May 25, 2010

Risk-Based Capital Guidelines; Capital Adequacy Guidelines; Capital Maintenance: Standardized Risk-Based Capital Rules (Basel II: Standardized Option)

Proposed Rule
Summary

Score: 27 / 60

Additional details
Agency
Joint Banking Regulators
Regulatory Identification Number
1557-AD07
Agency Name
Joint Banking Regulators
Rule Publication Date
07/29/2008

RULE SUMMARY

The Office of the Comptroller of the Currency (OCC), Board of Governors of the Federal Reserve System (Board), Federal Deposit Insurance Corporation (FDIC), and Office of Thrift Supervision (OTS) (collectively, the agencies) propose a new risk-based capital framework (standardized framework) based on the standardized approach for credit risk and the basic indicator approach for operational risk described in the capital adequacy framework titled ‘‘International Convergence of Capital Measurement and Capital Standards: A Revised Framework’’ (New Accord) released by the Basel Committee on Banking Supervision. The standardized framework generally would be available, on an optional basis, to banks, bank holding companies, and savings associations (banking organizations) that apply the general risk-based capital rules.

METHODOLOGY

There are twelve criteria within our evaluation within three broad categories: Openness, Analysis and Use. For each criterion, the evaluators assign a score ranging from 0 (no useful content) to 5 (comprehensive analysis with potential best practices). Thus, each analysis has the opportunity to earn between 0 and 60 points.

Criterion Score

Openness

1. How easily were the RIA , the proposed rule, and any supplementary materials found online?
The RIA cannot be found via links or searches from the Treasury web page. The proposed regulation can be found on regulations.gov with a RIN or keyword search. The regulation contains a link to the RIA on the Treasury website.
3/5
2. How verifiable are the data used in the analysis?
The RIA uses data but not enough information is given for a reader to verify the data. The analysis is heavy on description, not documentation. Phrases like "Based on rough assessment," "we expect," and "we estimate" should be replaced with relevant citations. Specifically, the methods for calculating numbers in tables 1 and 3 should be explained clearly and sourced (24, 30).
1/5
3. How verifiable are the models and assumptions used in the analysis?
Market failure is the theory but there are no empirics. Calculation of costs are based on plausible assumptions that aren't verifiable. The analysis cites some publications or analyses. The most helpful citations includ those to papers on moral hazard and savings and loan crisis (14), the three mutually reinforcing "pillars," and a description of comprehensive supervision: CAMELS assessment (22).
2/5
4. Was the analysis comprehensible to an informed layperson?
The analysis requires knowledge of banking and financial economics to understand.
3/5

Analysis

5. How well does the analysis identify the desired outcomes and demonstrate that the regulation will achieve them?
1/5
Does the analysis clearly identify ultimate outcomes that affect citizens’ quality of life?
A large body of research suggests that banks matter for human welfare. Most noticeably, banks matter when they fail. The impact analysis states outright that the “improved risk sensitivity” afforded by the Standardized Option will enhance social welfare through decreasing the probability of financial failure by allowing banking organizations to achieve prudent objectives more efficiently. Specifically, it reasons that better alignment of capital with risk will be able to support a “higher level of banking activity” while maintaining the same degree of confidence regarding “bank safety and soundness” and ensure “a higher effective level of solvency” for overall banking activity (OCC 25). A little more connection with the concerns of the average person would have been helpful.
4/5
Does the analysis identify how these outcomes are to be measured?
Items listed as "benefits" are not measured.
0/5
Does the analysis provide a coherent and testable theory showing how the regulation will produce the desired outcomes?
The analysis repeatedly asserts that the proposed regulation will lead to same level of safety and soundness with less sacrifice of efficiency. There is no proof of the first claim, but the second is somewhat plausible since it's voluntary.
1/5
Does the analysis present credible empirical support for the theory?
The analysis does not address this topic.
0/5
Does the analysis adequately assess uncertainty about the outcomes?
The analysis identifies the number of banks opting for this regulation as a key uncertainty and notes that this makes both costs and benefits uncertain. It argues plausibly that most benefits would be bigger if all banks either chose or were forced to adopt the new standard.
2/5
6. How well does the analysis identify and demonstrate the existence of a market failure or other systemic problem the regulation is supposed to solve?
3/5
Does the analysis identify a market failure or other systemic problem?
This analysis clearly identifies that capital regulation “seeks to address market failures” that stem from “the unique structure and role of banks in the financial system” (OCC 4). The analysis notes the presence of two market failures in bank capital regulation. First, the examination notes that market failure arises due to asymmetric information because the nature of the risk in a bank’s portfolio “hinders the ability of creditors and outside monitors” to discern a bank’s “actual risk and capital adequacy” (OCC 4). Moral hazard is presented as the second market failure in the analysis. In banking, moral hazard refers to the incentive financial institutions have to accept “greater risks in pursuit of higher returns” when they do not bear the full cost of losses associated with risky ventures (OCC 4). More specifically, the bank’s creditors fail to restrain the bank from taking excessive risks because “deposit insurance either fully or partially protects them from losses” (OCC14).
5/5
Does the analysis outline a coherent and testable theory that explains why the problem (associated with the outcome above) is systemic rather than anecdotal?
Throughout the RIA, the OCC implies that the purpose of financial regulation is to reduce the likelihood of systemic crisis. It follows that since bank failures are bad for society, the overarching goal of bank capital regulation is to ensure that such failures are avoided. The analysis describes the enormous systemic effect that the capital adequacy of one bank has on “depositors, borrowers, and the local economy” by mentioning that the failing of one institution affects how the market perceives the solvency of other banking organizations and that a loss in confidence in the banking system can “impose considerable costs on the macroeconomy” as a whole (OCC 14). Aside from the justification to correct market failures, “risk of a systemic crisis” in the financial realm is therefore an additional basis of the classical argument in favor of proposing bank capital regulation to insure banks against “liquidity shocks” despite its interference with the free functioning of markets (Santos 12).
5/5
Does the analysis present credible empirical support for the theory?
Surprisingly, aside from briefly referencing how banking externalities contributed to the Savings & Loan crisis of the 1980s and ensuing systemic financial meltdown, empirical evidence about the systemic nature of bank crises is lacking (OCC 14).
1/5
Does the analysis adequately assess uncertainty about the existence or size of the problem?
The analysis does not address this topic.
0/5
7. How well does the analysis assess the effectiveness of alternative approaches?
3/5
Does the analysis enumerate other alternatives to address the problem?
There are three options: baseline, proposed regulation, and mandatory approach.
4/5
Is the range of alternatives considered narrow (e.g., some exemptions to a regulation) or broad (e.g., performance-based regulation vs. command and control, market mechanisms, nonbinding guidance, information disclosure, addressing any government failures that caused the original problem)?
Options are relatively narrow, but the volunatry approach is relatively novel.
3/5
Does the analysis evaluate how alternative approaches would affect the amount of the outcome achieved?
While it may not be realistic to expect the analysis to include a thorough cost-benefit analysis of every alternative available, it is surprising that the assessment does not discuss any alternatives besides a manipulation of the Standardized Option itself. In its shortsightedness, the analysis leaves several unanswered questions about the efficiency of the proposed rule. Because adoption of the Standardized Option is mandatory under the alternative approach, the analysis assumes that “more banks will be subject to the Standardized Option provisions and the aggregate level of benefits…” of increased risk reduction will be higher (OCC 35). Claiming that a 100% adoption rate of the Standardized Option will enhance risk sensitivity to capital charges, and thus aggregate social benefits, at the sole cost of losing its optional provision clause, is a roundabout way of proving that the proposed rule is the most effective mechanism to enforce bank capital regulation. Again, the analysis would be improved if a broader range of alternatives had been suggested.
3/5
Does the analysis adequately address the baseline? That is, what the state of the world is likely to be in the absence of federal intervention not just now but in the future?
The analysis specifies a baseline. However, it also mentions that many banks carry more capital than required by regulation but does not explain how the regulation might alter bank practices compared to what they currently choose to do.
2/5
8. How well does the analysis assess costs and benefits?
2/5
Does the analysis identify and quantify incremental costs of all alternatives considered?
Additional costs calculated for the two options are considered. The RIA describes the costs to banking organizations of implementing the proposed rule involve both startup and ongoing costs. In terms of the costs to banking organizations, the explicit costs of implementing the proposed rule fall into two categories in the analysis: setup costs and ongoing costs. Startup costs include expenses related to the development of the regulatory proposals, costs of establishing new programs and procedures, and costs of initial training of bank examiners in the new programs and procedures. Ongoing costs include maintenance expenses for any additional examiners and analysts needed to regularly apply the new supervisory processes. In the case of the Standardized Option, the analysis claims that “because modest changes to Call Reports will capture most of the rule changes,” these ongoing costs are likely to be minor (OCC 31). Based on this rough assessment, the analysis estimates that implementation costs for the Standardized Option could range between $200,000 and $5 million depending on the size of the institution, and approximately $74 million would be spent by all national banks (OCC 29).
5/5
Does the analysis identify all expenditures likely to arise as a result of the regulation?
Identifies implementation expenditures by banks and government.
4/5
Does the analysis identify how the regulation would likely affect the prices of goods and services?
The analysis assumes that costs are 100% borne by banks with no effect on customers. The OCC notes that because many factors besides regulatory capital requirements “affect pricing and lending decisions,” that they do not expect the adoption or non-adoption of the Standardized Option to affect pricing or lending of goods and services. It follows that they do not anticipate any costs or benefits of the Standardized Option to affect the customers of competing institutions. For these reasons, the cost and benefit analysis of the Standardized Option is organized as primarily an analysis of the costs and benefits “directly attributable to institutions that elect to adopt its capital rules” (OCC 7). This section of the analysis could be improved if it acknowledged that the effect of the price of a bank loan to lenders and borrowers, oftentimes the effective “good” in question, depends on several factors like the cost of a bank’s funds, which determines the supply of loans, the interest rate, or, effectively the price of money, and the demand for loans, which is inversely correlated with the interest rate, to name a few.
3/5
Does the analysis examine costs that stem from changes in human behavior as consumers and producers respond to the regulation?
The analysis examines only compliance costs. It does not consider any behavioral changes even though it acknowledges that the proposal could alter banks' level of capital or the mix of investments.
0/5
If costs are uncertain, does the analysis present a range of estimates and/or perform a sensitivity analysis?
The analysis acknowledges uncertainties, and the costs calculated for the voluntary vs. mandatory option establish a range.
3/5
Does the analysis identify the alternative that maximizes net benefits?
The analysis appears to be groping toward this, but since benefits aren't measured, there's no way to figure out which option offers the greatest net benefits. The analysis claims that the proposed rule “aims to enhance safety and soundness by improving the risk sensitivity of regulatory capital requirements” and accomplishes these goals via nine direct benefits. The analysis’s implication that each of these nine “benefits” contributes equally to net benefits, however, is incorrect, as prolific research by critics had concluded that most of the listed “benefits” not only do not help, but actually hinder the safety and soundness of banking institutions. Additionally, since the cost analysis of alternative sceneries in the analysis is not broad enough to include regulatory considerations outside scope of the Standardized Option, it is difficult to say with conviction that the proposed rule maximizes net benefits for bank capital regulation nowadays.
1/5
Does the analysis identify the cost-effectiveness of each alternative considered?
The analysis concludes that the benefits "justify" the cost, but since the benefits aren't quantified, it can't calculate cost-effectiveness.
1/5
Does the analysis identify all parties who would bear costs and assess the incidence of costs?
The analysis notes that social benefits of the proposed rule are benefits that accrue directly to those subject to a proposal plus benefits that might accrue indirectly to the rest of society. Similarly, the overall social costs of a proposal are costs incurred directly by those subject to the rule and costs incurred indirectly by others. In the case of the Standardized Option, direct costs and benefits are those that apply to the banking organizations’ borrowers and lenders that are subject to the proposal. Indirect costs and benefits would then stem to other financial institutions that are not subject to the proposal, their bank customers and lenders, and, through the safety and soundness externality, society as a whole (OCC 22). The analysis mentions that direct influence of the Standardized Option will be felt by the banks who adopt it, and that broader effects will relate to society as a whole (OCC 22). Though the analysis considers the costs and benefits of a proposal as they relate to society as a whole, it does not asses the direct incidence of the costs and benefits. However, in theory, capital reserve ratios constrain the quantity of loans made, thereby diminishing the profit of the lender and the decreasing potential purchases of the borrower. Further, under the more “risk sensitive” calculations of the Standardized Option, it can be assumed that borrowers with higher creditworthiness profit at the expense of more risky borrowers, as the relative price they pay for their loans is lower due to differentiated risk. Since more-risky borrowers no longer receive “risk premium” financing from more prudent borrowers, they will realize more accountability for their high risks and purchase less loans as consequence. The analysis would have benefited from a more thorough treatment of an incidence spread of the costs and benefits of the Standardized Option.
2/5
Does the analysis identify all parties who would receive benefits and assess the incidence of benefits?
The analysis states that banks and the general public will receive benefits. It hints that banks with more mortgages might be more likely to take the proposed voluntary approach.
2/5

Use

9. Does the proposed rule or the RIA present evidence that the agency used the analysis?
The agencies assert that the RIA was used and present a summary of the main results from the analysis within the proposed rule but there is no direct evidence of this. Though not explicitly stated, the idea to make the proposal voluntary seems to be driven by a desire to keep the costs down.
2/5
10. Did the agency maximize net benefits or explain why it chose another alternative?
The voluntary nature of the regulation is justified on the grounds that this will ensure banks adopt the alternative when the benefits justify the costs. This maximizes net social benefits only if the social benefit is the same under either option the bank might choose; this is asserted but not proven.
3/5
11. Does the proposed rule establish measures and goals that can be used to track the regulation's results in the future?
No explicit measures or goals for the future are enunciated. Since OCC notes that "capital regulations cannot be static" and innovation in and transformation of financial markets require "periodic reassessments of what may count as capital and what amount of capital is adequate," it is likely that the continued changes in financial markets will create a need to change capital standards in the future (4) . As such, while the Standardized Approach presents methods that can be used to track capital adequacy measures in the future, they will likely be amended.
1/5
12. Did the agency indicate what data it will use to assess the regulation's performance in the future and establish provisions for doing so?
The agency mentions that it might reconsider this proposal if banks' capital falls significantly after it adopts it.
3/5
 
Total 27 / 60