Regulatory officials have noted that Basel I  continues to be an adequate capital framework for most banks, but its  limitations make it increasingly inadequate for the largest and most  internationally active banks. Federal Regulators Are Proposing a Regulatory Capital Framework that Differs from the International Basel II Accord in Several Respects

While Basel II is an international framework based on shared regulatory  objectives, it is subject to national implementation. Regulators indicated, based on comment letters  received, that due to the compliance burden associated with moving to  Basel IA, some small banks that are highly capitalized may choose to  remain under Basel I.

		U.S. Regulators Plan to Retain the Leverage Requirement and Apply Existing Prompt Corrective Action Measures

While the U.S.-proposed Basel II and Basel IA rules address revisions to  risk-based regulatory capital, regulators also plan to retain the existing  leverage requirements and prompt corrective action (PCA) measures. However, the advanced approaches are  not themselves without risks and realizing the benefits of these  approaches will depend in part on the sufficiency of credit default and  operational loss event data used as inputs to the regulatory and bank  models that determine required capital. This improved risk sensitivity could improve the safety and soundness of  the banking system. Changes in Capital Requirements Could Affect Competition among Banks

Possible changes in regulatory capital requirements have raised concerns  about competition between large and small banks domestically; between  large banks headquartered in the United States and foreign banks; and  commercial and investment banks in the United States, though the effect  of Basel II on bank competition remains uncertain. The Impact of Basel II on the Level of Bank Capital Is Uncertain, but Proposed Safeguards Would Limit Capital Reductions during a Transition Period

While initial estimates of the impact of Basel II showed large drops in  minimum required capital, a considerable amount of uncertainty remains  about the potential impact of Basel II on the level of regulatory capital  requirements and the degree of variability in these requirements over the  business cycle in the long term. Many officials also reported  that their banks faced challenges in implementing Basel II, including  operating without a final rule, obtaining data that meet the minimum  requirements for the A-IRB for all asset portfolios and data on operational  losses, and difficulty aligning their existing systems and processes with the  proposed rules. U.S. Regulators Are Integrating Preparations for Basel II into Their Current Supervisory Process but Face a Number of Impediments

While U.S. regulators have been integrating preparations for Basel II into  their current supervisory processes and building on their experience  overseeing risk management practices of the banks, a number of issues  remain to be resolved as regulators finalize the rule. It is also  important for regulators to resolve some of the uncertainty and increase  the transparency of their thinking by including in the final rule more  specific information about certain outstanding issues, such as how  regulators will treat portfolios that lack adequate data to meet regulatory  requirements for the advanced approaches, how regulators will calculate  reductions in aggregate minimum regulatory capital and what would  happen if the reduction exceeds a proposed 10-percent trigger, and how  worthwhile public disclosure will be under Pillar 3. Specifically, the proposed rule is ambiguous on a number of  important issues that, if left unresolved, could continue to result in  regulatory ambiguity for banks and concerns for industry observers,  including (1) what regulators plan to do when banks have limited data  available, especially for new financial products or portfolios that lack data  on the impact of a major economic downturn, and how they will ensure  that portfolios with insufficient data are treated prudently and  consistently, such as considering options like a higher risk-weight or  substituting Basel IA or the Basel Committee’s standardized approach for  these portfolios; (2) how regulators will calculate the 10-percent aggregate  reduction in minimum regulatory capital and what would happen if this is  triggered; and (3) the criteria for determining an appropriate average level  of aggregate capital and appropriate cyclical variation in regulatory  capital. Finally, Basel II also raises  competitiveness concerns between large and small U.S. banks. Appendix I: Scope and Methodology

The objectives of this report were to describe (1) the developments  leading to the transition to Basel II, (2) the proposed changes to the U.S.  regulatory capital framework, (3) the potential implications of Basel II’s  quantitative approaches and their potential impact on required capital, (4)  banks’ preparations and related challenges, and (5) U.S. regulators’  preparations and related challenges. Market Risk

Regulators have allowed certain banks to use their internal models to  determine required capital for market risk since 1996 (known as the  Market Risk Amendment or MRA).
Why GAO Did This Study

Concerned about the potential impacts of the proposed risk-based capital rules, known as Basel II, Congress mandated that GAO study U.S. implementation efforts. This report examines (1) the transition to Basel II and the proposed changes in the United States, (2) the potential impact on the banking system and regulatory required capital, and (3) how banks and regulators are preparing for Basel II and the challenges they face. To meet these objectives, GAO analyzed documents related to Basel II and interviewed various regulators and officials from banks that will be required to follow the new rules.

What GAO Found

Rapid innovation in financial markets and advances in risk management have revealed limitations in the existing Basel I risk-based capital framework, especially for large, complex banks. U.S. banking regulators have proposed a revised regulatory capital framework that differs from the international Basel II accord in several ways, including (1) requiring adoption of the most advanced Basel II approaches and by only the largest and most internationally active banks; (2) proposing Basel IA, a simpler revision of Basel I, and retaining Basel I as options for all other banks; and (3) retaining the leverage requirement and prompt corrective action measures that exist under the current regulatory capital framework. While the new capital framework could improve banks' risk management and make regulatory capital more sensitive to underlying risks, its impact on minimum capital requirements and the actual amount of capital held by banks is uncertain. The approaches allowed under Basel II are not without risks, and realizing the benefits of these approaches while managing the related risks will depend on the adequacy of both internal and supervisory reviews. The move to Basel II has also raised competitiveness concerns between large and small U.S. banks domestically and large U.S. and foreign banks internationally. The impact of Basel II on the level of required capital is uncertain, but in response to quantitative impact study results showing large reductions in minimum required capital, U.S. regulators have proposed safeguards, such as transitional floors, that along with the existing leverage ratio would limit regulatory capital reductions during a multiyear transition period. Finally, the impact on actual capital held by banks is uncertain because banks hold capital above required minimums for both internal risk management purposes as well as to address the expectations of the market. Banks and regulators are preparing for Basel II without a final rule, but both face challenges. Bank officials said they were refining their risk management practices, but uncertainty about final requirements has made it difficult for them to proceed further. Banks also face challenges in aligning their existing systems and processes with some of the proposed requirements. While regulators plan to integrate Basel II into their current supervisory process, they face impediments. The banking regulators have differing regulatory perspectives, which has made reaching consensus on the proposed rule difficult. Banks and other stakeholders continue to face uncertainty. Among the issues that regulators have yet to resolve are how the rule will treat bank portfolios that do not meet data requirements, how they will calculate reductions in aggregate minimum regulatory capital and what they will do if the reduction exceeds a proposed 10 percent trigger, and what criteria they will use to determine the appropriate average level of required capital and cyclical variation. Increased transparency going forward could reduce ambiguity and respond to questions and concerns among banks and industry stakeholders about how the rules will be applied, their ultimate impact on capital, and the regulators' ability to oversee their implementation.