One Nation, Left Behind

The race to cut compliance-based capital has begun, and U.S. banks are trailing the pack — badly.

U.S. banks want to go on a diet, but regulators are telling them they must remain chunky, even as their international competitors get captivatingly thin.

The diet in question is the internationally negotiated rule on bank capital that modernizes how risk is measured on financial institutions’ balance sheets. But squabbling between U.S. regulators over how to implement the rule has resulted in a delay that has put U.S. banks two to three years behind banks in Europe, Canada, and Asia. Those countries will begin operating under the new set of capital rules, based on the Basel Committee on Banking Supervision’s revised capital framework (and better known as Basel II), this January. In the United States, bankers have been told to expect a three-year phase-in period (the final rules were still not available in early September), meaning that the new capital standards will not be fully implemented until 2011. And the new Basel rules will be mandatory only for U.S. banks with $250 billion in assets or $10 billion in overseas exposure (though other banks will be permitted to opt in).

While their international counterparts will soon begin to shed excess weight, many U.S. banks will have to keep their balance sheets stuffed with regulatory capital — the reserves a bank must have on hand to insure against loan defaults.

That has large implications for U.S. banks.

Basel II, by virtue of being more sensitive to banks’ true credit and operational risks, allows financial institutions to free up cash and other liquid assets. Basel II banks can lend and invest this extra capital (and acquire other banks), earning higher returns than they would squirreling away the funds for compliance reasons. Because they have a head start on the United States, banks in nations adopting Basel II this January will also be able to offer lower prices on loans, at least temporarily.

Such regulatory inequality will give U.S. corporations reason to shop at banks based outside the United States — and possibly handicap some U.S. banks trying to capture business overseas. Once Basel II is fully implemented in the States, though, highly rated corporations may be able to borrow more cheaply, since Basel II banks will not have to hold as much capital against their credits. But that advantage will not come for another couple of years. In the meantime, overseas firms will get the chance to exploit it.

“If you’re UBS or HSBC, you can’t come to the U.S. and get a completely free ride just because your home base is in Europe and your regulatory capital may be lower there; you’re still subject to U.S. rules,” says Guillermo Kopp, an executive director of TowerGroup, a financial-services research firm. “In the aggregate though, [you] will have a bit of an edge. Depending on the bank’s global portfolio, it could be significant.”

The numbers bear that out. In a report released in August, The Netherlands–based ING, a $1.75 trillion bank, reported that it expects the capital it needs to hold against credit and other risks to drop by as much as 20 percent by 2009. By comparison, capital levels at banks here will not be allowed to fall more than 5 percent per year.

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