It took nearly seven years for the banking industry to hash out proposed revisions to the Basel Capital Accord and get the Federal Reserve to approve them. Now, while the industry awaits approval from the three other federal banking regulators, four large U.S. banks have raised objections as to how the revised accord should be implemented.

The four banks - Citigroup, JPMorgan Chase, Wachovia and Washington Mutual - want to be allowed to use a simpler version of Basel II, called the standard approach. This sets aside the advanced approach that allowed the banks to use internal estimates as to how much regulatory capital they need to hold against their assets. It also raises questions as to whether the federal banking supervisory agencies can meet their end-of-summer deadlines to approve the set of proposals and get the accord on track for implementation by 2008. At this point, some industry participants say the Basel II accord might not take effect in the U.S. until 2012.

The letter

The banks set the latest dispute in motion with a letter to the Federal Reserve in late June, essentially complaining that federal regulators require a very conservative framework on which they must apply their internal calculations. Therefore, they say, the advanced approach defeats the purpose of having a risk-sensitive approach and erases the cost benefit of setting up internal infrastructures to comply with it.

"The argument is that we've taken all the juice out of it," said a source at the Office of Thrift Supervision. "They call it a compliance exercise."

Market sources call it gamesmanship, a case of playing chicken. Another important aspect of the latest debate is the fact that all four agencies have had new chairpersons in the last year. That is another potential setback for implementation, said Doug Landy, special counsel with the securities and financial institutions department at Cadwalader, Wickersham & Taft's New York City office.

Ratings sensitive approach

The first Basel Capital Accord calls for risk weight buckets of 0%; 20%; 50%; and 100%. It does not distinguish between higher-or lower-quality assets, and banking industry professionals felt that in some cases, institutions were holding too much regulatory capital. Basel II attempts to correct that by using a more ratings sensitive approach to measuring the risks associated with a bank's assets. Lowering a bank's capital requirement would free up capital to invest in other assets, Landy said.

"The regulators support it because they believe that Basel II more accurately gives them a sense of the risks in the banking system," Landy said.

While there is no longer any risk-based capital benefit from asset-backed commercial paper conduits being off balance sheet, securitization industry professionals believe that the ABCP sector will derive meaningful benefit from the Internal Assessment Approach (IAA) under Basel II.

"Under the IAA, it is no longer necessary to have eligible liquidity. Banks can obtain low regulatory capital, reduce their credit enhancement and present an attractive product to their customers", said Jason Kravitt, a senior partner at Mayer, Brown, Rowe & Maw.

On the term ABS side, however, assets transferred off of a bank's balance sheet must be treated as a sale acceptable under GAAP rules. Basel II does not explicitly require that, and neither does the European Union. That requirement would, therefore, put American banks at a disadvantage.

"You would have to structure the transaction differently," Kravitt said. "Not every deal may be able to conform with that."

The banks also worry that using the advanced approach might put them at a competitive disadvantage to their rivals overseas, who are allowed to keep using the standard approach.

"You want a consistent system of capital requirements," Landy said. "If everyone is on the same system, you can judge the healthiness of banks across borders by comparing their capital."

Banks were told that in order to get to the point where they could prove they were holding more capital than was necessary to manage their risks, they had to invest in internal infrastructure.

"Once the Basel II rules came out and the hypothetical tests were run, it was not a surprise to anyone: the banks were holding much more capital than is needed."

This caught some federal regulators and members of Congress off guard, and the banks were asked to use a more conservative framework for applying their calculations. Banks such as JPMorgan Chase also realized that developing internal infrastructures to execute the advanced approach is very expensive, sometimes costing individual banks hundreds of millions of dollars to comply with it, a source familiar with the situation said.

Still, federal regulatory sources say that they are taking the banks' concerns seriously, because the agencies do not want to deliver a proposal that is dead on arrival.

"Will the implementation begin on time?" Landy asked. "We'll have to wait and see."

(c) 2006 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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