Remarks by

John D. Hawke, Jr.

Before the

Institute of International Bankers

Washington, D.C.

March 4, 2002

**The New Basel Capital Accord: A Status Report**

It\'s been an extraordinary year since I last spoke to the Institute in
this forum \-- a year that saw both unspeakable tragedy and
awe-inspiring heroism. And it saw something else that I think few people
expected in the wake of September 11: extraordinary solidarity in the
international community. To date, no fewer than 147 nations have frozen
assets linked to terrorist organizations. International cooperation in
the anti-money laundering campaign has been exemplary. Dozens of nations
are cooperating in the effort to root out terrorist cells. Others have
contributed combat and logistical support to the war in Afghanistan and
are now contributing significantly to the international effort to
rebuild that country\'s shattered infrastructure.

I believe this experience may have some relevance for those of us who
are engaged in the effort to bring about greater harmonization in the
supervision of internationally active financial organizations, in
particular for the Basel Committee on Banking Supervision. 2001 began
auspiciously with the release of the second consultative draft of the
Committee\'s proposal for a new capital accord \-- a 500-plus page set
of documents. The Committee also announced an ambitious schedule for
moving ahead with that proposal: a four-month comment period; final
publication of a new accord by year-end 2001; and full implementation in
2004.

As spelled out in the consultative package, the new framework for
regulatory capital \-- which I shall refer to as \"Basel II\" \-- aimed
to address many of the distortions that have resulted from Basel I, the
original 1988 capital accord. Although it represented a breakthrough in
many ways, the 1988 accord was found to be seriously deficient in
others, and these deficiencies have become more conspicuous with each
passing year. It is now widely acknowledged that Basel I inadequately
differentiates among institutions of varying risks and risk management
capabilities. In some respects, the Basel rules have even proved
counterproductive, having encouraged some institutions to move high
quality assets off the balance sheet, thus reducing the average quality
of bank loan portfolios.

Despite the good that has come from it \-- and the good has been
substantial \-- there\'s now a general and understandable sense that
time has overtaken the 1988 accord.

The proposal for a new accord that was rolled out last January is
designed to provide a framework that\'s as sophisticated as the industry
itself is today \-- and yet one that also accommodates the industry\'s
extraordinary diversity, both among and within its home countries.

Before it commenced work in earnest on the proposed new accord, the
Basel Committee laid out five objectives to guide its efforts.

-   First, any new capital rule should at least maintain the current
    overall level of capital in the banking system.

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-   Second, it should promote competitive equality and a level playing
    field for international banks.

-   Third, it should take a comprehensive approach to addressing risks.

-   Fourth, its approach to capital adequacy should be appropriately
    sensitive to the degree of risk inherent in a bank\'s positions and
    activities.

-   And, finally, a new capital rule should focus on internationally
    active banks, although its underlying principles should be suitable
    for application to banks of varying levels of complexity and
    sophistication.

> Those were the guidelines that the Committee set for its own work. I
> would add the following as important principles that should also guide
> the Committee.

-   First, I strongly believe that whatever rule we adopt must work in
    practice as well as in theory. A rule that is intellectually elegant
    but overly complex and difficult to comprehend and implement may
    create more problems than it solves.

-   Second, the rule has to provide supervisors with sufficient
    flexibility to accommodate differences among financial institutions.
    Institutions should not be forced to modify practices that raise no
    safety and soundness concerns, and settled, well-functioning markets
    should not be disrupted, simply in the name of compelling adherence
    to a common rule.

-   Finally, I believe it\'s exceedingly important from a domestic
    perspective that we avoid impairing the competitive vitality of U.S.
    banks, and from an international perspective that we avoid placing
    banks generally at a competitive disadvantage compared to other
    financial service providers. To be sure, banks play a special role
    in the economy of every country, and thus frequently warrant special
    treatment. But the line between banking and other financial services
    is becoming increasingly blurred, and we must recognize that
    investment banks, insurance companies, and other non-bank
    institutions are major competitors of banks.

So \-- how well did we do? Did the document released in January of last
year meet these standards or did it fall short? If the latter, what
steps should we now take to correct any deficiencies and to produce an
accord that will genuinely contribute to a safer and more competitive
global financial system?

To answer those questions, a more detailed review of Basel II \-- and of
the reaction to it from its various constituencies \-- is in order.

The new accord, as I\'m sure you know, is built on three pillars:
minimum capital, supervisory review, and market discipline. It would
reward banks that have developed the most advanced internal risk rating
systems by allowing them to use those systems in the calculation of
their capital requirements \-- the so-called \"internal risk
ratings-based approach,\" or IRB. Banks with less developed capabilities
would have a somewhat less advantageous methodology, while banks with
more rudimentary risk management systems would utilize risk weights and
capital charges established by the Committee under a standardized
approach.

But even banks adopting the IRB approach would not be unconstrained in
calculating their own capital requirements. The primary regulator would
still be responsible for evaluating and validating each institution\'s
models and risk rating system and for assuring that they are applied
with consistency and integrity. Banks\' internal processes would be
subject to regular supervisory testing \-- and intervention, if
necessary. And all internationally active banks, regardless of their
complexity, would be required to make a capital allocation for
operational risk.

Moreover, the Basel Committee envisions an important role for the
financial markets as a barometer of the financial condition and risk
profile of regulated institutions \-- as well as a reality check on the
job we do as regulators. Thus, the third pillar of Basel II would
require that financial institutions improve the quality and quantity of
the information they make public, so that financial markets have the
ability to make accurate and informed judgments on the health of each
institution.

The transparency pillar has an important additional function that should
not be overlooked. It will provide both banks and supervisors with
information that will enable them to assess how the requirements of the
accord are being observed and applied in other countries. In this
respect it will facilitate a kind of \"self-policing\" of compliance by
banks subject to the accord and their supervisors.

A brief summary obviously cannot do justice to a dense document of 500
pages, but there you have the highlights, at least, of Basel II \-- the
product of months of consultation among the principals and extraordinary
effort by the Committee secretariat and the staffs of the various
Committee members. That we have been able to come as far as we have is a
tribute to the strong and skillful leadership of Bill McDonough, who
brought to bear not only his standing as one of the world\'s leading
central bankers, but his extensive practical background as a banker. By
not underestimating the difficulties that stood in its way, Bill has
kept the highly collegial but occasionally fractious Committee on point
and headed in the right direction. Indeed, it is not taking anything
away from the great service our members have rendered to say that our
proceedings have been marked by spirited exchanges of viewpoints that
reflect the wide differences in legal, supervisory, and accounting
practice in our respective nations. The Committee\'s proceedings
underscored the importance of developing rules that make sense, at least
in terms of their broad principles, not only for the G-10 but also for
all nations expecting to operate under the Basel framework.

We expected that the reaction to the proposed accord issued in January
2001 would reflect the wide divergence in financial practice around the
world, and in this regard we were not disappointed. Some stakeholders
urged us to simplify; others asked that it be made even more risk
sensitive \-- and, at the same time, more complex. Smaller, noncomplex
institutions in the United States went on the record as expressing a
preference for the status quo; the gains promised under the new accord,
they said, seemed not worth the trouble and expense of shifting to a new
system. Many institutions particularly objected to the capital charge
for operational risk, disagreeing both with the definition of
operational risk [and]{.underline} with the amount of capital they would
be expected to set aside for that purpose. Even the risk rating
agencies, which might have been expected to applaud a system that would
utilize their services for banks without reliable in-house risk-rating
capabilities, worried publicly about conflicts of interest and the
possibility that they would be perceived as unduly influenced by the
regulators.

The Committee\'s initial cut at Pillar 3 raised very substantial
objections, and knowledgeable observers were quick to point out that
market discipline, as contemplated in Basel II, can be an elusive
concept \-- difficult to standardize and potentially burdensome in terms
of the disclosures the industry would be required to produce. Indeed,
just days before last January\'s release, a Federal Reserve-sponsored
working group issued a report that cast doubt on the value of
disclosures for regulators given the different risk management
methodologies in use among financial institutions. And a day after the
release of [that]{.underline} report, the Treasury Department and the
Federal Reserve released a joint study concluding that what some
industry analysts had viewed as among the most promising tools for
market discipline \-- the use of subordinated debt \-- was actually of
questionable value.

What we had at the end of the day, then, was strong support for the
Basel principles and equally strong opposition to many of the details of
the proposed Basel II rules. To the Committee\'s credit, it has devoted
a tremendous amount of time and energy in an effort to meet these and
other concerns and to continuing the dialogue with the industry. It has
already revised downward the proposed charge for operational risk from
20 percent of total regulatory capital to 12 percent in the standardized
method, and it has laid the groundwork for a non-formulaic approach to
operational risk in the other method \-- the Advanced Measurement
Approach, or AMA \-- that would look more to a bank\'s internal
assessments, much as the IRB-based approach does with credit risk \--
although the attractiveness of this approach may be appreciably lessened
by the prospect that a \"floor\" might be imposed. It has also cut back
significantly on the volume of disclosure that would be required under
Pillar 3. And in the area of retail credit, the Committee has issued a
working paper on the capital treatment of expected losses and future
margin income that is still open for comment.

Throughout this difficult process, the Committee has rightly maintained
that it would do whatever it took to get the new accord right. Thus,
when it became clear that it would be impossible to fairly evaluate the
concerns of market participants and still meet our own implementation
deadlines, we extended the deadlines. There will now be a third
consultative package, although that document will not be released until
Committee staff has completed an additional review aimed at assessing
the overall quantitative impact of a new accord on banks and the banking
system. In this \"quality assurance\" phase, the Basel Committee will
focus especially on the highly controversial question of appropriate
capital treatment of credits to SMEs, the small- and medium-sized
enterprises that are so vital to economic growth and job creation.

The Committee is also finalizing calibration of the minimum capital
requirement in order to achieve a level of capital that, on average, is
approximately equal to the amount of capital produced by the present
accord, while still providing incentives to banks to use internal
ratings systems.

Merely stating these objectives helps to convey the difficulty of the
Committee\'s challenges. How do you satisfy the political imperative of
avoiding a reduction in the overall capital of the banking system, while
at the same time holding out to the largest and most sophisticated banks
that a set of rules better tuned to risk may enable them to enjoy
[lower]{.underline} capital \-- unless, of course, the new rules will
result in an [increase]{.underline} in the capital of other more risky
banks?

In this connection, a comment may be appropriate as to just which banks
will be subject to the new accord. The intent is that it will be applied
to \"internationally active\" banks. U.S. regulators have made clear
that they do not intend to apply the new accord to the many thousands of
community banks that serve local markets in this country.

At the same time, many of us have real questions about how many of our
larger banks will be in a position to adopt the IRB approach. I think it
is a fair guess that only a very small handful of our largest, most
sophisticated banks \-- perhaps no more than 6 or 8 \-- will qualify, at
least initially, for the advanced IRB approach, and even the foundation
IRB approach may not be suitable for many large banks.

There are, of course, a number of thorny issues that remain to be worked
out. I have been quite concerned, for example, about the approach to
operational risk, and have voiced those concerns consistently in
Committee meetings. I view operational risk as the risk that inheres in
the quality of a bank\'s internal controls. Thus, two banks engaged in
an identical line of business may present vastly different quantities of
operational risk when the internal control systems of one are
significantly better than those of the other. A one-size-fits-all
approach to operational risk \-- such as a formulaic capital charge
based on some percentage of gross revenues or a percentage of the charge
for credit risk \-- while simple to apply, would disadvantage the best
managed banks and provide undeserved advantage to the worst managed.
Worst of all, it would provide no incentive to improve internal control
systems. For this reason I have repeatedly argued that operational risk
is particularly well suited for a Pillar 2 approach. But there are many
on the Committee who are very cautious about such a use of Pillar 2,
believing it would be used for supervisors to provide competitive
advantages to their banks. Those holding this view find strong comfort
in highly detailed prescriptive rules. While I find the AMA concept
quite appealing, I am concerned that it not be so constricted as to
diminish its attractiveness to banks.

I have also been concerned about the approach to securitizations. U.S.
bank regulators are keenly aware \-- increasingly so \-- of the various
risks involved in securitization, and we have seen numerous instances in
recent times in which badly managed securitizations have caused serious
problems for banks. On the other hand, securitization has been an
important risk management and funding technique for many of our
best-managed banks, which have developed securitization markets to a
high level of efficiency.

While we must address the real risks here, we need to do so with care,
so that we don\'t needlessly or unintentionally disrupt an important
market. We must also avoid a \"beggar-thy-neighbor\" approach. The
volume of securitization activity among U.S. banks vastly exceeds that
of all of the other G-10 countries combined. While the popularity of
securitization is certainly spreading, we must resist the temptation to
embrace new rules uncritically when their burden will fall most heavily
on countries other than our own.

Finally, I am concerned about the enormous complexity of the proposal.
With great respect for the various task forces and working groups that
have conscientiously produced extremely thoughtful papers, I would be
amazed if every member of the Committee has been able to plow through
the details of every paper. I\'m frank to say that I have not. I suppose
it\'s a character flaw of mine that as soon as I see the symbol for an
indefinite integral on a page, my attention starts to flag.
Unfortunately there are many pages of complex formulas in the
Committee\'s recent work.

I believe it is essential for a number of reasons that we make a very
strong effort to simplify the articulation of the basic rules. Bankers,
examiners, legislators, and policy makers need to be able to comprehend
the structure and content of the new accord without having to plow
through reams of mathematical minutiae. We need a reasonably concise set
of black-letter rules that lay out the structure of a new accord, with
such elaborating detail as is absolutely necessary left to annexes. And
we should not attempt to draft language addressing every possible
contingency or detail that might arise, to chase every rabbit down every
hole. Again, I believe we should put more reliance on Pillar 2 to fill
in the interstices. We in the U.S. have to keep in mind that before the
new accord can become effective for our banks, we will have to go
through a formal rulemaking proceeding, and while an agency head
probably can\'t be sent to jail for violating the \"plain language\"
requirement we are supposed to observe, we should at least make a stab
of it.

The Committee has demonstrated that it is not unresponsive to the views
and interests of the industry, and I believe that banks that have
provided input to the process have contributed immeasurably to our joint
effort. I have urged all of our large banks to analyze the Basel
proposals and to let us and the Committee know their views, and I have
personally met with a number of the more engaged banks to discuss the
issues. The dialogue in which we have been engaged together \-- as
supervisors and bankers \-- offers an excellent case study in
cooperation, which bodes well for our ability to develop the inevitably
complex rules that are so necessary to help us address increasingly
complex risks in the global banking system.

But I also believe that we must continuously ask ourselves what
\"getting it right\" really means. While competitive equity and
uniformity of application are important objectives of the Committee, we
need to consider the difficulty of delivering a comprehensive framework
that encompasses all the different ways that institutions are operated
and supervised across the G-10 and around the world. In the U.S., for
example, we have a highly developed system of bank supervision. The OCC
has full-time teams of resident examiners on site at our largest banks.
In other countries, the task of supervisory oversight may be quite
different, with an important role being left to the outside auditors.
Given such disparities, what can we expect in the way of uniform
application of highly complex and prescriptive rules? Would we be less
well served if the Basel process aimed instead at seeking agreement on
broad principles and modes of behavior? Should we consider emulating the
less prescriptive approach adopted by today\'s international coalition
against terrorism \-- or by the International Accounting Standards
Board, which promulgates global standards and principles, and leaves
implementation and enforcement to national authorities?

More than anything else, the Committee needs to work with and understand
the dynamics and operational incentives of the banking industry. We need
to make certain that the new capital framework reflects and reinforces
the best contemporary practice. We must be very careful to avoid
micromanaging the institutions that we supervise. And above all we must
be cautious not to disrupt or destroy settled markets by adopting new
approaches that could have serious unintended consequences.

In light of everything that has occurred over the past year, I believe
it is impossible to predict exactly what the Basel Committee\'s final
product will look like \-- or when we will come to closure. Although we
recognize that there are costs associated with further delay, a process
that involves such complexity and such a potential for causing
unintended consequences should not be rushed. We need to take the
required time not only to complete the testing and calibration of the
IRB approach, but also to assure that our approach to such issues as
operational risk makes good sense.

Over its distinguished history, the Basel Committee has functioned best
when it has focused on developing and articulating basic principles. The
\"Core Principles for Effective Banking Supervision,\" which the
Committee adopted in 1997, have made a tremendous contribution to the
improvement of supervisory practice worldwide. Basel has been an
invaluable forum for supervisors to use for sharing experiences and
insights and learning from them. We have done less well when we have
tried to make our vastly diverse and complex global banking system \--
and the variety of our supervisory arrangements \-- conform to a single
model.

The Basel Committee is unalterably committed to the goals of financial
stability and effective international bank supervision. But as we
continue to learn, it is both necessary and possible to come up with
mutually agreeable standards of international conduct without dictating
how those standards are to be achieved or enforced.

In the world of international politics, sovereign differences can be a
source of strength. I believe that\'s just as true for international
bank supervision. As the Basel Committee continues its important work,
we must respect those differences \-- and build on them \-- in order to
achieve a truly prosperous global economy.