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Home > Bank Resources > Bank Resources Publications > SRC Insights > 2004 > Second Quarter

SRC Insights: Second Quarter 2004

Basel II: The Impact on Competition in the U.S. Financial Services Industry

by Cynthia L. Course, CPA, Sr. Financial Specialist

On May 11, 2004, the Basel Committee on Banking Supervision announced that it had reached consensus on the issues regarding the new international regulatory standards for bank capital.¹ These proposed revisions are commonly referred to as Basel II. As work proceeded on the international front, the U.S. banking agencies continued to refine their approach to apply any revisions to the Basel Accord to U.S. banking organizations.

In an Advance Notice of Proposed Rulemaking issued in August, 2003, the U.S. banking agencies proposed that only the most advanced approaches under Basel II be offered for banking organizations in the United States: the advanced internal ratings-based approach for credit risk (A-IRB) and the advanced measurement approach for operational risk (AMA). As proposed, U.S. banking organizations with total banking (and thrift) assets of at least $250 billion or at least $10 billion in on-balance-sheet foreign exposures—about 10 large organizations based on current balance sheets—would be required to adopt the advanced approaches. However, other banking organizations could choose to adopt A-IRB. Organizations might choose to adopt A-IRB if they expect to grow into the size requirements, if the perceived benefits of the net change in capital requirements exceed the expected costs of adjusting risk management systems to conform with A-IRB requirements, or for other reasons. Any organization wishing to adopt Basel II would have to meet the same high standards applied to mandatory institutions.

The remaining U.S. banking organizations, which number in the thousands, have generally strong capital and straightforward balance sheets. For many of those institutions, the advanced approach of Basel II would be unnecessarily complex and not cost effective. Accordingly, the U.S. banking agencies have proposed that banks not operating under Basel II advanced approaches would remain under the current U.S. regulatory capital rules.

In response to expressed concerns about possible unintended effects of Basel II, the U.S. agencies have undertaken economic studies of the potential competitive effects of Basel II on U.S. banks. Board staff have already issued studies that analyze the competitive effects on lending to small and medium enterprises and the potential effect of Basel II on mergers and acquisitions. Future studies will address the potential competitive effects on credit card and mortgage lending.

Small and Medium Enterprise Lending
Community and regional banks are concerned that the reduction in the implicit risk weight for small and medium enterprise (SME) credits (i.e., small business loans) extended by A-IRB adopters might adversely affect the competitive position of banks that remain subject to current capital rules.

The SME credit capital requirements under the A-IRB approaches could theoretically adversely affect the competitive position of community banks or other large banking organizations that do not adopt A-IRB because it may reduce minimum regulatory capital and potentially lower the marginal costs of SME lending for A-IRB adopters. Some analysts and industry participants have argued that the decline in marginal costs at A-IRB banks relative to non-A-IRB banks might encourage A-IRB banks to reduce their pricing on and/or increase their quantity of SME lending, causing a trickle down effect of lower pricing and/or reduced market share for community and regional banks.

Capital Treatment of SMEs* Today: Under the current Basel Capital Accord, loans to small businesses (i.e., SMEs) generally fall in the 100 percent risk-weight category. Tomorrow?: In an Advance Notice of Proposed Rulemaking, the U.S. agencies have requested comment on a proposed $1 million threshold that would separate those SME exposures that banking organizations should be allowed to treat on a pooled basis under the retail A-IRB framework and those SME exposures that should be rated individually and treated under the wholesale A-IRB framework. Regardless of retail or wholesale treatment, A-IRB organizations would be required to determine the probability of default (PD), loss given default (LGD), and exposure at default (EAD) for SMEs, whether in pools (retail treatment) or individually (wholesale treatment). This would result in a capital treatment that could be less than or greater than Basel I capital, depending on the quality of the credit. * See the August 4, 2003 Press Release and attached Advance Notice of Proposed Rulemaking on the Board of Governors' website .

In February 2004, Board staff issued a paper titled Potential Competitive Effects of Basel II on Banks in SME Credit Markets in the United States.² Board staff concluded that the substitution effect of a decline in marginal costs of SME lending by banking organizations that adopt the A-IRB approach is likely to have a relatively minor competitive effect on the majority of community banks in the SME lending market. Although a marginal cost decline is likely to encourage A-IRB banks to reduce price and/or increase quantity of SME lending, thereby reducing the prices received by and/or market shares of community banks, the analysis in the paper suggests that this substitution effect is likely to be rather modest in most cases. A key factor with regard to the competitive effects on community banks appears to be the comparative disadvantage of large banking organizations in making relationship loans to informationally opaque SMEs, the primary recipients of small business loans from community banks. Community banks tend to have comparative advantages in such small business "relationship lending," and the paper finds that their market share and pricing should not be significantly adversely affected.

However, the analysis also suggests the possibility that the implementation of Basel II might adversely affect the competitive position in the small business credit market of large banking organizations that do not adopt A-IRB. Relatively large banking organizations tend to have comparative advantages in transactions loans to relatively transparent SMEs, and the A-IRB adopters already serving this market might be able to serve it at a lower marginal cost in the future. Non-adopters could experience pricing pressures and/or reductions in market share in loans to transparent SMEs.

Merger and Acquisition Activity
Concerns have also been raised that the excess regulatory capital at A-IRB organizations (due to the reduced capital requirements) and the competitive advantage associated with those reduced requirements would fuel A-IRB banks' acquisitions of non-adopting banking organizations. Some bankers fear that A-IRB banking organizations would have an incentive to acquire banks not subject to A-IRB capital standards because target banks would be worth more to A-IRB banks than to current owners. A-IRB banking organizations could acquire non-A-IRB banks and increase the return on equity associated with the acquired assets by either increasing income-earning assets without adding capital or holding less capital against the newly acquired assets.

In February 2004, Board staff issued a second paper titled Will the Proposed Application of Basel II in the United States Encourage Increased Bank Merger Activity? Evidence from Past Merger Activity.³ Board staff did not find convincing evidence that past changes in excess regulatory capital or that past changes in capital standards had substantial effects on merger activity. It therefore was presumed that the A-IRB approach likewise would not likely have a significant effect on merger activity.

Competitive Effects on Credit Card and Mortgage Lending. Two additional studies that explore the potential competitive effects of Basel II in the credit card and residential mortgage markets will be issued in the near future. The U.S. banking agencies will consider the results of all four studies when conducting another Quantitative Impact Study on the revised Basel II later this year. As Chairman Greenspan has noted, if analysis demonstrates that the proposed Basel II reforms will generate competitive problems, the U.S. agencies will take steps to address this issue.

To stay up-to-date on the activities of the Basel Committee on Banking Supervision and the activities of the U.S. banking agencies, visit one of the following websites:

Board of Governors' "Basel II Capital Accord" website
http://www.federalreserve.gov/generalinfo/basel2/default.htm

Federal Reserve Bank of Philadelphia's
"The New Basel Capital Accord Proposal" website http://www.philadelphiafed.org/src/basel.html

• ¹ The press release is available on the Bank for International Settlements' website .
• ² Potential Competitive Effects of Basel II on Banks in SME Credit Markets in the United States, by Allen N. Berger, is available on the Board of Governors' website .
• ³ Will the Proposed Application of Basel II in the United States Encourage Increased Bank Merger Activity? Evidence from Past Merger Activity, by Timothy H. Hannan and Steven J. Pilloff, is available on the Board of Governors' website .

The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.