Prompted by this piece over at the Banking Law Professor’s Blog, the situation in regards the US Basel II implementation is getting a little clearer.

What is clear to me now is that the US regulators are trying to achieve two, contradictory, objectives. They are:

  1. Implement Basel II in the US; and
  2. Not disadvantage the banks that cannot achieve “Advanced” accreditation.

Problem is, you cannot do both. The result is the confusing muddle you now see in the US.

The reason why you cannot do both is simple – Basel II is designed to give an advantage to banks that are managing their risks well. It is the incentive from the regulators to the regulated to encourage better management.

The problem is that the smaller institutions cannot meet the data and other requirements to show that they have their risks under control and, further, that it is simply not possible for them to control their risks in the same way – or as well.

Sure, a big bank can go bust just like a small one, but it takes a lot more to bring down a big one. Writing off a home loan worth, say, $400K is a small deal when your capital is measured in the billions (or trillions) but it is a big deal when your capital is only in the millions. As any insurance person will tell you risk dispersal and aggregation reduces overall risk, allowing a lower capital load. It is not some diabolical plot, just simple actuarial fact. Bigger banks, in general, are safer.

The so called Basel IA in the US allows lower capital loads for smaller banks than the Basel II Standardised, without any requirement to increase risk management. The bigger banks will have to implement Basel II Advanced – giing them lower capital loads. This has been recognised as a problem so the US FDIC is proposing a (risk insensitive) capital floor.

The whole thing means that all the benefits of Basel II will be lowered, or lost and risk management will be set back.

A real pity – and one that I expect the US Senate will have to deal with in the hearings related to the next big banking collapse in the US. Here’s hoping it will be a long time away – but I expect

it might not.