 

[41] For 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. 

[42] As 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. 

[43] In 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. § 1750.4. 

[44] The 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. 

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

[46] 71 Fed. Reg. 55855. 

[47] In 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. 

[48] See 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). 

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

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

[51] All 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. 

[52] The 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). 

[53] Covered 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. 

[54] The 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. 

[55] See, e.g., 12 C.F.R. Part 3, App. B § 4(e) (OCC). 

[56] Because 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. 

[57] 71 Fed. Reg. 55830, 55911-12. 

[58] However, such discussions would not be considered a supervisory 
issue because banks are not yet required to meet any Basel II 
requirements. 

[59] Typically 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. 

[60] The 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. 

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

[62] 71 Fed. Reg. 55380 (Sept. 25, 2006) (Basel II NPR); 71 Fed. Reg. 
77446 (Dec. 26, 2006) (Basel IA). 

[63] 68 FR 45900 (Aug. 4, 2003) (Basel II ANPR); 70 FR 61068 (Oct. 20, 
2005) (Basel IA ANPR). 

[64] In 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. 

[65] 61 Fed. Reg. 47358 (Sept. 6, 1996). 

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