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Fallout: The Financial Crisis

Banks brace for Basel II

Amy Scott Jul 2, 2008
Fallout: The Financial Crisis

Banks brace for Basel II

Amy Scott Jul 2, 2008


Bob Moon: Bankers from around the world were about the only ones who paid much attention to a meeting in Basel, Switzerland, 20 years ago. It was there that international financial regulators decided banks would be required to keep a certain amount of cash on hand to protect against unexpected losses.

If you’re wondering why this matters, consider the ongoing credit crunch. Had the banks been required to set aside a bit more capital to fund their risky subprime loans, they might not be suffering from the big losses that we mentioned at top of the program.

Now, U.S. banks are bracing for a new round of requirements known as Basel II.

Marketplace’s Amy Scott reports.

Amy Scott: At the offices of the Risk Management Association in Philadelphia, Pam Martin hefts a 600-page document onto a table.

Pam Martin: Here it is. This is Basel II and the U.S. implementation of Basel II.

Martin is the group’s head of regulatory relations, so she’s actually read all 600 pages.

Martin: Oh yes, several times.

What those pages say, in a nutshell, is that the more risks a bank takes by lending or investing, the more shareholder money it should have on hand. That way shareholders take a hit from any losses before the bank’s depositors do.

Martin: If you have a loan to a company with less risk, you would hold less capital. On the other side of the coin, if you have, say, a subprime mortgage for instance, you would have to hold a lot more capital.

Under Basel I, banks have to hold certain amounts of capital for loans regardless of their risk. To many, the new rules seem like a smart idea now that banks have lost billions of dollars on risky subprime loan investments and most of the world’s banks have adopted the reforms.

It could be a year or more before U.S. banks are ready to go. The delay is partly thanks to controversy over the rules. They require banks to follow complicated mathematical models to determine how much capital they need to set aside.

Bill Isaac is one of Basel II’s fiercest critics. He headed the Federal Deposit Insurance Corporation during the banking crisis of the 1980s. Now he’s a banking consultant. Isaac says the Basel II models are too complex.

Bill Isaac: I’ve been in this business for nearly 40 years and I don’t understand these models. It takes a mathematician and that is one of my principle objections to the models is that bank boards of directors and senior management, even senior regulatory people cannot understand these models.

Then there’s the complaint that models helped get us into this mess in the first place. They rely on past data to predict the future and Isaac says something unforeseen like home price declines always comes up.

Another criticism is that the regulations rely on credit rating agencies like Standard & Poor’s and Moody’s to determine how risky a loan is.

Karen Shaw Petrou: And we all have learned the hard lesson about how flawed S&P and other decisions are.

Karen Shaw Petrou is managing partner at Federal Financial Analytics. She studies the impact of regulations on financial institutions and their customers. Petrou says the kinks can be worked out later, but we need Basel II now.

Petrou: Even with the flaws in the Basel II rules, they need to be put in place quickly and then refined, because the longer we have Basel I, the more risk we have, the less we will have solved the problems that got us here.

In spite of the complaints, Basel II appears to be moving forward. By October, the very largest U.S. banks like Citigroup and Bank of America have to show regulators how they plan to put Basel II in place.

To find out how the finance world is preparing, I headed down to Wall Street. I found banker Rich Marin dining on calamari at Harry’s Cafe.

Rich Marin: Everybody’s aware of it, so I think what you’re seeing now is a lot of people making sure that their balance sheets are in as good a shape as they can be to meet those requirements.

But Marin admits Basel II’s timing could be better. It may force banks to raise capital just when investors are shunning bank stocks.

Marin: It just makes it all that much more challenging because they are generally, not across the board, but generally more stringent capital rules and it’s coming at a time where capital’s being impaired by the subprime crisis.

The banks don’t have to ask shareholders for more money. They could simply stop taking so many risks, but that would mean lending less and putting an even bigger squeeze on the economy.

In New York, I’m Amy Scott for Marketplace.

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