On February 15, two things happened that, at least in theory, advanced the nine-year effort to implement Basel II risk-based capital rules in the US for large, internationally active banking organizations. First, the federal bank and thrift regulatory agencies released three proposed supervisory guidance documents related to the agencies' September 2006 Basel II notice of proposed rulemaking (NPR) explaining the regulators' expectations for banks under certain aspects of the proposed Basel II framework. On the same day, the Government Accountability Office (GAO) released a Congressionally-mandated report examining the implementation of Basel II in the US. While the GAO report supported the need for implementing the Basel II framework, it suggested several areas for improvement and recommended yet another round of public comments on the Basel II NPR, a move that would further delay the adoption and implementation of final Basel II rules in the US. Public comments from some of the regulatory agencies following the release of the GAO report indicate that significant differences remain among the agencies as to how to proceed with Basel II implementation and that, as a result of these unresolved differences, the adoption of final Basel II rules in the US may still be a long way off.

Proposed Supervisory Guidance

At a meeting of the Board of Directors of the Federal Deposit Insurance Corporation (FDIC) on February 15, the FDIC, along with the Federal Reserve Board, the Office of the Comptroller of the Currency (OCC), and the Office of Thrift Supervision (OTS) (collectively, the Agencies), cleared for public release and comment three long-awaited interagency supervisory guidance proposals detailing how the Agencies intend on implementing the Basel II NPR and setting forth their expectations for banks adopting the credit risk and operational risk approaches under the proposed Basel II framework. The first proposal relates to the advanced internal ratings-based (A-IRB) approach for calculating credit risk. The A-IRB guidance updates and consolidates the 2004 proposed guidance on corporate and retail credit exposures, and it includes new discussions on securitizations, counterparty risk, and banking-book equity exposures. The second proposal sets forth proposed supervisory guidance on the advanced measurement approach (AMA) for operational risk. The AMA guidance updates the 2003 proposed guidance and provides additional context and detail to help banks meet the qualification requirements outlined in the Basel II NPR related to operational risk. The third proposal, being issued for the first time, proposes guidance on the supervisory review process (Pillar 2) under Basel II. The proposed guidance addresses the Pillar 2 internal capital adequacy assessment process (ICAAP), one of the most contentious Basel II issues.

According to the Agencies, the proposed supervisory guidance documents are companion guidance to the Basel II NPR and, as such, are designed to be consistent with the NPR. The Agencies believe the documents, which are designed to provide clarity and practical examples, are necessary to supplement the NPR with standards to promote safety and soundness and encourage comparability across banks. However, during the February 15 FDIC Board meeting at which the proposals were approved, representatives of both the FDIC and the OTS expressed concerns that the proposals are too prescriptive and perhaps not sufficiently "user-friendly." The proposals, which can be found here, were published in the Federal Register on February 28. The comment period for the proposals ends on May 29.

GAO Gives Basel II a Cautious Go-Ahead

Also on February 15, the GAO released its report on Basel II implementation in the US. As part of last year's Federal Deposit Insurance Reform Conforming Amendments Act, Congress ordered the GAO to study and report on the potential impact on the US financial system of the implementation of Basel II. The GAO found that, due to uncertainties related to the proposed rules, it was not able to assess the potential impact of Basel II on the minimum capital requirements, the actual amount of capital held by banks under the Basel II framework, or the costs associated with implementing the Basel II rules.

To the relief of the Agencies, the GAO concluded that the Agencies should proceed with finalizing Basel II rules and begin the transition period to implement the new framework. However, the GAO's "go-ahead" came with a warning — proceed with caution! The GAO stated that only with the use of appropriate safeguards during the transition period is it appropriate for the Agencies to proceed with finalizing Basel II and proceed with a parallel run and transition period.

The GAO expressed concerns about a number of questions yet to be resolved by the Agencies, such as how the Agencies would treat bank portfolios that do not meet data requirements for advanced approaches, how they will calculate reductions in aggregate minimum regulatory capital, what would happen if a reduction exceeds the proposed 10 percent trigger, and what criteria they will use to set the appropriate average level of required capital and appropriate cyclical variation. The GAO recommended the Agencies clarify these issues prior to the proposed parallel run and transition period. The GAO criticized the Agencies for lack of transparency during the Basel II rulemaking process and suggested that the Agencies issue periodic public progress reports reporting on the progress of the Basel II implementation. The report also called for the Agencies to reevaluate the appropriateness of Basel II at the end of the transition period.

Perhaps the most noteworthy recommendation from the GAO was a suggestion that the Agencies issue another NPR if the final rule differs "materially" from the current Basel II NPR or if the Agencies decide to include an option to use the "standardized" approach in the final rule, as has been requested by banks. See the October 2006 Update. Another NPR would mean another round of public comments, which would delay the Basel II final rule for a third time and put the US further behind other countries in the Basel II implementation process.

In separate speeches shortly after the release of the GAO report, the FDIC and the Federal Reserve Board painted vastly different pictures of where the Basel II implementation process stands. While outgoing Federal Reserve Board Governor Susan Bies said on February 26 that the Board was "very intent" on completing the Basel II rulemaking in time to allow for the targeted 2008 implementation and stressed the importance of moving ahead with the Basel II NPR, FDIC Chairman Sheila Bair made it clear the same day that she is not happy with where things currently stand with Basel II rules. The speeches did suggest that the Board and the FDIC have closed some ground on the issue of the "standardized" approach (which the FDIC supports and the Board has opposed). However, Ms. Bies indicated for the first time that the Board might be flexible on the leverage ratio requirement in the Basel NPR, while Ms. Bair made it very clear that the FDIC has no interest in making any changes to the leverage ratio. All in all, the two speeches showed that these two key agencies remain far apart on how to proceed.