Banking regulators issued a 36-page proposal last week, and while it never mentioned the words "Basel II," it amounted to a first step toward reworking the tortured capital accord.

Last week's proposal would correct a flaw in the Basel accord, which did not require banks to hold capital against off-balance-sheet assets, by forcing them to raise potentially hundreds of billions more in capital against such assets when an accounting change takes effect in January.

Though the banking agencies do not expect to make the most significant changes to the Basel II capital rule until the financial crisis subsides, they were forced to act after the Financial Accounting Standards Board (FASB) issued a rule in June designed to force off-balance-sheet assets back on to the banks' books.

Since the FASB had no power over capital standards, the banking regulators were left to figure out how to determine capital levels once the accounting change takes effect.

"FASB precipitated the issue," said Chris Cole, a senior regulatory counsel for the Independent Community Bankers of America. "Now they [banking regulators] are having to confront it."
Karen Shaw Petrou, the managing director of Federal Financial Analytics, agrees the FASB played a role. But she also points to the international Basel Committee on Banking Supervision, which has urged national regulators to require more capital for off-balance-sheet assets.

"They've had to deal with the issue … that has been resolved at the global level but has yet to be reckoned with in the domestic rules," Petrou said. "This one they [banking regulators] can't duck. This one can't go into another 800-page rule."

Privately U.S. bank regulators insist they were not cornered by the FASB or the Basel Committee. Last week's proposal, they say, reflects their long-standing desire to strengthen capital requirements for off-balance-sheet holdings. None of the banking agencies would discuss the question for publication.

The proposal would require capital to be held behind assets brought on to the balance sheet by the FASB rule, and that capital would have to be in place on Jan. 1. Regulators did ask for comment on whether it a one-year phase-in should be allowed. Banking industry representatives want more time, asking for a three-year phase-in period. "Bankers should not be whipsawed by requiring capital beyond actual risk exposure or by upending capital plans," said Robert Davis, an executive vice president at the American Bankers Association. "An adequate phase-in period is essential."

Some former regulators said such a delay makes sense.

"I can understand why they might want three years," said Robin Lumsdaine, a former associate director in the Fed's banking regulation and supervision department who is now a professor at American University. "Some firms could have difficulty making the necessary modifications, collecting the data and performing the computations in a timely fashion."

Banks are still struggling to adopt the Basel II rule. Institutions with more than $250 billion of assets submitted plans to their boards in October 2008 detailing how they would comply. They have until April 1, 2011, to complete four consecutive quarters of a "parallel run" in which they comply with Basel I capital requirements while simultaneously calculating Basel II capital levels.
Only one bank is said to have begun that transition so far.

While several regulators have publicly acknowledged that Basel II has serious shortfalls, efforts to change it have been slow to take hold. The Basel Committee suggested revisions, and released proposed "enhancements" to the rule in July that would include better managing risk concentrations and compensation practices while also clamping down on resecuritizations.
Member nations of the Basel Committee are allowed to deviate from its proposals however they like as the U.S. notably did by retaining a leverage capital ratio. But regulators here have offered little in the form of firm guidance on how the Basel Committee's proposals will filter down into domestic rules. "Efforts are under way to improve the quality of the capital used to satisfy minimum capital ratios, to strengthen the capital requirements for other types of on- and off-balance-sheet exposures and to establish capital buffers in good times that can be drawn down as economic and financial conditions deteriorate," Federal Reserve Board Gov. Daniel Tarullo told the Senate Banking Committee last month. "Capital buffers, though not easy to design or implement in an efficacious fashion, could be an especially important step in reducing the procyclical effects of the current capital rules."

Regulators are wary of revising Basel II until they get more direction from the Basel Committee and have more resources to devote to the issue, but observers said they could do a better job of teeing up exactly how the rule will be changed, even if they are not ready to make firm proposals yet.

"So much time has passed that a lot of people have lost track about what is the purpose, what are the ideas and what has changed given the events of the last few years," said Jeff Brown, a managing director at Promontory Financial Group and a former regulator at the Office of the Comptroller of the Currency. "It would be beneficial to have a clearer discussion to remind the public what is being changed, why it is being changed and how it is happening."

Talks among the agencies over how Basel II should be revised are ongoing, and some participants say the changes will not be that extensive. Still, there is concern that if the discussion does not go public soon, final Basel II implementation could have to be postponed beyond 2011.
"We need to put out the next round of proposed rulemakings and get all that work done so we have something ready to go when the industry is in a position to take it," Petrou said. "If we start thinking about what to do when the industry is fully restored, we're not looking at even starting to think about this until 2011 or 2012, at which point the next crisis could be upon us."


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