On Friday, July 20, the four Federal Banking Agencies, FRB, OCC, OTS and FDIC ("Agencies"), announced that they had reached an agreement on how to implement the Basel II risk-based capital rules in the United States. This accord was an extremely significant development that happened after a six-year sojourn in the wilderness. The accord will enable the Agencies to issue a single final Basel II capital rule sometime by the end of September. The Basel IA proposal, which was intended to be adopted by the noncore banks, will be dropped. This accord will subject the 11 large core banks to the more risk-sensitive and advanced approaches of the Basel II capital rules. A number of the larger non-core banks will likely opt in and subject themselves to the same Basel II capital rules as the core banks.
The agreement was achieved as a result of a compromise position taken by the Agencies, primarily the FDIC. The 10 percent aggregate capital reduction cap that the FDIC strongly supported will be deleted from the final rule. It was contained in the September 2006 proposed rule. In exchange, the core banks will be subject to the Advanced-IRB approach in measuring their capital requirements; they will not be able to use either the basic or standardized approaches in determining their capital charge for credit risk. Instead, they will use their in-house computer models to calculate their capital needs subject to approval by their examiners. Instead of Basel IA as an option, non-core banks that choose not to opt in can use the standardized capital approach in Basel II, which is based on the rating agencies' credit ratings, and is much less burdensome and less costly to implement. These banks can also choose to remain under the existing Basel I capital rules, but their tradeoff is to not have the opportunity to possibly see a reduction in their current capital requirements. Once Basel II becomes fully implemented in the United States, required capital for the core and opt-in banks likely may decline significantly. However, the U.S. banks will remain subject to a leverage requirement. One important item to note is that Basel II imposes a discrete capital charge for Operational Risk that is not found in Basel I. Core banks must use the Advanced Measurement Approach for determining their Operational Risk capital charge.
The final rule will retain the September 2006 NPR's proposed transitional floor periods. Assuming the rule becomes effective January 2008, a one-year parallel run period will run with both Basel I and Basel II in place. Basel II takes full effect January 2009, but its capital impact is phased in. The maximum cumulative reduction is 5 percent for 2009, 10 percent in 2010 and 15 percent in 2011. After 2010, at the end of the second transitional year period, the Agencies will publish a study that evaluates the new framework "to determine if there are any material deficiencies." If material deficiencies are found in the new framework, banks may not be allowed to move into the third and final transitional year by their individual banking agency. However, if their primary banking regulator issues a public report explaining its rationale, its supervised banks may move into the final transitional year. Thereafter, starting January 2012, those banks' capital will be subject to the new more risk-sensitive rules subject to no floor, just like banking organizations outside the United States.
Having been very much involved in the Basel II capital rules from the beginning of the process, this is an important development and one that will help improve the competitive position of U.S. banking organizations versus their competitors overseas. However, it should be recognized that outside the United States, the Basel II capital rules will already be in place without a transitional floor and without any leverage rule.
Turning to another important recent Basel II development, Standard and Poor's ("S&P") released a detailed set of recommendations July 11 calling for additional disclosures by banks and their parent holding companies. This action by S&P follows Basel II's Third Pillar, an advocacy for greater public transparency under the heading of Market Discipline. Basel II views Market Discipline as complementing the minimum capital requirements of Pillar One and the enhanced supervisory review process, in Pillar Two. The idea is that through the enhanced transparency of the advanced approaches, investors can better evaluate a bank's capital structure, risk exposures and capital adequacy. By receiving more relevant and in-depth information, market participants should be in a position to better evaluate a bank's risk management performance, earnings potential and financial strength.
Pillar Three's focus on enhanced public disclosures has been an area inadequately addressed by commenters to date and maybe will now be subject to greater scrutiny and consideration by the industry. The Sept. 5, 2006 NPR issued by the Agencies has a discussion of the enhanced disclosures at pages 268 to 279 and 466 to 479. There are at least three principal concerns with Pillar Three as proposed: (1) There would be an uneven disclosure playing-field between banks and their non-bank competitors, and that would become more exacerbated as U.S. banking organizations' activities expand as a consequence of the Gramm-Leach Bliley Act; (2) banks and their parent holding companies already provide substantial financial disclosures to their regulators and in conformance with SEC required disclosures; and (3) there is increased likelihood that additional disclosures will provide a roadmap for class action litigators. There needs to be recognition that disclosure of reserves or loss information, or insurance coverage, will have a negative impact on a banking organization's ability to maximize its recovery on its claim.
These two developments are evidence that Basel II very likely will become a reality and fully implemented in the United States on or about January 2012. The core banks have been identified. The opt-in banks need to make a decision on their competitive positions promptly. Over time, most major banking organizations will choose to opt in. The Consolidated Supervised Entities subject to the SEC's rules have a less burdensome regulatory alternative.