Alert July 15, 2008

US Banking Agencies Publish Interagency Guidance on Advanced Basel II Qualification Process

The four US banking agencies published an interagency statement (the “Interagency Statement”) on the Basel II Advanced Approaches (“Advanced Basel II”) qualification process.  Advanced Basel II is discussed in detail in the November 6, 2007 and November 27, 2007 issues of the Alert.  Terms used but not defined in this article have the meanings set forth in those Alerts.  The Interagency Statement  updates the qualification process guidance published in January 2005.  The Interagency Statement  separates its discussion into four components:  implementation plan, parallel run, transitional floor periods, and other matters. 

Implementation Plan.  The Interagency Statement mandates that each bank that plans or is required to use Advanced Basel II adopt a board-approved implementation plan (the “Implementation Plan”).  The Implementation Plan must cover the consolidated bank holding company (or top-tier savings association) as well as each individual depository institution (“DI”) within the structure.  The Implementation Plan must address all requirements of Section 22 of Advanced Basel II (including its internal capital adequacy assessment process (Pillar 2) and approach to public disclosure (Pillar 3)).  The Implementation Plan also must address a self-assessment of where the bank is in meeting the qualification requirements, a gap analysis of what still needs to be done, and a timetable to address areas identified in the gap analysis.   While the agencies will permit a wide variety of formats for the Implementation Plan, it must include address (via appendices or individual plans) the specifics of how each DI will comply.

Because the Implementation Plan is the only precondition to entering a parallel run, the agencies have “high expectations” for its overall quality.  The Implementation Plan should be provided to the primary point of contact, such as an Examiner-in-Charge, at each bank’s primary agency supervisor.   As to timing, core banks (as defined in Advanced Basel II) must adopt the Implementation Plan by October 1, 2008 (or, if later, within six months of becoming a core bank).  Every bank must submit its Implementation Plan at least 60 days before the start of its parallel run, unless the agency grants a waiver from the prior notice requirement.  Core banks generally must provide for a first transitional period by April 1, 2011.  The agencies will provide feedback throughout this period, with more robust feedback during the parallel run period.

Parallel Run.  As discussed in Advanced Basel II, during the parallel run period a bank adopting Advanced Basel II will remain subject to the current capital rules, but will also report its risk-based capital as calculated according to Advanced Basel II.  The Interagency Statement reiterates that a parallel run will be deemed satisfactory, and thus allow a bank to progress to the next phase, if it has at least four consecutive quarters of complying with the Advanced Basel II qualification requirements (e.g., ICAAP, AMA, IRB) to the satisfaction of its primary federal regulator.  Indeed, the Interagency Statement provides that a bank “should not consider beginning the parallel run until it expects to be in a position to demonstrate compliance with the qualification requirements detailed in section 22 of [Advanced Basel II] for at least four consecutive quarters.”

Transitional Floor Periods.  After successful completion of the parallel run, the Interagency Guidance states that the appropriate federal regulator will identify the start date for a bank’s first transitional floor period.  Each transitional floor period has its own maximum reduction from the current risk based capital rules (i.e., first-5%; second 10%; third-15%), and a bank may not move from one transitional period to the next without four consecutive quarters of compliance and approval of its federal regulator.  Moreover, in 2010, the regulators must publish a study that evaluates the implementation of Advanced Basel II, and if any material deficiencies exist must make appropriate adjustments (including, perhaps, by amending Advanced Basel II).  The Interagency Statement provides that during this period each covered bank must provide five capital ratios to the regulators (i.e., risk based under the current rules and Advanced Basel II, and the leverage ratio), and the regulators expect constant improvement in systems and processes throughout the transition periods.

Other Matters.  The Interagency Statement also addresses a number of items under a category referred to generically as “Other Matters.”  In this regard, the Interagency Statement highlights that a strong validation process, both as to point-in-time assessments as well as ongoing activities, is critical to a satisfactory Advanced Basel II system.  Moreover, the Interagency Statement provides that a bank must notify its regulator if it makes any change that would result in a material change in risk-weighted assets for a type of exposure, or any significant change in modeling assumptions.  The Interagency Statement also provides in this section that supervisory exemptions from Advanced Basel II for DI subsidiaries are expected to be “granted on an infrequent basis.” 

In addition, in the event of a merger or acquisition, the acquirer must (1) submit an Implementation Plan within 90 days of the merger to bring incorporated exposures into Advanced Basel II within 24 months, and either (2) if the target already is using Advanced Basel II, continue to use those systems during the interim period, or (3) if the target is not using Advanced Basel II, continue to use the current capital rules during the interim period.  If an acquirer acquires a target during the acquirer’s implementation of Advanced Basel II, the acquirer is not required to take any special steps, but rather simply must comply with the process described immediately above (e.g., the 90 day Implementation Plan requirement).  Finally, the Interagency Statement notes that there are a number of areas (in addition to those described above) where Advanced Basel II requires prior agency approval, including:  (1) the internal models methodology for counterparty credit risk; (2) double default treatment; (3) the Internal Assessment Approach for ABCP securitization exposures; and (4) the Internal Models Approach for equity exposures.