In certain wholesale markets, core banks often compete with U.S.  investment firms. U.S.-based core banks also compete with foreign-based  banks in foreign markets and in U.S. markets where foreign-based banks are  very active. Core Banks Compete with Other Core and Non-core Banks

Core banking organizations—those that meet the requirements in terms of  asset size and foreign exposure for mandatory adoption of the Basel II  advanced approaches—have adopted a variety of business models, but all  compete with some other core banks. In this capacity, core U.S.-based banks compete with  foreign-based banks, with investment firms, and with asset management  firms that do not own depository institutions and are not subject to  regulatory capital requirements. Differences in Capital Requirements Have the Potential to Create Competitive Disparities

Because holding capital is costly for banks, differences in regulatory  capital requirements could influence costs, prices, and profitability for  banks competing under different capital frameworks. New U.S. Capital Rules Have Reduced Some Competitive Concerns about Basel II

The new U.S. capital rules address some competitive concerns of banks;  however, other concerns remain. Other factors, such as the leverage  requirement, may reduce differences in capital for banks competing in the  United States. U.S. Final Rule on the Advanced Approaches Addresses Some Competitive Concerns Raised by Banks, but the Leverage Ratio Continues to Be a Concern

Although regulators have harmonized some aspects of the advanced  approaches final rule with the New Basel Accord, concerns remain about  remaining differences in the final rule and other issues such as the  leverage requirement that could have competitive effects. Proposed Standardized Approach May Reduce Competitive Concerns of Non-core Banks, as May Other Factors

As discussed earlier, because non-core banks compete with core banks in  some markets, non-core banks were concerned that core banks would be  able to hold less capital than non-core banks were holding under Basel I  for the same assets. Bank Regulators Have Taken Limited Actions to Address Additional Competitive Effects of Basel II Implementation on U.S. Banking Organizations

Many factors have affected the pace of Basel II implementation in the  United States, and while the gradual implementation is allowing regulators  to consider changes in the rules and reassess banks’ risk-management  systems, regulators have not yet addressed some areas of uncertainty that  could have competitive implications. The final rule provides regulators  with considerable flexibility and leaves open questions about which banks  will be exempted from the advanced approaches. Regulators also have not fully developed plans  for a required study of the impacts of Basel II implementation. Lack of  development or specificity in criteria, scope, methodology, and timing will  affect the quality and extent of information that regulators would use to  help address competitive and other effects and make future changes in the  rules. Finally, the uncertainty over which banking institutions ultimately will have to  adopt the advanced approaches continues because the advanced approaches  rule says all core banks will be required to adopt detailed implementation plans  for the complex advanced approaches by October 1, 2008, and the proposed  standardized approach rule, which will not be finalized by that time, contains a  question about whether and to what extent core banks should be allowed to  use the simpler proposed standardized approach. As delineated in the advanced  approaches rule, the study will measure the changes in capital and  portfolios held by the core banks and will look at the differences in  required capital for these banks if they were under the standardized  approach rule or Basel I—necessary steps for evaluating the  competitive impact of Basel II—but it does not explicitly describe  components needed to determine if there are material deficiencies in  the rule or for regulators to reach agreement on whether banks should  be permitted to fully implement the advanced approaches. GAO staff who made major contributions to this  report are listed in appendix V.

Appendix I: Objectives, Scope, and Methodology

Our objectives in this report were to discuss (1) the nature of the  competitive environment in which U.S. banking organizations compete, (2)  the extent to which different capital requirements may have competitive  impacts on U.S. banking organizations internationally and domestically,  and (3) actions regulators could take to address competitive effects and  other potential negative effects of the new capital rules during  implementation. In addition, we interviewed officials from all of the core banks and other  banks, both foreign and domestic, with operations in the United States. Risk-Based Capital: Regulatory and Industry Approaches to Capital and  Risk.
Why GAO Did This Study

Basel II, the new risk-based capital framework based on an international accord, is being adopted by individual countries. It includes standardized and advanced approaches to estimating capital requirements. In the United States, bank regulators have finalized an advanced approaches rule that will be required for some of the largest, most internationally active banks (core banks) and proposed an optional standardized approach rule for non-core banks that will also have the option to remain on existing capital rules. In light of possible competitive effects of the capital rules, GAO was asked to examine (1) the markets in which banks compete, (2) how new capital rules address U.S. banks' competitive concerns, and (3) actions regulators are taking to address competitive and other potential negative effects during implementation. Among other things, GAO analyzed data on bank products and services and the final and proposed capital rules; interviewed U.S. and foreign bank regulators, officials from U.S. and foreign banks; and computed capital requirements under varying capital rules.

What GAO Found

Large and internationally active U.S.-based banks (core banks) that will adopt the Basel II advanced approaches compete among themselves and in some markets with U.S.-based non-core banks, investment firms, and foreign-based banks. Non-core banks compete with core banks in retail markets, but in wholesale markets core banks often compete with investment firms and foreign-based banks. Because holding capital is costly for banks, differences in regulatory capital requirements could influence costs, prices, and profitability for banks competing under different capital requirements. The new U.S. capital rules addressed some earlier competitive concerns of banks; however, other concerns remain. By better aligning the advanced approaches rule with the international accord and proposing an optional standardized approach rule, U.S. regulators reduced some competitive concerns for both core and non-core banks. For example, the U.S. wholesale definition of default for the advanced approaches is now similar to the accord's. Core banks continue to be concerned about the leverage requirement (a simple capital to assets calculation), which they believe places them at a competitive disadvantage relative to firms not subject to a similar requirement. Foreign regulators have been working with U.S. regulators to coordinate Basel II implementation for U.S. banks with foreign operations. The proposed standardized approach addresses some concerns non-core banks raised by providing a more risk sensitive approach to calculating regulatory requirements. But other factors likely will reduce differences in capital for banks competing in the United States; for example, the leverage requirement establishes a floor that may exceed the capital required under the advanced and standardized approaches. Many factors have affected the pace of Basel II implementation in the United States and, while the gradual implementation is allowing regulators to consider changes in the rules and reassess banks' risk-management systems, regulators have not yet taken action to address areas of uncertainty that could have competitive implications. For example, the final rule provides regulators with considerable flexibility and leaves open questions such as which banks may be exempted from the advanced approaches. Although the rule provides that core banks can apply for exemptions and regulators should consider these in light of some broad categories, such as asset size or portfolio mix, the rule does not further define the criteria for exemptions. Some industry participants we spoke with said that uncertainties about the implementation of the advanced approaches have been a problem for them. Moreover, regulators have not fully developed plans for a required study of the impacts of Basel II before full implementation. Lack of specificity in criteria, scope, methodology, and timing will affect the quality and extent of information that regulators will have to help assess competitive and other impacts, determine whether there are any material deficiencies requiring future changes in the rules, and determine whether to permit core banks to fully implement Basel II.