In November, the FDIC, the Federal Reserve Board, the OCC and the OTS finally released the long-awaited final rule to implement the Basel II Accord risk-based capital rules in the US for large, internationally active banking organizations, thus achieving a major milestone in the nine-year effort that has been marked by delays, setbacks and squabbling among the regulatory agencies. The final rule marks a major development in the effort by the US agencies to achieve the purposes of the Basel II Accord, which include harmonizing capital rules internationally, making regulatory capital rules more risk sensitive and improving overall risk management practices by financial institutions. The approval of the final Basel II rule also raises a number of significant issues for banking organizations in the US.

The final Basel II rule, which is the result of a hard-fought compromise reached by the agencies in July, is several hundred pages long and very complex. As a result, the rule does not lend itself to an easy summary or general assessment as to its potential impact. However, it is clear that the effects of the new capital rule will be felt throughout the US financial services industry. For example, changes in risk-based capital requirements resulting from the new rule will likely have a considerable effect on the cost and availability of credit. In addition, the new rule will have a significant impact on the providers of credit and operational risk mitigation, including providers of derivatives and similar instruments. Also, the implementation of the new capital rule will begin at a time when banks are already facing pressures on their capital due to recent market developments, raising concerns about the potential significant increased capital charges that the new rule might require. Some of the more noteworthy aspects of the new Basel II rule are highlighted below, followed by a discussion of what comes next.

The New Rule: What's In and What's Out

Despite the goal of the Basel II Accord of harmonizing global capital rules, the US rule remains at odds with the international accord in a number of important areas. In general, the US rule is considerably more conservative than the international Basel II Accord in a number of very important respects. As signaled by the July compromise agreement, the final rule does not give large US banks the option of utilizing the "standardized" approach provided for under the international accord. As noted in the October 2006 Update, US banks pushed hard for the "standardized" approach option, citing competitive equality concerns due to the fact that banks subject to the international Basel II Accord could choose this simpler approach. Over the objections of the US banking industry, the agencies also retained the prompt corrective action standards and leverage ratio requirements of current US capital rules. The international accord does not contain similar requirements.

The agencies also retained the three-year conditional transition period, which is one year longer than the international Basel II Accord requires and, when combined with a required one-year parallel run period, will put full implementation of the Basel II final rule in the US at least two years behind countries that already began the international accord's two-year transition period this year. Unlike the international accord, the final US rule also retains transitional floors on overall capital reduction during the transition period. After a parallel run in 2008 (during which banks that are subject to the new rule or opt in to the rule must calculate their risk-based capital under both the current capital rule and the new Basel II rule), the transitional floors provide for maximum cumulative reductions in capital of five percent during the first year of implementation, 10 percent during the second year and 15 percent during the third year. The agencies dropped a proposal championed by the FDIC to stop the implementation of the Basel II rule in the US if overall industry risk-based capital fell by 10 percent or some other "material" amount. Instead, the agencies agreed to conduct a study of the effect of the rule at the end of the second transition year. If the study finds "material deficiencies" in the Basel II rule, the agencies will not allow banks to exit the third transitional year to full implementation of the Basel II rules. Also, the agencies could decide then to make major adjustments to the rule or scrap the rule completely.

What's Next?

Even with the release of the final rule, the overall implementation of Basel II in the US remains very much a work in progress. Much remains to be done before new risk-based capital rules are widely implemented in the US. First, the final rule is mandatory only for the 11 or 12 largest US banks ("core" banks) (other banks may opt in to the rule's advanced approaches, if they meet applicable qualification criteria). As part of the July compromise agreement, the US regulatory agencies decided to withdraw the "Basel 1A" proposed rules, which would have covered all but the core and opt-in banks. The agencies decided instead to draft new rules that will provide banks other than core and opt-in banks with the option of adopting the "standardized" approach of the international Basel II Accord. The agencies intend to propose this new rule in early 2008 and they hope to have the final standardized approach rule in place before 2009. 

There are a number of other significant unresolved issues for US banks subject to the new Basel II final rule. For one, the US regulatory agencies have yet to issue final rules covering market risk, which were proposed in September 2006. The agencies have stated that they expect to finalize these issues shortly. Additionally, the agencies have not yet finalized three supervisory guidance proposals issued in February 2006 that are intended to be used in conjunction with the final Basel II rule. See the March 2007 Update for a summary of these proposals.

The final Basel II rule was published in the Federal Register on December 7. While the rule is effective April 1, 2008, a core or opt-in bank will not be fully subject to the rule until 2012 at the earliest. A bank may commence the required one-year parallel run in 2008, but only after the bank's primary federal regulator has approved the bank's Basel II implementation plan. After the parallel run year, banks may commence the three-year transition period beginning in 2009 and ending in the first quarter of 2012 at the earliest.