Bankers Disagree On Basel II StepsBankers Disagree On Basel II Steps

In a rare display of public disharmony, two banking industry executives disagreed in congressional hearings last week over steps the Federal Reserve should take to control operational risk. The Fed has proposed that banks measure operational risk, which covers risk of loss from fraud, acts of God, computer glitches, and negligence, for each line of business and set aside capital to cover their total exposure.

Testifying before the Senate Banking Committee, Kevin Blakely, chief risk officer at KeyCorp in Cleveland, said such an approach applies a needed sense of market discipline to the industry. "Investors must have adequate information to compare the risk of one institution against another on an apples-to-apples basis."

In testimony before the House Financial Services Committee, Steven Elliott, senior vice chairman of Mellon Financial Corp. in Pittsburgh, said that the Fed's approach "would impose a capital charge against a risk that can't be measured or even defined in a fashion on which all agree." He proposed instead that regulators evaluate banks individually on their overall risk-management practices.

The Federal Reserve is acting on a set of recommendations known as Basel II from the Basel Committee on Banking Supervision, an international regulatory body. Due to go into effect in 2006, Basel II would be the biggest overhaul to banking supervision since 1988. The Fed is responsible for implementing Basel II in the United States.

Banks already have systems in place for controlling market risk (e.g., the risk of losses due to rising interest rates) and credit risk (e.g., the risk of losses due to loan defaults). Operational risk attracted headlines in 1995 when Nick Leeson, a derivatives trader in the Singapore office of Barings plc, lost more than $1.4 billion betting on Nikkei futures. Since then, regulators have been pushing to get banks to tighten their internal controls. The Sept. 11 terrorist attacks provided further evidence of the scope of operational risk.

KeyCorp has been a proponent of the risk-based capital model, in which capital is allocated to various lines of business based on the amount of risk they take. Under this model, for example, a risky credit-card portfolio should be charged more capital than a portfolio of government bonds.

KeyCorp has learned firsthand the need to accurately measure risk. Lured by fat profits, the company over-invested in leveraged loans in 1996, only to find itself stuck with millions of dollars in losses when the market collapsed two years later. "If we had our risk-based capital model in place, the kind proposed by Basel II, such knowledge would have caused us to avoid this lending activity," Blakely said.

Mellon's Elliott argued that existing systems already cover these types of risks. Credit-card lenders, for example, have well-tested models for predicting the likelihood of fraud. "Fraud is counted by Basel as an operational risk, but most lenders consider this a routine credit risk. A capital charge atop these serves no purpose, other than to increase the cost of credit to Americans."