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.

Why It Matters

For every loan a bank makes, it holds a percentage of the total amount lent in a liquid form — cash, certain securities, Treasury paper — to protect against a borrower defaulting. The amount should reflect the percentage of its loan portfolio that is statistically likely to go into default. But historically, banks have tended to keep in reserve more capital than was strictly necessary, as a cushion against errors in credit-risk modeling.

Basel II uses sophisticated risk-measurement techniques that, ostensibly, will allow banks to safely lower the amount of capital they hold against loans to borrowers with good credit, without compromising safety and soundness. Cutting the capital requirement on a $10 million loan from 8 percent to 5 percent, for example, translates into $300,000 in freed-up cash.

Already, banks in other Basel II–adopting nations are seeing advantages. As long ago as September 2006, says Pamela Martin, the Risk Management Association's director of regulatory relations, lender trade associations like hers were seeing "an increasing willingness of international lenders to price longer-term low-risk deals to reflect lower capital requirements."

"Europeans and Canadians will have a leg up on us for a couple of years," says Kevin Blakely, the former chief risk officer for KeyCorp. who recently took over as president and chief executive officer of the RMA. "It will probably hurt U.S. banks trying to compete in foreign markets. It could also hurt because of large [foreign] banks coming here and trying to compete in the large corporate space."

In the short run, disruptions in the financial markets caused by subprime lending may make competitive imbalances difficult to spot, as lenders of all stripes tighten terms.

"If all returns to normal, the bulk of the hit is on market share," says Karen Shaw Petrou, managing partner of Federal Financial Analytics, a Washington, D.C.-based consulting firm. For U.S. banks, losing overseas business is no small matter. Citigroup, for example, has reported sequential quarterly revenue growth from all of its overseas activities at 4.2 percent for the first half of 2007, compared with a relatively sluggish 0.8 percent domestically.

For CFOs of U.S. banks, the Basel reforms mean finding a way to keep investors satisfied with growth, with a balance sheet that is much more restrictive than that of foreign competitors. "Consistent and constant growth is important, and the level of capital has a direct impact on how much you can leverage that capital into growth," says Brian Bara, CFO of McHenry Savings Bank, in McHenry, Illinois. "The concern is how much you are held back by how much you have to hold in capital."

Safety Net or Hindrance?

The lengthy phase-in of Basel II is not the only problem. Alone among banking supervisors worldwide, U.S. regulators have included in the rule a leverage ratio. In essence, the leverage ratio sets a floor — in this case the equivalent of 5 percent of assets — below which bank capital is not allowed to drop.

Critics say the U.S. leverage ratio flies in the face of modern risk-management philosophy. Indeed, argue bankers, the leverage ratio could have the perverse effect of creating incentives for U.S. banks to move low-risk assets off their balance sheets in favor of higher-risk assets. Essentially, if a bank is going to be required to hold 5 percent of overall capital for its loan portfolio, then holding a mortgage loan that, by itself, carries a capital charge of less than 1 percent under the new rules is economically unsound.

Earlier this year, JPMorgan Chase CFO Michael J. Cavanagh listed his objections with the leverage ratio in a letter to regulators. "Should the leverage ratio become binding," he wrote, "the result will be that affected banks will either hold undue amounts of excess capital," thus giving competitors a pricing advantage, "or will shift to riskier assets to provide an adequate return."

"The Europeans don't have a leverage ratio," says Bert Ely, founder of Ely & Co., an Alexandria, Virginia-based consultancy. "So they are in a situation where they are not penalized for holding lower-risk assets, such as high-quality corporate lending or home mortgages. I would fully expect them over time to wind up not only with lower capital ratios but less-risky balance sheets."

U.S. regulators have insisted that the slow adoption of Basel rules will not hurt U.S. banks. In a speech last May, Federal Deposit Insurance Corp. chairman Martin Gruenberg pointed out that even before the upcoming Basel revamp, U.S. banks already held more reserve capital than most foreign banks. "There is no clear evidence today that U.S. banks are at a competitive disadvantage relative to their foreign counterparts," he says.

"Bankers in the U.S. will figure out how to game it so they can compete in the marketplace in a way that allows them to live with capital penalties of the leverage ratio," says Ely. Banks performed just such "regulatory arbitrage" with the first Basel, securitizing high-quality assets and holding on to riskier ones, according to a Fitch Ratings report.

New Unease

This past summer's liquidity crisis begged the question of whether or not Basel II will have a stabilizing effect on banking. One concern is Basel II's assignment of "risk weights" to various classes of loans. These risk weights are based on the arguably flawed models of credit-rating agencies. Another worry is that, in some instances, Basel II creates incentives for banks to invest in rated securitization structures rather than directly hold a comparable pool of unsecuritized assets. Securitized assets, of course, were at the root of financial-market turmoil this year.

On the other hand, Basel II forces banks to adopt sophisticated risk-management systems to monitor not only the quality of their portfolios but also derivatives transactions attached to them, says TowerGroup's Kopp. The penalty for not doing so? Having to put aside more funds in case something goes wrong.

Basel II may have its flaws, but barring some improbable regulatory changes of heart, U.S. banks are likely to fall behind international competitors once the curtains open on 2008. The only question will be the magnitude of the effect: How much regulatory-capital deadweight will international banks drop, and, so unburdened, how large a lead can they open up on U.S. competitors?

Rob Garver is a freelance writer based in Virginia.


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