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  • CFO Magazine

Basel Faulty?

New international banking rules could improve loan pricing, but have raised concerns at the Fed.

Basel II may at long last be coming soon to a bank near you. And for better or worse, the new international bank regulatory regime promises to shake up the loan market.

The accord sets new guidelines for determining how much capital banks in 13 developed countries around the world must hold in reserve. It is scheduled to take effect in its most advanced form in 2008, nine years after initial work on the standards began. Because the new guidelines are more risk-sensitive than the existing ones, it has been widely expected that Basel II will make lower-risk bank lending cheaper, since banks will be required to hold less capital against such assets. That’s expected to produce lower-cost loans for large, healthy companies.

On the other hand, higher-risk borrowers could see costs rise, because banks that lend to them would have to hold more capital in reserve under the new regulatory setup. In fact, our survey of finance executives (see “Last Banks Standing“) found that 7 percent of the respondents expect Basel II to increase their cost of capital, while less than 1 percent feel that it will decrease it. And the new rules could put smaller banks that aren’t covered by them at a competitive disadvantage, which could mean high-credit-quality borrowers may want to consider shopping for bigger providers (see “Attention Shoppers,” below). More broadly, banking experts aren’t uniformly convinced that the new approach will be good for the U.S. banking system.

Proponents of Basel II say it’s needed to rationalize the current reserving requirements, which treat loans to junk borrowers as no more risky than loans to A-rated credits. They also point out that the world’s largest and most highly developed banks already use sophisticated internal risk models that take such disparities into account and argue that Basel II is needed simply to keep pace with real-world practice. Critics counter that by inviting banks to develop their own reserving models, as Basel II does, regulators will be injecting new risk into the U.S. banking system and perhaps threaten its stability. “The difficulty is that the assumptions going into these advanced models do not always hold,” warns Dimitri Papadimitriou, president of the Levy Economics Institute at Bard College. He cites the experience of hedge fund Long-Term Capital Management, which had to be bailed out by a consortium of banks and investment houses to the tune of $3.6 billion in 1998 after its sophisticated fixed-income arbitrage models came unraveled. “The more sophisticated the models, the more likely they are, I think, to be vulnerable,” Papadimitriou says.

Basel II is being developed by the Basel Committee on Banking Supervision, an arm of the Bank for International Settlements, although final rules are the responsibility of banking regulators in each of the 13 participating countries and those additional countries that voluntarily sign on.

Progress in the United States was slowed early this year when a dry run by nearly 30 of the country’s largest banks revealed that minimum capital requirements would go down by nearly 50 percent at some institutions and up by 50 percent at others. U.S. regulators were taken aback not only by the wide dispersion of the numbers, but also by the degree of the declines indicated for some banks. In response, they postponed their notice of proposed rule-making — which was to outline exactly how Basel II should be implemented in this country — until this fall.

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