WASHINGTON - Critics have long said that the Basel II international capital rules are unwieldy and could be too easily violated.
Their argument was helped Tuesday when federal bank and thrift regulators acknowledged a mistake in a crucial formula more than two months after it was published that could have led banks to underestimate their capital requirements by hundreds of millions of dollars.
A low-key notice appeared in the Federal Register correcting a 30-page guidance on retail credit that the Federal Reserve Board, the Federal Deposit Insurance Corp., the Office of the Comptroller of the Currency, and the Office of Thrift Supervision had issued for comment in late October.
The mistake: a square-root sign that had been inadvertently extended over too many figures.
The result: a flawed formula that could have left banks 60% to 70% short of the necessary capital for retail credits.
"Here we have four agencies for the U.S. government, and in an effort to put out very sensible guidance, they found a glitch that has a significant impact," said John D. Hawke Jr., a former comptroller of the currency who was active in the Basel II negotiations until his term ended in October. "Compare that with some countries that haven't even put out their guidance. How are we ever going to get evenhanded application of Basel II?"
To calculate capital levels for retail credit - products like credit cards, residential mortgages, and small-business loans - bankers are supposed to plug different risk variables into a formula that will spit out their capital charge. As complex as some of the Basel II formulas appear, most can be easily inserted in computer spreadsheets to let bankers input risk information to determine capital requirements. There are about a dozen of these formulas.
Marc Intrater, a managing director of the finance and risk practice at Mercer Oliver Wyman who advises banks on Basel II compliance, said some bankers might have caught the mistake. But others who had no prior familiarity with the formula may have "assumed that since this was the latest formula, it was correct," he said.
A Fed spokesman said the mistake was a publishing error. Several people said that earlier representations of the equation, published by the Fed and the Basel Committee on Banking Supervision, were correct.
But many bankers were using the incorrect version. In fact, officials at Fifth Third Bancorp were said to have caught the mistake.
Basel II requires bankers to hold more capital for riskier loans, and one of the variables used to measure risk is the "probability of default." The higher the probability a borrower is going to default on a loan, the more capital is required.
Given certain assumptions, Basel II would require a bank with $10 billion of home equity loans that had a 2% probability of default to hold at least $703 million in capital. The faulty Basel II formula would have calculated the required capital to be 69% less.
In June international regulators signed off on the framework for the risk-focused capital rules they had been working on since 1998. The standards were set to replace the first Basel rules, written in 1988, which many viewed as not risk-sensitive enough. Since last summer domestic regulators have tried to work through some of the unresolved matters, such as which regulator has jurisdiction over banks operating in multiple countries. The U.S. agencies are expected to issue a preliminary proposal for implementing Basel II this summer and an updated proposal next year.
Bankers from close to 30 institutions are crunching numbers to determine Basel II's effect when it is takes effect in 2008. Between eight and 10 of them will have to use the new standards, because they have more than $250 billion of assets or more than $10 billion of foreign exposure.
But at least 20 other banks (and some say that estimate is conservative) are still weighing whether to adopt the new rules.
These could be the banks most affected by errors like the one corrected this week, several people said. Mr. Intrater said that large banks were more likely to have caught such a mistake in the Federal Register, because they have been using the correct formulas for more than a year, while small banks trying to catch up were more likely to have missed it.
Midsize banks have far fewer people "who would understand this well enough" to catch the error, he said. "It reminds us of how complicated it is and the difficulty of turning something so complicated into a regulation, as opposed to a management judgment."
Regulators could hear more griping about the error or other matters. Comments on their retail credit guidance are due Jan. 25.
"Things of this sort can happen," Mr. Hawke said. "But it does reinforce the point that I've been making all along. This whole thing is enormously complicated. … In Basel II, the potential for evenhanded application around the Basel II countries is somewhat questionable."
