U.S. GOVERNMENT PRINTING OFFICE

WASHINGTON : 

For sale by the Superintendent of Documents, U.S. Government Printing Office

Internet: bookstore.gpo.gov Phone: toll free (866) 512–1800; DC area (202) 512–1800

Fax: (202) 512–2104 Mail: Stop IDCC, Washington, DC 20402–0001

50–306 2009

S. HRG. 109–1084 

AN UPDATE ON THE NEW BASEL CAPITAL 

ACCORD 

HEARING 

BEFORE THE

COMMITTEE ON 

BANKING, HOUSING, AND URBAN AFFAIRS 

UNITED STATES SENATE 

ONE HUNDRED NINTH CONGRESS 

SECOND SESSION 

ON 

THE RECENT DEVELOPMENTS REGARDING THE IMPLEMENTATION OF 

BASEL II AND BASEL IA AND THE CONCERNS RAISED ABOUT THE 

BASEL II REGULATIONS PROPOSED BY FEDERAL BANKING REGULATORS 

TUESDAY, SEPTEMBER 26, 2006 

Printed for the use of the Committee on Banking, Housing, and Urban Affairs 

( 

Available at: http://www.access.gpo.gov/congress/senate/senate05sh.html 


jbell on DSKDVH8Z91PROD with HEARING
(II) 

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS 

RICHARD C. SHELBY, Alabama, Chairman 

ROBERT F. BENNETT, Utah 

WAYNE ALLARD, Colorado 

MICHAEL B. ENZI, Wyoming 

CHUCK HAGEL, Nebraska 

RICK SANTORUM, Pennsylvania 

JIM BUNNING, Kentucky 

MIKE CRAPO, Idaho 

JOHN E. SUNUNU, New Hampshire 

ELIZABETH DOLE, North Carolina 

MEL MARTINEZ, Florida 

PAUL S. SARBANES, Maryland 

CHRISTOPHER J. DODD, Connecticut 

TIM JOHNSON, South Dakota 

JACK REED, Rhode Island 

CHARLES E. SCHUMER, New York 

EVAN BAYH, Indiana 

THOMAS R. CARPER, Delaware 

DEBBIE STABENOW, Michigan 

ROBERT MENENDEZ, New Jersey 

WILLIAM D. DUHNKE, Staff Director and Counsel 

STEVEN B. HARRIS, Democratic Staff Director and Chief Counsel 

ANDREW OLMEM, Counsel 

LEE PRICE, Democratic Chief Economist 

JOSEPH R. KOLINSKI, Chief Clerk and Computer Systems Administrator 

GEORGE E. WHITTLE, Editor 


jbell on DSKDVH8Z91PROD with HEARING
(III) 

C O N T E N T S 

TUESDAY, SEPTEMBER 26, 2006 

Page 

Opening statement of Chairman Shelby ................................................................ 1 

Opening statements, comments, or prepared statements of: 

Senator Sarbanes .............................................................................................. 2 

Senator Johnson ............................................................................................... 4 

Senator Schumer .............................................................................................. 5 

Senator Carper ................................................................................................. 24 

WITNESSES 

John C. Dugan, Comptroller of the Currency ....................................................... 8 

Prepared statement .......................................................................................... 51 

Response to written questions of: 

Senator Shelby ........................................................................................... 175 

Senator Sarbanes ...................................................................................... 179 

Sheila C. Bair, Chairman, Federal Deposit Insurance Corporation .................... 9 

Prepared statement .......................................................................................... 64 

Response to written questions of: 

Senator Shelby ........................................................................................... 183 

Senator Sarbanes ...................................................................................... 187 

Susan S. Bies, Governor, Federal Reserve Board of Governors, Federal Reserve System ......................................................................................................... 11 

Prepared statement .......................................................................................... 78 

Response to written questions of: 

Senator Shelby ........................................................................................... 191 

Senator Sarbanes ...................................................................................... 196 

John M. Reich, Director, Office of Thrift Supervision .......................................... 13 

Prepared statement .......................................................................................... 91 

Diana L. Taylor, Superintendent of Banks, New York State Banking Department ...................................................................................................................... 14 

Prepared statement .......................................................................................... 102 

Response to written questions of: 

Senator Sarbanes ...................................................................................... 224 

James Garnett, Head of Risk Architecture, Citigroup ......................................... 35 

Prepared statement .......................................................................................... 118 

Kathleen E. Marinangel, Chairman, President, and CEO, McHenry Savings 

Bank ...................................................................................................................... 36 

Prepared statement .......................................................................................... 127 

William M. Isaac, Chairman, Secura Group, LLC ................................................ 37 

Prepared statement .......................................................................................... 152 

Daniel Tarullo, Professor of Law, Georgetown University Law Center .............. 39 

Prepared statement .......................................................................................... 160 

ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD

Prepared statement of the Independent Community Bankers of America ......... 230 


jbell on DSKDVH8Z91PROD with HEARING

jbell on DSKDVH8Z91PROD with HEARING
(1) 

AN UPDATE ON THE NEW BASEL CAPITAL 

ACCORD 

TUESDAY, SEPTEMBER 26, 2006 

U.S. SENATE, COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, Washington, DC. 

The Committee met at 10:06 a.m., in room SD–538, Dirksen Senate Office Building, Senator Richard Shelby (Chairman of the Committee) presiding. 

OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY 

Chairman SHELBY. The Committee will come to order. 

Today we will continue our oversight of the new Basel II Capital 

Accord and the proposed revisions to existing capital requirements, 

known as Basel IA. After years of development and consideration, 

we are now entering into a critical phase for the implementation 

of Basel II and Basel IA. Federal banking regulators recently approved the Notice of Proposed Rulemaking for Basel II and are expected to issue shortly the Notice of Proposed Rulemaking for Basel 

IA. 

During the public comment period for these regulations, Federal 

banking regulators will consider whether any modifications are 

necessary before the regulations become final. The decisions Federal banking regulators make over the next few months will have 

profound consequences for the long-term stability of the U.S. economy. 

Capital requirements play a key role in ensuring the safety and 

soundness of our banking system and protecting U.S. taxpayers 

from the cost of bank failures. We only need to look at U.S. economic history to see how thinly capitalized banks have in the past 

made our financial system vulnerable to unanticipated economic 

shocks and how a crisis in the banking system quickly infects the 

rest of our economy. And due to the existence of Federal deposit 

insurance, in the end, taxpayers pay the cost of bank failures attributable to a lack of capital. 

The risks posed by undercapitalized banks are heightened by the 

rapidly increasing sophistication of our financial system. In the 

world of derivatives and off-balance-sheet transactions, it is vital 

that banks utilize advanced risk management practices to effectively monitor and control their financial exposures. Accordingly, 

Basel II and Basel IA must be implemented within the utmost care 

and diligence. There is little margin for error when it comes to capital requirements. Yet concerns have been raised about the Basel 

II NPR. 


jbell on DSKDVH8Z91PROD with HEARING
2 

At the Committee’s last hearing on Basel II, we heard testimony 

that questioned whether Basel II would leave banks sufficiently 

capitalized and whether regulators possess the expertise necessary 

to implement Basel II. Furthermore, several banks have requested 

that they be allowed to choose the Standardized Approach for setting their capital requirements. Currently, banks adopting Basel II 

in the U.S. will be permitted to use only the Advanced Approach. 

Before Basel II and Basel IA go forward, I believe we must have 

a clear picture of how they will change our financial system. We 

must also know that our banks will hold the appropriate amount 

of capital, that our regulators will be able to implement a regime 

as complex as Basel II, and that our small banks will not be placed 

at a competitive disadvantage. 

I look forward to hearing the witnesses’ testimony on these important questions today. At today’s hearing we will have two panels. 

The first panel will consist of the Honorable John Dugan, Comptroller of the Currency; the Honorable Susan Schmidt Bies, Governor of the Federal Reserve Board of Governors, a member of the 

Federal Reserve; the Honorable Sheila Bair, Chairman of the Federal Deposit Insurance Corporation; the Honorable John Reich, Director of the Office of Thrift Supervision; and the Honorable Diana 

Taylor, Superintendent of the New York State Banking Department, on behalf of State Banking Supervisors. We will just go to 

the first panel first. 

Senator Sarbanes. 

STATEMENT OF SENATOR PAUL S. SARBANES 

Senator SARBANES. Well, thank you very much, Chairman Shelby. I want to commend you for holding not just this hearing but 

a series of hearings on the status of Basel II. There have been very 

important developments since our last hearing. I am sure this 

hearing today will help us to understand those. 

As people know, and let me just say at the outset, I am very 

skeptical of proposals that would reduce bank capital requirements 

or threaten to do so in the future. 

Like others on this Committee, I have been around long enough 

to remember the difficult years of the late 1980s and early 1990s 

when our banking system became undercapitalized. Some banks 

and thrifts had negative capital and were closed. Most others were 

forced to increase their capital, and in that period, the American 

taxpayer paid an enormous cost to make good on the promises of 

deposit insurance. We were here together, I think, in those days, 

Mr. Chairman. 

Chairman SHELBY. Dark days. 

Senator SARBANES. I do not think anyone on this Committee 

would want to go through an experience like that again. 

When banks are forced to rebuild their capital, they make fewer 

loans to the riskier startup businesses that are important to job 

creation. But we managed through legislation and regulation to get 

our banking system back on a firmer footing. Many experts believe 

that the U.S. economic performance was much better than the Japanese performance in the late 1990s because our banking system 

had successfully recapitalized and the Japanese banking system 


jbell on DSKDVH8Z91PROD with HEARING
3 

had not. Strong bank capital protects taxpayers and promotes 

healthy and stable economic growth. And, furthermore, it does not 

appear to have hurt the profitability of our Nation’s banks. They 

are earning record profits and are doing much better than their 

competitors abroad, even though, it is constantly pointed out, the 

foreign banks have lower capital requirements. 

Many experts welcomed the original Basel I in the 1980’s as an 

unprecedented accord among bank regulators in the U.S., Europe, 

Japan, and Canada to raise bank capital requirements. Over the 

years, it has been updated many times, but in the late 1990’s it 

was decided to develop a new agreement, Basel II. Basel II was finalized in 2004. It provides for three different approaches for capital regulations: standardized, foundational, and advanced internal 

ratings-based. 

The Federal Reserve has taken the lead in long maintaining that 

the Advanced Approach should be mandatory for our largest banks. 

My concern with this is that the Advanced Approach under Basel 

II may indeed end up threatening the safety and soundness of our 

banking system. 

Last year, a year after the terms of Basel II were settled, we 

learned the likely effect of the Advanced Approach on bank capital 

requirements. The so-called QIS–4 study of 26 of our largest banks 

found that the capital requirements in one instance for one of those 

banks would plunge nearly 50 percent and the capital requirements for half of the banks would fall at least 26 percent. 

Seeing these results—in fact, we had been constantly assured in 

testimony before this Committee that there was not going to be a 

substantial reduction in bank capital. Seeing these results, the four 

bank regulators wisely agreed—I gather with some internal dissension—that they should maintain the leverage ratio, slow the decline in any one bank’s capital, and limit the decline in overall capital in the banking system. 

I have yet to hear a single outside expert on our banking system 

argue that our banks today are overcapitalized. In fact, Bill Isaac, 

who will be testifying on the second panel, says in his statement, 

and I quote him, talking about the original premise behind Basel 

II about developing these mathematical capital models while broadly maintaining the overall level of capital: ‘‘The models—incomprehensible to mere mortals, such as boards of directors and senior 

management of the banks’’—and Members of Congress. That is my 

addition, not his. He is very polite to the Members of the Congress. 

He left us out of this problem. 

Chairman SHELBY. At least here. 

Senator SARBANES [continuing]. ‘‘Would measure the risks in 

these institutions’ assigned capital to cover those risks.’’ 

‘‘This original premise was somehow transferred into an expectation that large banks would be offered the carrot of reduced capital 

in exchange for developing the models. Let us pause right here’’— 

this is Isaac—‘‘and think about the proposition that the largest 

banks have excess capital and should be allowed to reduce their 

capital materially.’’ 

‘‘Does anyone really believe in that notion—particularly anyone 

who lived through the two decades in banking from 1973 to 1993? 

Thousands of banks and thrifts failed during that period—many 


jbell on DSKDVH8Z91PROD with HEARING
4 

more, including most of the largest banks, would have failed but 

for very strong and costly actions taken by the FDIC and the Federal Reserve to maintain order. It was a very scary period that 

nearly careened out of control.’’ 

‘‘For any regulator to accept the premise that the world’s largest 

banks as a group have significant excess capital is unfathomable 

to me, yet that is the glue holding Basel II together.’’ 

Now, I also worry about the complexity and potential conflict of 

interest in the structure of the Advanced Approach. For many of 

these reasons, the limits on capital reduction allowed under the 

Advanced Approach makes a lot of sense. 

Now, over the summer, a new proposal emerged that would allow 

all banks to use the Standardized Approach. This proposal has won 

the endorsement of large and small banks, bank associations, and 

State bank regulators. The four bank regulators recently decided to 

seek public comment on this proposal in their Notice of Proposed 

Rulemaking. 

The Standardized Approach appears to have the merit that it 

would apparently not lead to large reductions in required bank capital. I have been concerned about this effort to achieve large reductions in capital requirements, and I know that some in the banking 

industry pushed for this Advanced Approach, but without the restrictions on how low their capital could go. 

The Standardized Approach also addresses the concerns that the 

Advanced Approach would favor the largest banks at the expense 

of smaller banks. 

So, Mr. Chairman, this is a very important hearing, and again, 

I commend you for scheduling it. I want to just close by again 

quoting Bill Isaac, who, of course, had the distinguished service as 

a former Chairman of the Federal Deposit Insurance Corporation. 

At the close of this statement he says, and I quote him, ‘‘This is 

by far the most important bank regulatory issue in front of us 

today. If we get this one wrong, our Nation and taxpayers will almost certainly pay a very big price down the line—a price that will 

make the S&L debacle seem like child’s play.’’ 

Thank you very much. 

Chairman SHELBY. Senator Johnson. 

STATEMENT OF SENATOR TIM JOHNSON 

Senator JOHNSON. Chairman Shelby and Ranking Member Sarbanes, thank you for holding today’s hearing on Basel II Capital 

Accord. One of the most important duties of this Committee is to 

ensure the safety and soundness of our financial system, and oversight of Basel II is a critical element of that responsibility. 

As we consider the state of Basel II, I would urge the regulators 

not to lose sight of three main goals. 

First, all banks deserve a level playing field. I am pleased that 

we seem well on our way to solving the domestic competitiveness 

concerns that confronted us last year, and I would like to thank the 

regulators for taking those concerns seriously. I look forward to reviewing the forthcoming Basel IA proposal, and I also support offering all banks of whatever size the internationally negotiated 

Standardized Approach. Small community banks remain the lifeVerDate Nov 24 2008 01:21 Nov 24, 2009 Jkt 050306 PO 00000 Frm 00008 Fmt 6633 Sfmt 6633 E:\HR\OC\A306.XXX A306

jbell on DSKDVH8Z91PROD with HEARING
5 

blood of many of our communities, and Basel II must not impair 

their ability to compete. 

Ironically, though, we appear now to be on the verge of placing 

large internationally active U.S. banks at a serious disadvantage 

against foreign competitors, and even against U.S. consolidated supervised entities. I would urge the regulators to review the U.S. 

banking Notice of Proposed Rulemaking to avoid duplicative requirements and to take great care before piling on a host of new 

requirements that diverge from the international version of Basel 

II. 

Second, risk-based capital should remain a priority. Clearly, our 

main concern must be the safety and soundness of U.S. financial 

institutions. However, it has been well established that more capital is not always better. In fact, the recognition that more is not 

always better is largely why we embraced the Basel negotiations 

in the first place. The current system, which fails to peg capital to 

risk, perversely encourages risk-taking. Basel II recognizes that 

when risk and regulatory capital are aligned, capital is adequate 

but not excessive, and banks are forced to internalize their risks. 

We all benefit from the right balance. 

The challenge, of course, is identifying the optimal balance. 

Under our risk-based system capital is meant to change depending 

on the risk of the underlying asset or activity, as well as underlying economic conditions. In reviewing the impact of any proposed 

rule, it is important to keep in mind that not all capital drops are 

bad. Of course, some may well be bad, and that is the point of Pillars 2 and 3. 

Third, international harmonization should be a goal. In reviewing the newly published NPR, I am very concerned that we are 

undervaluing the creation of uniform international capital standards. The marketplace for products and services is increasingly 

global; therefore, it is critical that everyone plays by the same rules 

and U.S. banks are not disadvantaged. Of course, we need to make 

sure that the system works and banks are closely monitored. But 

the number of significant changes to the international text, which 

would apply only to U.S. banks, strikes me as a strange and unwanted result given our original goal of international harmonization. 

Mr. Chairman, I think we would all agree that we have some 

way to go on Basel II to get it right. Clearly, all of the regulators 

have devoted considerable time, energy, and resources to ensuring 

the safety of our institutions and the vitality of our economy, and 

I value that dedication. I urge you in the coming months to continue working together to achieve the necessary balance in Basel 

II. I also urge the regulators to keep an open mind to giving all 

banks of whatever size the option of implementing the international version of the Standardized Approach. 

Thank you, Mr. Chairman. 

Chairman SHELBY. Senator Schumer. 

STATEMENT OF SENATOR CHARLES E. SCHUMER 

Senator SCHUMER. Well, thank you, Mr. Chairman. I really want 

to thank you for holding this timely hearing. We are fighting to remain competitive in the financial markets. I think every American 


jbell on DSKDVH8Z91PROD with HEARING
6 

wants us to stay No. 1, but no one more than those of us who represent New York City, which is our financial capital. And we have 

a tremendous dilemma here and not just in this area. 

As the world economy becomes internationalized and financial 

markets become one, you run the tension between having a system 

of regulation—which with this country has worked extremely well. 

I think in the last quarter of the 20th century, we achieved quite 

an exquisite balance. I have always said I like people who are both 

pro-business and pro-regulation, and I think there is no contradiction between the two. Those on the left wing who just want to regulate, regulate, regulate, and tie the hands of an entrepreneurial 

system, that makes no sense. And those on the right wing who just 

say do whatever business wants have not learned the lessons of 

history, plain and simple. 

So there is a balance and we achieved it, but now it has sort of 

been thrown up in the air because of internationalization. And you 

can run into the problem of lowest common denominator. In other 

words, the place with the least regulation, that is where people will 

go, because regulation is a public good and it does not affect the 

individual making the deal unless the whole system collapses. You 

know, there is a book by Mancur Olson, ‘‘The Logic of Collective 

Action,’’ which is very relevant here, which talks about that. 

Well, I have to disagree with some of my Democratic colleagues 

who say we must keep every regulation in place because they have 

worked in light of the international challenge. But I disagree with 

saying let’s get rid of them all as well. We have to find that balance, and this hearing is an attempt to do it. 

Now, let me make some comments here. We have all heard about 

IPOs, only one of the top 24 being registered in the U.S., four in 

London. But listen to this: London already accounts for 70 percent 

of global bond trading, 40 percent of derivatives, 30 percent of foreign exchange activity, and 30 percent of cross-border equities. 

As Senator from New York, these are the kinds of things that 

keep me awake at night, and I know they keep our great banking 

superintendent, Diana Taylor, who is here, awake as well. Hi, 

Diana. Nice to see you. 

Ms. TAYLOR. Hello. Thank you. 

Senator SCHUMER. Now, with respect to Basel II, I was there 

when Basel was—you know, I was involved as a Congressman on 

the Banking Committee when Basel started up. We all thought it 

was a great thing. We had seen the banking crisis, the S&L crisis, 

and we knew that capital standards, rather than strict regulation, 

were the way to go. Plain and simple. 

Now we have not had a banking crisis for 15 years, so the need 

to have capital standards sort of declined a little bit. But we need 

them. 

The problem is, again, when other countries say we are going to 

do much less, the imperative of New York companies, American 

companies to their stockholder says, well, if we can be more profitable doing it over there, we should. That is the dilemma we face, 

and if we are too rigid, we will lose all the business, and we will 

have no regulation and no business. If we are not rigid enough— 

I mean, if we are too flexible, we will have the kinds of crises we 

saw before. 


jbell on DSKDVH8Z91PROD with HEARING
7 

So, as I said, we need to look at this carefully. Everything is 

interconnected. One failure is going to lead to the failure of many, 

and it is going to hurt taxpayers. So we have to be careful. We 

have to be careful. 

But we should not fool ourselves into thinking a bigger capital 

cushion always means a safer system. Advances have occurred in 

risk management. Management makes it possible to use capital requirements to make banks internalize their risk, and if a bank 

takes a calculated risk, obviously it should have more capital in 

those investments than the ones that do not. But if they have to 

hold onto too much capital against safe activities, that is where we 

are losing out, and I think that is the nub of this problem that we 

have to look at. 

So a number of Members have discussed these issues, but I have 

to say candidly I am concerned that at a time when we are struggling to maintain our stature as the world’s economic center, this 

Notice of Proposed Rulemaking can hurt our ability to compete 

with France, Germany, and Japan, and particularly London. And 

make no mistake about it, London is making a strong effort to replace New York as the financial capital. Their regulators are here. 

They actually go solicit companies, which we are not doing. And, 

in fact, I formed a little group along with Mayor Bloomberg to discuss what we should do, and we are going to be examining that 

very seriously in the next few months. 

So let me say here I believe in giving all banks access to the 

international Standardized Approach, and that is an important 

step and I support it. At least banks will have one option that allows them to follow the same rules as the rest of the world. And 

with respect to the Advanced Approach, I am a little less optimistic. I take pride in representing the world’s financial capital. I 

want to make sure that our noble intentions do not backfire, and 

we need to keep the system safe and strong. We need to give New 

York banks a fair shot. 

By the way, they are not New York banks anymore. They are in 

New York, but they are international banks, and they could locate 

somewhere else very quickly. And that is their job. I would get mad 

at them if they do it. I would fight less hard for them if they did 

it. But their first obligation is to their stockholders. And so this is 

a real dilemma. 

Senator SCHUMER. And one other point, Mr. Chairman. There 

would be value if the GAO were to look at how any differences in 

the bank proposal could affect U.S. banks. So I am going to ask the 

GAO to conduct an expedited impartial analysis to report on the 

differences between the U.S. and foreign implementation of Basel 

II to determine which differences could have an adverse competitive consequence on U.S. banks and an adverse consequence on 

safety and soundness. 

And with that, Mr. Chairman, I really thank you for holding this 

timely and important hearing. 

Chairman SHELBY. Thank you, Senator Schumer. Comptroller 

Dugan, we will start with you. All of the written testimony will be 

made part of the hearing record in its entirety. A lot of you are not 

strangers here, so you proceed. 


jbell on DSKDVH8Z91PROD with HEARING
8 

STATEMENT OF JOHN C. DUGAN, 

COMPTROLLER OF THE CURRENCY 

Mr. DUGAN. Chairman Shelby, Senator Johnson, and Senator 

Schumer, I appreciate this opportunity to discuss the U.S. banking 

agencies’ proposals to enhance our regulatory capital program 

under Basel II. 

The U.S. implementation of Basel II is, at its core, the effort to 

move away from the simplistic Basel I capital regime for our largest internationally active banks. The inadequacies of the current 

framework are pronounced with respect to these banks, which is a 

matter of great concern to the OCC because we are the primary 

Federal supervisor for the five largest. These institutions, some of 

which hold more than $1 trillion in assets, have complex balance 

sheets, take complex risks, and have complex risk management 

needs that are fundamentally different from those faced by community and mid-sized banks. 

Because of these attributes, Basel II is necessarily complex, but 

it would be mandatory for only a dozen large U.S. institutions. The 

new regime is intended not only to align capital requirements more 

closely to the complex risks inherent in these largest institutions, 

but, just as important—and this is a total departure from the existing capital framework—it would also require them to substantially 

improve their risk management systems and controls. This would 

be accomplished using a common framework and a common language across banks that would allow regulators to better quantify 

aggregate risk exposures, make more informed supervisory decisions, disclose more meaningful risk information to markets, and 

make peer comparisons in ways that we simply cannot do today. 

Earlier this month, the agencies took a critical step forward in 

this process by approving a notice of proposed rulemaking. In addition to establishing the basic Basel II framework in the United 

States, the NPR addresses two key issues about implementation. 

The first concerns the reliability of the framework itself. As you 

know, last year’s quantitative impact study of the potential impact 

of an earlier version of Basel II predicted substantial drops and dispersions in minimum required capital. These QIS–4 results would 

be unacceptable to all the agencies if they were the actual results 

produced by a final, fully supervised and implemented Basel II 

rule. But they were not. Some changes already made in the proposed rule—and others that will be considered during the comment 

period—should mitigate the QIS–4 results. More important, we believe that a fully supervised implementation of a final Basel II rule, 

with examiners rigorously scrutinizing the inputs provided by 

banks, is likely to prevent unacceptable capital reductions and dispersions. 

We cannot be sure, however, and that is why the proposed rule 

will have strict capital floors in place to prevent such unacceptable 

results during a 3-year transition period. This will give us time to 

finalize, implement, supervise, and observe ‘‘live’’ Basel II systems. 

If during this period we find that the final rule would produce unacceptable declines in the absence of these floors, then we will have 

to fix the rule before going forward, and all the agencies have committed to do just that. 


jbell on DSKDVH8Z91PROD with HEARING
9 

The second issue concerns optionality. The NPR asks whether 

Basel II banks should have the option of using a simpler approach. 

This is a legitimate competitive question, given that the largest 

banks in other Basel II countries have such an option, although, 

as a practical matter, all such foreign competitors appear to be 

adopting the Advanced Approaches. We are very interested in comments about the potential competitive effects of providing such an 

option to U.S. banks. 

The OCC has been a frequent critic of many elements of the 

Basel II framework, and we have worked hard to make important 

changes to the proposal that we thought made sense. But at critical 

points in the process, the OCC has supported moving forward toward implementation, and our reason for doing so is simple. An appropriate Basel II regime will help both banks and supervisors address the increasingly complex risks faced by our very largest institutions. While we may not yet have all the details right, and we 

will surely make changes as a result of the public comment process, I fully support the objectives of the Basel II NPR for the supervision of our largest banks. Likewise, for non-Basel II banks, I fully 

support our interagency effort to issue the so-called ‘‘Basel IA’’ proposal in the near future as a way to more closely align capital with 

risk without unduly increasing regulatory burden. 

In closing, let me emphasize that, as we move forward with these 

proposals, the agencies will continue to foster an open process, consider all comments, heed good suggestions, and address legitimate 

concerns. 

Thank you very much. 

Chairman SHELBY. Chairman Bair. 

STATEMENT OF SHEILA C. BAIR, CHAIRMAN, 

FEDERAL DEPOSIT INSURANCE CORPORATION 

Ms. BAIR. Thank you, Chairman Shelby, Senator Sarbanes, Members of the Committee. I appreciate the opportunity to testify on 

behalf of the Federal Deposit Insurance Corporation concerning the 

Basel II International Capital Accord. 

At the outset, I would like to emphasize that we all support moving ahead to the next step in the Basel II deliberative process. The 

FDIC Board of Directors recently voted to publish the Basel II Notice of Proposed Rulemaking for public comment. U.S. bank and 

thrift regulators also are developing a more risk-sensitive capital 

framework for non-Basel II banks, known as Basel IA, which we 

hope to publish for comment in the near future. 

While it is important to move ahead with the process, there is 

also agreement that we must not do so in a way that will result 

in significant reductions in capital or in the creation of wide disparities in capital among different types of insured depository institutions. 

The agencies’ most recent QIS study suggested that the Basel II 

Advanced Approaches would result in a substantial reduction in 

risk-based capital requirements. The results also showed wide variations in capital requirements for similar risks. The agencies found 

these results unacceptable, and as a result, included a number of 

important and essential safeguards in the NPR to address them. 


jbell on DSKDVH8Z91PROD with HEARING
10 

I look forward to the comments on the NPR, and I will approach 

those comments with an open mind. I particularly look forward to 

comments on the question of whether the regulators should allow 

alternatives to the Advanced Approaches. We have had a number 

of requests to allow any U.S. banks to use the Standardized Approach to capital regulation that is a part of the Basel II Accord. 

The U.S. is the only country proposing to make the Advanced Approaches mandatory for any group of banks. 

The Standardized Approach includes a greater array of risk rates 

than the current rules. It is simpler and less costly to implement 

than the Advanced Approaches. In addition, because there is a floor 

for each risk exposure, it does not provide the same potential for 

dramatic reductions in capital requirements. 

On the other hand, there is the argument that only the Advanced 

Approaches would provide an adequate incentive for the strengthening of risk measurement systems at our largest banks. Whether 

our largest banks should be required to use the Advanced Approaches is a fundamental issue, and as I just mentioned, I look 

forward to public input on this question. 

Before concluding my remarks on Basel II, I would like to say 

a few words about the leverage ratio. The FDIC has consistently 

supported the idea that the leverage ratio, a simple capital-to-assets measure, is a critically important component of our dual capital regime. I am pleased that all the bank regulators have expressed their support for preserving the leverage ratio. I appreciate 

that banks in most other Basel Committee countries are not constrained by a leverage ratio and that effective capital standards 

around the world vary widely as a result. Indeed, if large European 

banks were subject to the U.S. Prompt Corrective Action standards, 

several would be considered as undercapitalized. 

For this reason, I believe that the United States should ask the 

Basel Committee to initiate consideration of an international leverage ratio. The leverage ratio has provided U.S. supervisors with 

comfort that banks will maintain a stable case of capital in good 

times and bad. Similarly, the establishment of an international leverage ratio would go far in strengthening the liquidity and stability of the international banking system and help limit the consequences of reduced risk-based capital levels with Basel II implementation. 

In conclusion, it is important that we improve the current riskbased capital rules without significantly reducing capital requirements. In addition, we should not allow ourselves to be drawn into 

a debate about lowering capital ostensibly as a means of promoting 

international competitive advantage. The U.S. has always had high 

capital standards, and this has been a source of strength, not 

weakness, for our banking system. 

I will support implementing the Advanced Approaches only if I 

can develop a comfort level that strong capital levels will be preserved. To this end, I will review with an open mind the possibility 

of allowing the U.S. version of the Standardized Approach as an alternative option for implementation of Basel II. 

In addition, as I indicated, the Basel Committee should consider 

an international leverage ratio as a way to promote liquidity and 


jbell on DSKDVH8Z91PROD with HEARING
11 

ensure a baseline of capital for safety and soundness throughout 

the global banking system. 

I look forward to working with my fellow regulators to achieve 

a consensus on an outcome that is in the public interest. I appreciate the opportunity to testify regarding Basel II and look forward 

to answering any questions the Committee may have. 

Thank you. 

Chairman SHELBY. Thank you. 

Governor Bies. 

STATEMENT OF SUSAN S. BIES, GOVERNOR, FEDERAL RESERVE BOARD OF GOVERNORS, FEDERAL RESERVE SYSTEM 

Ms. BIES. Thank you, Mr. Chairman, and I appreciate the attention of the Members of the Committee. 

First of all, I think holding this hearing at this time recognizes 

the major events that have occurred in the last month, where we 

have issued the Basel II NPR and also the market risk NPR which 

will, for the first time, provide similar capital treatment for securities and banking firms in the United States. It implements a global 

accord between the Basel Committee on Banking Supervision and 

IOSCO, and I think that also is a major step forward in getting a 

more level playing field. 

Let me focus today in my remarks on Basel II and where we are. 

As has already been mentioned, Basel II and our NPR are proposing that the core banks, who we define as the very largest and 

internationally active banks—it would be about a dozen—would 

have to adopt the most Advanced Approaches, the A–IRB for credit 

risk, and the Advanced Measurement Approach, the AMA for operational risk. 

The U.S. proposed framework has been compared with the Basel 

framework other countries will implement where there are a variety of options in the Basel II framework. One point I would like 

to make, though, is in many countries Basel I goes away when that 

country adopts Basel II. We have made the choice in the United 

States to maintain Basel I for the vast majority of our banking institutions. For those countries where Basel I goes away, banks in 

those countries who are both small and large, therefore, need a variety of approaches. And so some of the Standardized Approaches 

were designed by the Basil Committee with the smaller, simpler organizations in mind when Basel II was drafted. And I think that 

is one of the questions we will want to get comments on in the 

NPR, of how that would apply in the United States. 

The other point I would like to make is that we do know that 

while there is large variety, the largest globally active banks at 

this time are indicating that all of them are going to adopt the Advanced Approaches, and that has been stated most recently in a 

public format in the Basel Committee’s report on QIS–5. The 

United States did not participate, but the other major countries 

did, and that is what the large international banks indicated at 

that time. 

Chairman SHELBY. Does that include the Japanese banks? 

Ms. BIES. Yes. 

We also have focused so much attention on Pillar 1, I hope people 

also recognize that Pillar 2 is there. Pillar 2 involves processes to 


jbell on DSKDVH8Z91PROD with HEARING
12 

address the kinds of risks that aren’t captured in credit or operational risks in Pillar 1. It can require additional capital if there 

are those other risks, and it is part of the supervisory process that 

makes the Basel II Framework so effective. 

Finally, in looking at alternative approaches under Basel II, we 

also hope we get comment on what the implications are for Pillar 

3. Pillar 3 is the public disclosure standard of the Basel II Capital 

Accord. One of the challenges here is that we had envisioned in the 

U.S. NPR to have the very complete disclosure of risk that the 

more sophisticated models would entail. The question then is: will 

the disclosures under a Standardized Approach to Pillar 1 be sufficient to give good disclosure of how risks are managed so we have 

market discipline about risk-taking of the largest organizations. 

We continue to believe at the Fed that Basel I is inadequate for 

the largest, most complex U.S. banking organizations because they 

cannot fully capture the array of risks that these institutions face. 

Basel I does not recognize operational risk embedded in many services, and in our Basel I NPR that we are working on, as we did 

in the A–NPR, we do not anticipate an operational risk. Now there 

is a question that has been added about how to deal with operational risk if we provide a standardized credit risk approach. 

Basel I also does not differentiate the riskiness of assets within 

asset types, and we have learned that the large organizations have 

quite a variety of the kind of risk exposure even though they have 

similar asset types. 

Basel II draws upon many of the economic capital models that 

the banks use for their own risk management. But one of the challenges that we have seen is understanding the validity that these 

models have because they have different approaches. Already 

through the working in QIS–4 and –5, regulators are understanding that by requiring a more standardized framework, it allows us more effectively to have transparency into how those models work and gives us an ability to assess and identify weaknesses 

in risk management models. And for that reason, we also think 

that it is an important goal to support Basel II. 

We will continue to work on QIS–4 questions. We have strengthened Basel II in the NPR, and I would note that some of the things 

that we have strengthened, the Basel Committee in QIS–5 also 

noted as areas that need further attention by the Basel Committee. 

And so many of the things we already have put in our NPR I think 

create timing differences and will be addressed on a global basis 

as the regulators worldwide work to completion of the Basel II. 

Finally, I would say, as the central bank, the Federal Reserve 

has responsibility for maintaining stable financial markets and ensuring a strong financial system, and that mandates that we require banking organizations to operate in a safe and sound manner 

with adequate capital that appropriately supports the risks they 

choose to take. 

And for that reason, the Federal Reserve will continue to work 

to make sure that Basel II is implemented in an effective and safe 

and sound manner. 

Thank you. 

Chairman SHELBY. Thank you, Governor Bies. 

Director Reich. 


jbell on DSKDVH8Z91PROD with HEARING
13 

STATEMENT OF JOHN M. REICH, DIRECTOR, 

OFFICE OF THRIFT SUPERVISION 

Mr. REICH. Thank you, Chairman Shelby. I appreciate the opportunity to present the views of the Office of Thrift Supervision. I feel 

compelled to state that I began my banking career 42 years ago, 

in 1964, and I grew up with a generation of bankers who believed 

in two principles: one, you cannot have too much capital; and, two, 

you cannot have too much in loan loss reserves. And I hold those 

principles today as a member of the banking regulatory—— 

Chairman SHELBY. I think you are a wise man. We all do. 

[Laughter.] 

Mr. REICH. When I testified before this Committee last year, I reported on the progress with the other Federal banking agencies on 

the development of the Basel II Framework, including the then recently completed QIS–4. At the time, I noted that a number of the 

concerns with the results of QIS–4. This week, the agencies are 

publishing an NPR on Basel II. I believe the NPR addresses a 

number of the issues that are raised by QIS–4, but questions obviously remain, and there is still work to be done between now and 

full implementation scheduled for 2012. 

I do believe the addition of various prudential safeguards that 

are included in the NPR go a long way toward ensuring the safety 

and soundness of Basel II in the United States. 

Challenging policy issues remain, and we are committed to working to resolve these issues based on comments received and to be 

received from the industry and other interested parties. I believe 

that our longer implementation period in the United States will 

provide the opportunity and the time to make whatever changes 

are necessary to implement Basel II, but this is in part predicated 

upon our receipt of ample and detailed comments from institutions 

that may be directly or indirectly affected by the proposal. 

In my written statement, I detail the various challenges presented by the Basel II Advanced or models-based approach. While 

this approach attempts to level the playing field for banks around 

the world and provide a more accurate system of bank capital 

based upon risk, it is also complex and costly to implement, and 

it presents a number of policy and operational hurdles. 

As we develop a more sophisticated risk-based capital framework, it is also important that we consider the Standardized Approach, the less complex alternative to the Basel II models-based 

approach. 

The Basel II NPR requests comment on this alternative, and I 

believe it is important for the Federal banking agencies to consider 

whether a Standardized Approach could achieve a number of the 

same goals as the models-based approach, but at a lower cost and 

with greater clarity and transparency. 

A critical aspect of the Basel process for U.S. regulators is ensuring that Basel II rules do not competitively disadvantage U.S. institutions that may choose to continue operating under the Basel Ibased approach. In addition, to address competitive equity concerns, as well as to modernize capital rules for institutions other 

than the core institutions that are expected to operate under Basel 

II, the banking agencies are also working on modernizing the existVerDate Nov 24 2008 01:21 Nov 24, 2009 Jkt 050306 PO 00000 Frm 00017 Fmt 6633 Sfmt 6602 E:\HR\OC\A306.XXX A306

jbell on DSKDVH8Z91PROD with HEARING
14 

ing Basel I rules, and we expect to release the Basel IA NPR in 

the near future. 

Before my time as the Director, OTS was an early advocate of 

comprehensively revising and modernizing Basel I. We strongly 

support amending the existing Basel I standards simultaneously or 

in close proximity to Basel II to improve the risk sensitivity of the 

current capital framework without unduly burdening affected institutions. 

Finally, while Basel IA is intended to increase risk sensitivity 

and minimize potential competitive inequities from Basel II, many 

highly capitalized institutions have indicated that they will likely 

prefer to continue operating under the rules of Basel I. I am particularly dedicated to the proposition that we should not unduly 

burden these institutions, and I support this flexibility consistent 

with balancing safety and soundness with regulatory burden concerns. 

The Federal banking agencies anticipate issuing the Basel IA 

NPR within the next month, and as with the Basel II NPR, we encourage comment on the flexibility of this system operating parallel 

with Basel and Basel II-based standards. 

OTS supports the goals of Basel II, and we are prepared to make 

whatever changes may be required during the next few years of 

transition in order to make Basel II work satisfactorily for U.S.- 

based institutions. We look forward to continuing the dialog on 

Basel II and the parallel implementation of the Basel IA rulemaking, and we will continue to work with this Committee, with 

the industry, and with our fellow Federal banking regulators. 

Thank you. 

Chairman SHELBY. Ms. Taylor. 

STATEMENT OF DIANA L. TAYLOR, SUPERINTENDENT OF 

BANKS, NEW YORK STATE BANKING DEPARTMENT 

Ms. TAYLOR. Good morning, Chairman Shelby, Ranking Member 

Sarbanes, and distinguished Members of the Committee. Mr. 

Chairman, before I begin my oral statement, I would like to pay 

tribute to Senator Sarbanes for his many dedicated years of service 

on the Senate Banking Committee. Senator Sarbanes has been a 

wonderful person to work with. He has been a true friend to the 

States and a staunch protector and defender of States rights, and 

we will miss him. 

Adoption of Basel II clearly has potential domestic implications 

that could affect our banking system and our economy. Specifically, 

we must understand the impact of these regulations on safety and 

soundness and competitive equity. 

CSBS is fully supportive of the original objectives and goals of 

Basel II to better align regulatory capital requirements to underlying risks and to provide incentives to banks to hold lower-risk assets in their portfolios. However, the changes that would be implemented by Basel II must be well understood and must not have unintended consequences that may prove harmful to our valuable 

banking infrastructure which has served us so well for so many 

years. 


jbell on DSKDVH8Z91PROD with HEARING
15 

Therefore, before we decide to move ahead with the implementation of Basel II’s Advanced Approaches, I believe we need to address a number of important issues. 

First, the results of QIS–4 in the United States showed a drastic 

drop in required capital. My fellow State supervisors and I have 

traditionally been vigilant with regard to capital requirements because of the pivotal role capital plays in ensuring safety and soundness and in stimulating economic growth. It is our responsibility to 

ensure that changes in capital requirements are prudent, do not 

unduly benefit one type of bank over another, and that any transition to a new calculation of capital is carefully managed. In fact, 

a major concern of mine as a State banking supervisor is that if 

Basel II goes into effect as currently constructed, the result could 

be a further erosion of the dual banking system and our Nation’s 

broad and diverse financial industry. 

Second, in order to successfully implement regulations such as 

Basel II in the United States, I believe State supervisors must have 

a more substantive role in the drafting and implementation process. We are very appreciative of Governor Bies’ willingness to provide regular briefings to State supervisors on the status of Basel 

I and Basel IA. However, despite our status as the primary supervisor for most institutions, we have not been included in the drafting process of either Basel II or the Basel IA NPR. 

Third, CSBS is pleased with the inclusion of several safeguards 

that have been incorporated into the Basel II NPR. Primarily, the 

maintenance of the current leverage ratio is crucial in preserving 

safety and soundness in the domestic banking system. We commend Chairman Bair for initiating a dialog on the need for an 

international leverage ratio. This would be a significant step to 

strengthening the international banking system. 

I am aware of the criticism of the so-called conservativism of the 

U.S. approach to Basel II and the concern about international competitiveness. I do not believe we should be basing competitive equity on reduced capital. Also, this is an unfounded criticism. U.S. 

banks currently hold more capital than international institutions, 

yet our banks are generally more profitable than their international counterparts and remain highly competitive. 

I agree that our banks must remain internationally competitive, 

but our first priority must be preserving the safety and soundness 

of the system and then ensuring a level playing field for our domestic institutions. 

We now have the opportunity and the responsibility to make sure 

that when Basel II is implemented in the U.S. it will meet the objectives first put forth in 1999. I propose that we consider simpler 

Basel II options until we better understand the consequences of 

adopting Basel II’s Advanced Approaches. Therefore, CSBS recently requested that the Federal agencies seek public comment on 

offering the Standardized Approach in the United States. The 

agencies have included such a question in the Basel II NPR, and 

we commend them for doing so. In my opinion, it is possible that 

adopting the Standardized Approach could allow us to increase the 

risk sensitivity and comprehensiveness of current risk-based capital requirements and establish uniform capital requirements 

across all institutions. Our domestic financial system could benefit 


jbell on DSKDVH8Z91PROD with HEARING
16 

from a less complex, more risk sensitive approach to monitor riskbased capital requirements. 

Ultimately, the intention of Basel II is to produce a stronger 

international system that does not weaken our domestic dual banking system. The objectives put forth in 1999 must be met as we implement Basel II in the coming years. In our rush to improve safety 

and soundness and competitive equity in the international system, 

we absolutely cannot afford to weaken safety and soundness and 

competitive equity in our domestic institutions. As U.S. regulators, 

our first priority must be to our domestic institutions. 

I commend you, Chairman Shelby, Ranking Member Sarbanes, 

and the distinguished Members of the Committee for addressing 

this matter. On behalf of CSBS, I thank you for this opportunity 

to testify, and I look forward to any questions. 

Chairman SHELBY. Thank you. 

I will address this first question to Chairman Bair and Governor 

Bies. For capital requirements to be effective, regulators must have 

a reasonable approximation of what the proper level of bank capital 

should be. Using that approximation, they can then determine 

whether capital requirements are too strict or too lax. A key question for Basel II is whether the expected declines in capital will 

leave U.S. banks undercapitalized. 

Would you comment, starting with you, Ms. Bair, on whether 

U.S. banks are sufficiently capitalized at the present time or 

whether they are over- or undercapitalized? And then explain how 

you arrive at your conclusion. And how confident are you about 

what capital levels will be under Basel II? Do you have an estimate 

of the number of Basel II banks whose capital will fall enough to 

hit the floors of the Basel II NPR? 

That is a mouthful. 

Ms. BAIR. A long question. [Laughter.] 

Well, I am very comfortable with current capital levels, yes, and 

I would repeat—— 

Chairman SHELBY. Do you believe that our banking system is in 

good shape today? 

Ms. BAIR. Absolutely. The banking sector is healthy. All indications are that it continues to be healthy, even though we are seeing 

some softening in certain areas. I think our capital standards are 

relatively high vis-a-vis other non-U.S. jurisdictions. That plays a 

crucial role in the health of our banking system. 

I would like to note, when Basel—I was not around when Basel 

II started, but going back and reading the materials of the Basel 

Committee itself and its pronouncements, consistently you will see 

that the Basel II process was not supposed to be about lowering 

capital. It was supposed to be about making the risk-based capital 

framework more risk sensitive, not about lowering capital. So it is 

frustrating to me—go ahead. 

Chairman SHELBY. But the lowering of capital has gotten into 

the equation. 

Ms. BAIR. It certainly has. 

Chairman SHELBY. OK. 

Ms. BAIR. That is a frustration to me because I see a healthy 

banking sector now, one that has been healthy for many years, and 

I see, as others have testified, banks, if anything, hold higher capVerDate Nov 24 2008 01:21 Nov 24, 2009 Jkt 050306 PO 00000 Frm 00020 Fmt 6633 Sfmt 6602 E:\HR\OC\A306.XXX A306

jbell on DSKDVH8Z91PROD with HEARING
17 

ital than their regulatory requirements. So it does not immediately 

suggest to me that banks themselves think their capital is too high. 

I think going forward the QIS–4 results were very troublesome. 

We do not know if QIS–4 is an accurate predictor of what will actually happen under the Advanced Approaches. Some analysis suggests that actually the capital requirements—the risk-based capital 

requirements—could be even lower than suggested by QIS–4. It requires a lot more analysis. 

If we go by the QIS–4 results, though, most of the banks participating in QIS–4 would be considered to be undercapitalized if that 

was the only constraint setting their capital. So, yes, I think that 

is why all the regulators viewed QIS–4 as unacceptable and why 

we need a lot more work and analysis before we know whether this 

is going to work or not. 

Chairman SHELBY. Do you have an estimate of the number of 

Basel II banks whose capital will fall enough to hit the floors in 

the Basel II NPR? 

Ms. BAIR. I do not know the number off the top of my head. We 

could provide it for you. 

[The information follows:] 


jbell on DSKDVH8Z91PROD with HEARING
18 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 51 here 50306A.001
19 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 52 here 50306A.002
20 

Chairman SHELBY. Can you do that for the record? 

Ms. BAIR. The QIS–4 participants, which included both core and 

opt-in banks, most of them would have been below PCA levels. 

Chairman SHELBY. Governor Bies, do you have any comments in 

that area? 

Ms. BIES. Well, let me start by echoing what Chairman Bair just 

said, that none of the regulators would have accepted the state of 

the databases and models for any of the banks that participated in 

QIS–4. 

Having said that, as we got in and looked at the QIS–4 information, we really did find areas where either the models as we had 

defined them in our regulatory framework or where the banks were 

in the stage of implementation made us want to include additional 

safeguards in the NPR to strengthen capital in a few areas. And 

we have done that in this NPR. And there are a lot of other areas 

that we hope to get some input on. 

One of the interesting things is that, in the discussion about how 

much capital can drop under Basel II, it is important we differentiate between regulatory minimum capital and actual or total capital that banks hold. Today, banks hold way above regulatory minimums because they are driven more by the marketplace and the 

rating agencies and other investors who also require strong capital. 

So there is more than one constituency here in terms of looking at 

total capital. 

So it is not clear to me, no matter what minimum regulatory capital does, how much that will affect banks’ actual capital. 

But we want to make sure, as we work through this, that there 

is enough capital for the different risks, both in this NPR and 

in—— 

Chairman SHELBY. Well, that is the basis of a sound banking 

system, is it not? 

Ms. BIES. It is. And one of the challenges we have is the banks 

use economic capital models internally that are very similar to 

what we have specified. The big difference is the banks use them 

to manage their strategy. Long run, where are they going? What 

is the kind of variation they are likely to encounter? But as regulators, we want capital to be there when the banks come under 

stress, and so we tend to focus on downturn events and more of the 

tail losses than the banks do in their internal models. And that is 

one of the reasons we are asking for more capital—that is, higher 

minimum regulatory capital—than many of them have in their internal models. 

Again, the comments we hope to get on the Basel II framework 

will help strengthen that, but we want to make sure we are comfortable that the capital is there in those stress periods. 

Chairman SHELBY. Governor Bies, Senator Sarbanes brought 

this up a few minutes ago. But former FDIC Chairman William 

Isaac, who is well respected in the banking area, has raised serious 

concerns about the reliability of the data that banks will collect 

and compute to determine their capital requirements understand 

Basel II’s Advanced Approach. In prior testimony to this Committee, former Chairman of the FDIC Isaac noted that banks do 

not have loss data going back far enough and that mergers and acVerDate Nov 24 2008 01:21 Nov 24, 2009 Jkt 050306 PO 00000 Frm 00024 Fmt 6633 Sfmt 6602 E:\HR\OC\A306.XXX A306

jbell on DSKDVH8Z91PROD with HEARING
21 

quisitions in the banking industry have left banks without consistent data. 

To what extent, Governor Bies, will these problems with data collection—knowledge, in other words—undermine the effectiveness of 

Basel II’s Advanced Approach? Have you taken this into consideration? And, if not, will you? 

Ms. BIES. We are taking it into consideration. It is one of the 

things that we spent a lot of time analyzing in the QIS–4 results 

and our foreign counterparts did in QIS–5. 

When we look at the capital, we know that all of these models 

are providing estimates. Banks also are creating new products all 

the time, and one example would be the new mortgage products 

that some of us are very concerned about that the banks are underestimating risk. But that is why I emphasize that Pillar 2—— 

Chairman SHELBY. Mortgage products with no downpayments, 

all those kind of things. 

Ms. BIES. Those negative ams and payment shocks and all those 

wonderful bells and whistles. 

Chairman SHELBY. That should keep bank regulators up at 

night. 

Ms. BIES. It keeps us awake at night, and that is why Pillar 2 

is so important. It allows us as supervisors, where we feel either 

it is a new product, the model is not reliable, or it has a kind of 

risk that the Pillar 1 does not pick up—because Pillar 1 does not 

pick up all risk. We can specify additional capital the banks have 

to hold beyond their Pillar 1 numbers. 

Chairman SHELBY. Chairman Bair, I am not picking on you. 

Ms. BAIR. That is all right. 

Chairman SHELBY. You just have a big portfolio here. All of you 

do. But in your testimony, you call for considering an international 

leverage ratio as a way to eliminate the competitiveness concerns 

presented by the retention of the leverage ratio under Basel II, as 

well as a way to improve global capital standards. 

Could you discuss with us the idea here a little further today and 

whether foreign regulators would be receptive to the idea? 

Ms. BAIR. Thank you, Mr. Chairman. Yes, the leverage ratio is 

obviously a very simple capital-to-assets ratio. There is no cost to 

implement it. It is a hard number; it is an easy-to-determine number. 

We have had many years’ experience with it. It has worked very, 

very well for the banking system. Canada is the only other country 

that has something like a leverage ratio, and the way they calculate theirs is a little different from ours. But I have been engaged in conversations at the staff level and at the principal level 

with other Basel country members and their representatives. I will 

be going to Mexico next week for the next Basel Committee meeting and hope to be talking more and will be formally pushing to 

have an international leverage ratio put on the agenda. 

Some responsiveness, some reluctance, a lot of reticence. This obviously is new—not a concept that has been embraced heretofore. 

But, I think particularly as we look at the potentially dramatic 

drops in risk-based capital under the Advanced Approaches as we 

are moving forward, and it is not just U.S. banks that are seeing 


jbell on DSKDVH8Z91PROD with HEARING
22 

this, that that can make the leverage ratio more attractive as a 

hard baseline. 

We are not sure we are getting it right with the Advanced Approaches. That is why we need more work. We are not sure that 

we are actually measuring risk under risk-based capital, and one 

of the good things that would occur through the leverage ratio is 

to give us a baseline, if we are not getting it right, at least providing a floor under which capital could not drop. 

Chairman SHELBY. Senator Sarbanes. 

Senator SARBANES. Well, thank you very much, Mr. Chairman, 

and I want to thank the panel. I know you summarized the statements, and I have been through the statements, and I appreciate 

the time and effort that obviously went into them. 

Chairman Bair proposed that we negotiate an international 

agreement to establish a common leverage ratio in her testimony. 

In the next panel, Professor Tarullo supports that concept with the 

recommendation that it includes off-balance-sheet activities as well. 

The first question I want to put: Is there anyone at the table who 

holds the position that the United States should not continue to require the leverage ratio? I take it everyone takes the position that 

we should require the leverage ratio. Is that correct? 

All right. Now, if we continue the leverage ratio, is there any reason not to seek an international agreement on a common leverage 

ratio? What is the argument, if any, against at least undertaking 

this initiative? Basel I, after all, as I recall, was an effort to raise 

the amount of capital in the international banking system, which, 

of course, is a very deep concern of ours. And Professor Tarullo in 

his statement, which is coming later in the morning—I would like 

to get these up in front of you, because you all testify and then you 

up and go away, and then these other folks come on, and they 

make these statements, and we do not have you here to sort of respond to them. So I am trying to get the horse ahead of the cart 

in this respect. 

He says, ‘‘The last thing many Basel Committee members want 

to do is to return to negotiations over international capital standards. Understandable as that sentiment may be, I would nonetheless urge our banking agencies to use the breathing space created 

by adoption and implementing regulations for Basel II to pursue alternatives both domestically and internationally. The problem with 

the A–IRB approach more than justified this response. At this juncture, the most promising approach may be a relatively simple 

international minimum capital rule accompanied by complementary domestic measures for achieving appropriate bank risk management and by enhanced international cooperation supervising 

complex, multinational banks. Specifically, I would suggest that the 

banking agencies raise with the Basel Committee the idea of an 

international minimum leverage ratio.’’ 

Then he recognizes that it is a simple rule that does not necessarily address all the complexities, but he says, ‘‘Because of its 

very simplicity, it is far more transparent in its application, far less 

easy to manipulate than more complex regulatory capital requirements. It can serve, as it does today in the U.S., as a useful warning sign to regulators and markets. Its application could be fairly 

easily monitored domestically and internationally.’’ 


jbell on DSKDVH8Z91PROD with HEARING
23 

So I come back to my question. If you all believe we should have 

the leverage ratio, is there any reason not to seek an international 

agreement on a common leverage ratio? Mr. Dugan, why don’t we 

begin with you and go right across the panel. 

Mr. DUGAN. Sure, Senator. Chairman Bair has put this issue on 

the table, but it is not one that we have had a chance to meet on 

as a group and discuss. 

You have stated the issue quite well in terms of our being committed to the leverage ratio in the United States. It has worked 

well here. Just by way of background, other regulators have not 

imposed a leverage ratio in their countries and in the past have 

been quite adamant, in many cases, about not believing it is appropriate. 

I think the concern that some of us have had is if this gets put 

into play internationally, what is the tradeoff? What is the potential price that we would have to pay in such a negotiation? How 

would such a leverage ratio be computed? Would there be a risk 

that our particular leverage ratio would be decreased as a matter 

of international harmony? Because, after all, the Basel Committee 

is not and never has been intended to result in identical capital requirements set by an international standard body. There has always been an element of national discretion. And, while we prefer 

the leverage ratio in our country, there are other aspects of the Accord that other countries prefer that we do not like. I would want 

to see what the entire package was before committing to it. I think 

those are the kinds of concerns that we need to think about as we 

discuss this issue. 

Senator SARBANES. Are those concerns so weighty in your mind 

that you would not even put it on the table for discussion? 

Mr. DUGAN. I think that is the discussion we ought to have as 

an interagency group. We really have not had any serious discussion about the pros and cons, and I would like to have that discussion. 

Senator SARBANES. Ms. Bair, I already know your position, but 

go ahead. 

[Laughter.] 

Ms. BAIR. Well, I would be happy to have anytime, anywhere, 

even more discussions on this. I think it is very hard to argue 

against at least having a debate on something. And I think we all 

agree that any discussion of eliminating the leverage ratio is off the 

table domestically. I hope the representatives of the large banks 

sitting behind me that are concerned about competitive disparities 

and treatment are listening to that, because they are going to have 

a leverage ratio here in the United States. So it seems to me that 

if people are worried about competitive disparities, frankly, I am 

more worried about liquidity and stability in the global banking 

system, particularly if we see further declines internationally in 

risk-based capital, which right now is the only constraint for the 

vast majority of Basel countries. So I think getting it on the table, 

at least forcing people to talk about it, is very, very important. We 

can control where it goes. I am not going to make any significant 

concessions on our own standards to get the debate going, but I 

think that we do need to have the debate. And since we are starting with a zero baseline for most Basel countries since they have 


jbell on DSKDVH8Z91PROD with HEARING
24 

no leverage ratio, anything we can get them to do is going to raise 

the bar up in those countries. 

Senator SARBANES. Ms. Bies. 

Ms. BIES. Senator, I think we should raise the issue at the Basel 

Committee. As Mr. Dugan just commented, this has been raised before at other periods, and other countries have been very vocal 

against the idea. 

I think one of the challenges we will have is the legal framework 

in different countries in terms of the kind of activities that go on 

within a bank varies, and that is why we have made more progress 

using a risk-based framework where similar activities are treated 

similarly. We would have to anticipate how to deal with that issue 

because that is sort of the heart of each nation’s ability in terms 

of powers within the banks. 

Senator SARBANES. Mr. Reich. 

Mr. REICH. Senator, when OTS has a seat at the Basel table, I 

will be happy to join Chairman Bair in advocating for an international leverage ratio. 

[Laughter.] 

Senator SARBANES. OK. Fair enough. 

Ms. Taylor. 

Ms. TAYLOR. Ditto, Chairman Reich. 

Chairman SHELBY. Senator Carper. 

STATEMENT OF SENATOR THOMAS R. CARPER 

Senator CARPER. Thanks, Mr. Chairman. To our witnesses, welcome. It is good to see you. Thank you for joining us today. 

I do not know if my Chairman and Ranking Member have ever 

used this before, but a lot of times issues come before us, and we 

are divided. We are not sure really how to go, and oftentimes we 

will see some of my friends are for it, some of my friends are 

against it, and I am for my friends. 

In reading through my briefing materials for this hearing today, 

it looks like some banks, including some banks that have substantial operations in Delaware, are for this and some are not. And I 

understand we are starting a 120-day comment period so that everybody can weigh in and say what they believe is good or bad 

about this? 

Do I understand that there are about 20 banks in this country 

that would be affected? Is that correct? 

Mr. DUGAN. There are about a dozen core banks that, as proposed, would be mandatory, and then there is another group of 

banks that has talked about opting in. 

Senator CARPER. And it is their choice, opt in or opt out? Why 

would they opt in as opposed to opting out? What is the rationale 

for that? 

Mr. DUGAN. I think the rationale is that the Advanced Approaches are viewed as a more sophisticated system that address 

for large banks the kinds of risks that they would be involved with 

anyway. The notion is—and we heard this actually with the securities firms that testified on the other side—that it is a measure and 

an indicia of being a large, sophisticated player. If it became a 

standard, large banks would get measured against it, and they 


jbell on DSKDVH8Z91PROD with HEARING
25 

want to rise to that level, assuming it is a more rigorous way to 

measure risk in the system. 

Senator CARPER. For the banks, especially American banks, I understand there are three or four that really like this approach, and 

some that are less enamored with it. But for the ones who really 

think this is the right thing to do, what—I think I understand the 

rationale, but what is it? 

Mr. DUGAN. I think the idea is that there is support for tying 

capital more closely to risk—that is how they do it themselves— 

and a recognition that the current system is not a very good measure of that. Among other benefits, if there were a common way that 

it was done, regulators would understand better how this was computed, and there would be disclosures to markets that would reward banks that had a less risky profile according to the risk-based 

capital measurements of the Advanced Approaches. So there are 

several reasons why institutions would think this was a positive 

thing, if it were done correctly. The devil is in the details, as you 

will hear. 

Senator CARPER. All right. Others, please. 

Ms. BIES. Senator, I think one of the other issues that we hear 

as we talk to banks, not only in the U.S. but globally, the sophisticated models that banks use to run their shops day to day are very 

opaque to the outside world. And what Basel II, especially the Advanced Approaches, does is give them the confidence that regulators, in a common framework that we set out as requirements are 

confident the bank’s measure of risk is within the range of the expected variance for the risk exposure and it is done in a consistent 

way. Today they all do it in different manners. 

The additional disclosures that are required in Pillar 3 compared 

to what is there today would give users of financial statements and 

bank customers and investors better information about the nature 

of risk the bank is taking. And as they go through time and see 

what real risks are from period to period, they can look at how reliable the bank’s risk management practices are and how well they 

anticipate the kinds of situations that could create loss for that organization. 

Senator CARPER. Among the 12 or so banks that will be directly 

affected—they do not have a choice; they are going to be in whether 

they opt in or not—the folks that are less enamored with this approach, what are they saying? What are their concerns? Are they 

legitimate? 

Mr. REICH. Too costly, too burdensome; that the regulators have 

added some safeguards which make it less conducive, less beneficial to them. 

Senator CARPER. So it is burdensome, it is costly, it is not beneficial. But other than that, they are OK—— 

Mr. REICH. Other than that, it is a good thing. 

[Laughter.] 

Senator CARPER. Let us say that you lived in Salisbury, Maryland, or Foley, Alabama, or—— 

Chairman SHELBY. Tuscaloosa, Alabama. 

Senator CARPER. Whatever. Or Lewes, Delaware. Why should 

you care about this stuff? Why is it important to folks there? 


jbell on DSKDVH8Z91PROD with HEARING
26 

Mr. DUGAN. I had an outreach meeting with a group of community bankers last week, and I think there is a recognition that the 

very largest institutions are in a very different business in many 

ways from the community bankers, and there is a concern that if 

ever there were a problem with a large institution, it would affect 

the entire system. 

So there is concern, and I get this question all the time: What 

are you doing to make sure you have your arms around the complex risks that the largest institutions take? And one of the answers, one of the fundamental reasons we are trying to get Basel 

II right, is because it is an opportunity to move toward a more sophisticated approach and to enhance risk management in a way 

that allows us to look across our largest institutions to help ensure 

that they operate in a more safe and sound manner, given the very 

different and very complicated types of risks that they take as they 

perform their function in the economy. 

Senator CARPER. Ms. Bair, do you want to add anything to that? 

Ms. BAIR. Yes, I would, because I think we all agree that complex 

banks need complex risk management tools. The question is whether you tie that to capital reductions, whether you use capital reductions as an incentive or whether under our supervisory powers, the 

banks under our jurisdiction, we ask them to have risk management systems that are conducive to their business model. So I 

think that is really where the issue is, not with regard to whether 

complex banks need complex risk management tools. 

Also, in the sense that these models that we are requiring banks 

to implement in the Advanced Approaches are giving us accurate— 

complex as they are—risk measurements, that is a very, very key 

question. The QIS–4 results showed that there were wide dispersions in how large banks were measuring risk for identical exposure. So that suggests to me that these complex models need a lot 

more work before we can have confidence that they are really giving us precise measures that might justify reductions in capital. 

Senator CARPER. My time is expired. Can I just ask one more 

quick question? 

Chairman SHELBY. Go ahead. 

Senator CARPER. After 120 days goes by and people have had a 

chance to comment, what happens? 

Ms. BAIR. We will all come together and make a decision. 

[Laughter.] 

I would say I want to pay tribute to Sue Bies in particular for 

the leadership she has shown and her knowledge on this issue. And 

as you can tell, we have differing perspectives, different emphasis, 

different questions. But I think everybody has worked together 

very collegially to try to come together. We did it with the Basel 

II NPR. We are doing it again with the Basel IA NPR. And I think 

when we go to final rulemaking, it will be that same collaborative 

spirit. 

Senator CARPER. All right. Thanks. 

Ms. BIES. I would just like to add that, you know, we will be 

coming out next month with the Basel I NPR, and so both the 

Basel II and Basel IA NPRs will be out for comment, because we 

also care about the competitive issues within the U.S. banking system. So we want to look at all the comments from both proposals 


jbell on DSKDVH8Z91PROD with HEARING
27 

and look at how they fit together and see if we have struck the 

right balance and have addressed the concerns of banks of all sizes, 

and that we end up with a strong capital framework going forward. 

Senator CARPER. Great. My thanks to each of you. 

Thanks, Mr. Chairman. 

Chairman SHELBY. Thank you. 

I think this is a very important hearing, not just for you, the 

panel, but for us and the public. I will direct these questions to 

Comptroller Dugan, Director Reich, and Superintendent Taylor. 

Basel II will not only impact the large banks that adopt it, but 

also smaller banks that will have to compete with those Basel II 

banks that will then have different and possibly lower capital requirements. Will the significant up-front costs necessary to qualify 

to use Basel II serve as a barrier, Mr. Dugan, to entry that will 

prevent banks from growing and becoming large enough to qualify 

for Basel II? In effect, will Basel II cement the position of the largest U.S. banks and give them a competitive advantage over all 

other banks? 

Community banks are especially concerned about how Basel II 

will impact them. Could you please comment on the steps that you 

have taken both to address the competitiveness issues between 

Basel II banks and community banks and to address concerns that 

Basel II will reduce loans to small businesses, which could have an 

impact on our economy? Are there additional measures necessary? 

We will start with you, Mr. Dugan. 

Mr. DUGAN. Thank you, Mr. Chairman. That is exactly why we 

are putting Basel IA out for comment. You are right, it takes a 

very substantial investment in order to qualify for Basel II, and ordinarily that would be out of reach for community banks. So the 

question is: In the way that Basel II is structured, does it create 

a competitive imbalance that is serious enough that we have to 

worry about ways to address it? We are concerned about that, and 

Basel IA is an effort to address some of those issues. I cannot say 

it is going to be an identical rule. If it were, we would have Basel 

II all over again. The question is: Have we struck the right balance 

there? 

In terms of small business lending, there was a proposal in the 

international version of Basel II that created a specific capital 

break, if you like, for small business lending that we did not include in the notice of proposed rulemaking for Basel II precisely because of this capital question. But the comparison between that 

treatment in Basel II and Basel IA is exactly why we need to put 

this out for comment and hear from people, and why we have been 

advocating an overlapping comment period so we get both sets of 

rules on the table before we get to the decisions of how to go final 

on both proposals. 

Chairman SHELBY. Director Reich. 

Mr. REICH. Well, I am very concerned about the impact on community banks with the changes that are being proposed, and I will 

be vigilantly defending and looking out for the interests of community banks as we go forth with Basel II and Basel IA and Basel 

I. 

One of my greatest fears at the outset a few years back about 

Basel II is that it might result in accelerated industry consolidation 


jbell on DSKDVH8Z91PROD with HEARING
28 

and the disappearance of community banks from the scene. I do not 

want to see that happen. 

Chairman SHELBY. Could that have an adverse effect on our job 

creation machine, small business? 

Mr. REICH. Absolutely. It would have tremendous social costs to 

local communities. 

Chairman SHELBY. Ms. Taylor. 

Ms. TAYLOR. Once again, I want to say ditto to Chairman Reich. 

I agree with everything that he said. I am very concerned about 

the competitive imbalance, potential competitive imbalance between the very large banks which take the advanced IRB approach 

as opposed to the smaller banks. And I am very happy that the two 

comment periods for Basel II and Basel IA are overlapping. 

Chairman SHELBY. I have a number of questions here for Governor Bies and Comptroller Dugan, and you might want to do this 

for the record, but we would like to have this information. 

We would like to better understand your agencies’ decision to request comments in the Basel II NPR on whether banks should be 

allowed to choose the Standardized Approach. Your agencies had 

previously decided that Basel II banks would only be allowed to use 

the Advanced Approach. 

So my question is: Why did your agencies originally decide not 

to allow banks to use the Standardized Approach? Second, why 

have you now decided to re-evaluate this decision? And, third, what 

factors will you consider when deciding whether to allow banks to 

use the Standardized Approach? Given that Fed Chairman Ben 

Bernanke, during his last appearance before this Committee, expressed concerns about whether the Standardized Approach is appropriate for large global banks, is the Standardized Approach a realistic alternative for our biggest banks? 

You might want to do that for the record. Do you want to comment on it now? 

Ms. BIES. Let me just make one—— 

Chairman SHELBY. Because this is a mouthful here. 

Ms. BIES. Right. I would like to do a written comment, but let 

me just put one thing in perspective. 

When we chose to go with the core group of banks, about a 

dozen, we were focusing on the complex organizations. The complex 

organizations, we feel, need some risk framework that reflects the 

kind of positions they are taking, the sophisticated instruments 

they are using. But the comment letters and requests that we recently got come from small organizations, too. And the Standardized Approach, as I have commented on, is in Basel II for the countries who no longer have Basel I for their smallest organizations. 

So the way the questions are teed up, you will see the way Basel 

IA is teeing it up, to ask how could a Standardized Approach be 

used, and for what institutions is it appropriate. And we want to 

hear comments on this because if we want to change direction we 

want specific input—that is why we are still in the comment period. 

Chairman SHELBY. Would you give us a comprehensive answer 

on that for the record? Because our staff and all of us would like 

to closely look at that. 

Mr. DUGAN. Mr. Chairman, if I could just add one point briefly? 


jbell on DSKDVH8Z91PROD with HEARING
29 

Chairman SHELBY. Yes, go ahead. 

Mr. DUGAN. We will be happy to provide an answer for the 

record. The Standardized Approach, the one that was adopted for 

the international community, has some hard risk weights that 

raise some concerns about whether they would be appropriate in 

the United States, and we will have to look at what would be an 

appropriate version in the United States if we were going to go 

down that path. That is exactly what we will be asking questions 

about in Basel IA, and I think that is appropriate. 

Chairman SHELBY. Ms. Bair. 

Ms. BAIR. I would just say I think that is a very central question, 

and I think key to that debate is input on, again, whether we see 

the need for further complex risk management, whether that can 

be done under Pillar 2 supervisory authorities or whether it has to 

be tied to capital levels. 

Chairman SHELBY. I will direct this question to Governor Bies 

and Comptroller Dugan. How will your agencies monitor the implementation of Basel II Advanced Approach by foreign regulators? 

Second, given that the implementation of Basel II will be opaque 

to anyone outside the banks and the regulators involved, what assurance does this Committee and, more importantly, the public at 

large have that Basel II will be implemented properly? Governor 

Bies. 

Ms. BIES. Well, first in terms of—— 

Chairman SHELBY. Because there is a lot of difficulty here. You 

have all said that. 

Ms. BIES. Yes, and we have been working very hard at this with 

our staffs now for a couple years. 

The Basel Committee a couple years ago created the Accord Implementation Group that has been working under the leadership of 

Nick Le Pan, who heads the Canadian bank supervisory authority, 

to work out answers to exactly the question you are asking: How 

do we work internationally to get to as much comparability as we 

can get? Internationally, you never get exactly the same treatment. 

But we want to identify how we are going to rely on each other and 

how, what we call our home host issues will be addressed. 

In addition, for the global banks—and luckily we are only talking 

about 50 or so that really create a lot of countries’ involvement— 

where they are in multiple countries across the globe, we actually 

have created a college of supervisors around that unique institution 

where we already are in a couple cases testing out what are the 

biggest issues, how would we deal with it, how would we implement it in different countries given different legal, national requirements, and then look at the consolidated entity. So we are 

heavily into this, in part because Europe, as you know, goes live 

in January 2007 for Basel II. So we are far along in this. 

In terms of opaqueness, when we issued the NPR this week, 

there are also some templates for additional data disclosures. Some 

of these will be made public because call report data today does not 

reflect risk-taking the way we need to for these complex activities. 

There is also some additional information that will be gathered 

by the regulators and kept confidential that will allow us to look 

across organizations at comparability. 


jbell on DSKDVH8Z91PROD with HEARING
30 

The public part of it we think will greatly give more transparency to the risk-taking of each of these organizations compared 

to what we provide today through today’s call report definitions. 

Chairman SHELBY. Ms. Taylor, I would like to direct this next 

question to you, if I could. State banking regulators oversee the 

vast majority of our Nation’s financial institutions. Hence, Basel II 

and especially Basel IA will directly affect not only the safety and 

soundness of the institutions that State banks regulate, but also 

how State banking regulators oversee State banks. 

What has been the role of State banking regulators in the process for developing Basel II and Basel IA? Have you or other State 

banking regulators been included at all in the drafting process for 

the regulations? And if not, is there a mechanism through which 

your input is taken into account by Federal banking regulators? 

Ms. TAYLOR. No, we have not had a seat at the table. 

Chairman SHELBY. You have not been consulted, basically, have 

you. 

Ms. TAYLOR. No. We have been briefed on what—— 

Chairman SHELBY. Briefed? There is a lot of difference between 

briefing and being consulted. 

Ms. TAYLOR. Yes, sir. 

Chairman SHELBY. So you have not really had any input into 

this process, have you? 

Ms. TAYLOR. No. 

Chairman SHELBY. Thank you. 

For the entire panel, and, Governor Bies, I will start with you, 

and maybe you can answer it for everybody. Where are we in the 

process with respect to hitting the expected starting date of the 

Basel II parallel run in 2008? And would delay of implementing 

Basel II have any implications for the competitiveness of U.S. 

banks and on the safety and soundness of our banking system? 

Ms. BIES. Well, obviously, it is hard to anticipate what all the 

comments are going to be around Basel II, and I think the real 

issue is going to be how close we are in the NPR to what the commenters would like us to end up with. If we hear major changes 

in the comments, it could create time pressures because we clearly 

have to get the final rule out for banks to have enough lead time 

to start and be ready for the parallel run in January of 2008. I 

think we really need to see what the comment letters are, but it 

is a very tight timetable that we are under right now. 

In terms of internationally, that could create some transitional 

issues. But, again, the AIG recognizes that different countries are 

moving at different paces. Some countries actually are moving 

ahead of the mid-year agreement. So some are further along already than we are. So we have been anticipating the transition 

issues. Further differences in timing will make those last longer, 

and it could create some longer-term implications. But we already 

are dealing with timing issues, and I think the timing issues generally are a little bit easier to deal with than the permanent differences that may happen. 

Chairman SHELBY. Up to this point, a lot of our discussion here 

today has entirely focused on the application of Basel II on domestic firms. Let’s just switch the focus for a moment and ask whether 

Basel II’s reduced capital requirements could hurt a foreign bank, 


jbell on DSKDVH8Z91PROD with HEARING
31 

foreign firm, and the collapse of that firm or bank could then have 

a ripple effect that ultimately hurts our bank or our banking system. You know, the reverse. It is always possible, is it not, that a 

large foreign bank under Basel II, which they have adopted, doing 

business in a big way in the U.S., if they got in trouble, it could 

have a ripple effect, could it not, Mr. Dugan? 

Mr. DUGAN. Yes, but the whole point of Basel II is to get onto 

a common scheme and to have more harmony in terms of capital 

requirements. The effort is to avoid exactly that result. 

Ms. BAIR. And I hate to be a Johnny One-Note, but this is one 

of the reasons why I think it is very important to get a debate 

going on an international leverage ratio, if we are seeing further 

reductions in risk-based capital, which is the only constraint for 

most Basel countries. We really need to get a debate going on leverage—another nice thing about the leverage ratio is that it is a 

constraint on leverage so it helps promote liquidity in the global 

banking system. So I think your question is very much responsive 

to the need for an international standard of leverage. 

Chairman SHELBY. Governor Bies. 

Ms. BIES. Let me just comment on how we deal with differences 

in the strength of supervision because we have this situation today. 

When a foreign bank has a legal entity in the United States, where 

any of us might be the primary supervisor, we require within that 

legal entity to hold the same kind of capital and controls that we 

would of any domestic bank. 

The additional issue, though, is when foreign bank subsidiaries 

are part of a global group, they may be branches here or they may 

rely on different control systems from the global group that are not 

in the United States physically, and that is where it is so important that we work with foreign supervisors. The Federal Reserve 

as a holding company supervisor looks at the strength of foreign 

bank supervisor in what we call our SOSA ratings, and we take 

that into account, whether we can rely or not rely on the foreign 

supervisors and whether we give that foreign entity the ability to 

operate in the U.S. on a level playing field. 

We have limited expansion or prohibited expansion by banks 

from certain countries where there has not been strength of their 

domestic supervision because of the contagion effect of something 

happening at their parent company. 

Chairman SHELBY. Mr. Reich, do you have a comment? 

Mr. REICH. Well, I would agree with Chairman Bair that your 

question highlights the importance of an international leverage 

ratio. 

And speaking to another part of your question, I think that getting Basel II right is more important than deadlines that currently 

exist, and if the deadlines need to be adjusted, as one participant 

at this table, I am willing to adjust them. 

Chairman SHELBY. Ms. Taylor. 

Ms. TAYLOR. I think it is important to get it right the first time 

when it goes out because it is a lot harder to fix if it is wrong going 

down the road than it is to fix now. 

Chairman SHELBY. Senator Sarbanes. 

Senator SARBANES. Well, thank you very much, Mr. Chairman. 

I know you want to get to the next panel. 


jbell on DSKDVH8Z91PROD with HEARING
32 

Chairman SHELBY. I think this first panel is important. 

Senator SARBANES. It certainly is. But I am going to try to be 

very quick here. 

First of all, I want to again quote what I said in my opening 

statement, quoting Bill Isaac. ‘‘This is by far the most important 

bank regulatory issue in front of us today. If we get this one wrong, 

our Nation and taxpayers will almost certainly pay a very big price 

down the line—a price that will make the S&L debacle seem like 

child’s play.’’ 

I agree with that. I think this is a very large issue. I am deeply 

concerned how we got down this path without fully examining a lot 

of the implications and consequences. It is interesting to me that 

four large banks came in now and want to be able to choose the 

Standardized Approach, which would, of course, allow them to go 

into Europe without a problem, which is—or to be in Europe without a problem, although you have that one issue you say you need 

to pay attention to. 

But the consequences here are very large. I mean, we talk about 

the effects on smaller banks and small business. Isaac, who is coming up on the next panel, says, and I quote him, ‘‘We have already 

experienced a great deal of consolidation in the U.S. banking industry, with the 25 largest banking companies now controlling some 

70 percent of the Nation’s banking assets. I am convinced that creating a large disparity in capital standards between the large and 

small banks will lead to increased consolidation, leaving fewer 

banking choices for smaller businesses. Further consolidation in 

banking is inevitable, but it ought to be driven by market forces, 

not by capital rules that favor larger banks.’’ 

And Tarullo, when he appeared here last year, said, and I quote 

him, ‘‘After seeing the risk weights that will be applied to residential mortgage and small business lending under Basel II, the 9,000 

U.S. banks that will not be applying the advanced rules will become concerned that they will be disadvantaged in competing with 

the advanced banks in those lending markets.’’ 

Second, we have talked here—the Chairman I think focused on 

it early on, and I think it is a very important issue—about the 

data. I mean, models, no matter how sophisticated, are no better 

than the data that go into them. The proposed Basel II rules require that the banks have a minimum of 5 years of data, but we 

have not had a serious recession for most lending activities in 10 

to 15 years. 

And Bill Isaac, in our hearing last year, said, and I quote him 

again, ‘‘Basel II is based on inadequate and unreliable data. It is 

virtually impossible to build reliable models with such a paucity of 

information, particularly when the decade that the available data 

covers is the most prosperous in banking history.’’ 

I mean, talk about a leap into the unknown. In fact, I am told 

that banks are being told to put a recession into their data if it is 

not there already. Now, that is an interesting approach. You know, 

we are going to, in effect, create a scenario and try to plug it into 

the model to cover a recessionary situation. 

Now, let me address this question of the international competition, that we would be at a competitive disadvantage. Isaac, in his 

testimony that is going to come, says, ‘‘It is argued that large 


jbell on DSKDVH8Z91PROD with HEARING
33 

banks from other countries will have a competitive advantage unless U.S. banks are allowed to use the advanced modeling approach. I do not buy that argument. The fact is that U.S. banks are 

by far the best capitalized, most profitable banks in the world. 

They do a great job of meeting the credit needs of business and individuals and are a major reason the U.S. has the strongest economy in the world.’’ 

He says, ‘‘Other countries should emulate the U.S. system, not 

the other way around. The U.S. should urge other countries to impose minimum capital standards on their banks, rather than enabling U.S. banks to lower their capital to unsafe levels.’’ Which, of 

course, goes to this initiative. 

Is it not the case that the U.S. already has a higher capital requirement than those abroad? 

Ms. BAIR. Yes. 

Senator SARBANES. Now, is it the view of any regulator at the 

table that these higher capital requirements have put U.S. banks 

at a serious competitive disadvantage? 

Ms. BAIR. No. 

Senator SARBANES. Well, then, what is it—I mean, we are constantly hearing this argument being advanced that we are at a 

competitive disadvantage, we have got to lower the capital standards. 

We have got the profitability of major banks, percentage of total 

average assets. There is the U.S. pre-tax profits, first on the list. 

First on the list. We seem to have been able to have better, higher, 

more quality capital standards and still sustain profitability. 

In fact, this Advanced Approach would require the banks to 

spend an inordinate amount of money to try to develop these models, would it not? Isn’t it an expensive proposition to develop these 

models? 

Mr. DUGAN. Yes, it is, Senator. I do not think any of us takes 

the position that there is a competitive disadvantage because of the 

higher capital that U.S. banks hold. I think the issue is which approach will produce a more safe and sound result for the particular 

bank. 

Senator SARBANES. All right. Now, here is what Isaac says. I bet 

you are all sorry I read this statement ahead of this witness. 

[Laughter.] 

‘‘Models are important to large banks in managing banks and 

pricing risks. They are a management tool, but are very poorly 

suited for use in setting regulatory capital standards.’’ 

Now, the banks develop these models in any event, to some extent, and would continue to do so, as I understand it. 

Mr. DUGAN. Senator, that is not quite right. We regulators have 

the model, the banks provide the inputs to the model, and our 

model then computes the capital charge. 

Senator SARBANES. Isaac says this: ‘‘Nearly every professional 

bank supervisor with whom I have spoken believes the Advanced 

Approach under Basel II is fundamentally flawed. Every major industry trade group has requested that the Standardized Approach 

be made available as an option.’’ And they go on to talk about its 

complexity and that no one would understand it. You know, it lacks 

transparency and so forth and so on. 


jbell on DSKDVH8Z91PROD with HEARING
34 

It seems to me that both of these witnesses on the next panel 

sort of say, well, look, there is a way to work ourselves out of this 

box we are in. You retain the leverage ratio. You try to get it 

adopted internationally, which would be a significant improvement 

in the capital situation worldwide with respect to the banking industry. You allow the Standardized Approach, which has more sophistication than where we are right now. But you do not get into 

all of the problems inherent in going to the Advanced Approach. 

Yet, as I understand it, some of our regulators are bound and determined that these major banks will go into the Advanced Approach with all of the problems that come along with that. 

It seems to me—and I know you all took an initiative. Ms. Bies, 

you were in the forefront of that, I guess, and the Fed pushing 

down that path, and now it is, I would presume, awkward in dealing with your international partners to sort of come along and say, 

well, you know, wait a second, there are a lot of implications here 

and we need to come back and rethink this. 

But it seems to me, given the concerns that are being raised— 

very reasoned, I think, and rational concerns—that we need to say, 

now, wait a minute here, let’s re-examine this. 

I do not want some leap into the dark. And I do not want to be 

told that, well, you know, we can hypothetically do these models 

and everything is going to be OK. We have been through some 

rough patches up here, and we need to—and at the moment, we 

have got high capital standards and we are highly profitable. That 

seems like a pretty good combination to me. 

Thank you, Mr. Chairman. 

Chairman SHELBY. Thank you. 

Before we move on to the next panel, I want to associate myself 

first with some of the remarks of Senator Sarbanes. While I recognize that the development of Basel II required a considerable 

amount of time and energy, I do not think the fact that such efforts 

have been undertaken in and of itself justifies moving forward. We 

should not adopt Basel II simply to adopt Basel II. We should 

adopt Basel II if it is sound public policy and improves the risk 

management of our financial institutions, and ultimately helps our 

economy. 

This Committee is committed to continuing its oversight of the 

Basel II process and to making sure that any changes in our capital requirements are prudent and proper. However, the complex 

and technical nature of Basel II means that the responsibility for 

the final Basel II regulations falls distinctly on your agencies that 

you represent here today. And I think this is a matter of critical 

importance. In fact, I believe that I can say without overstating the 

significance of this issue, developing and successfully implemented 

new capital standards will be the single most important task that 

each of you will undertake during your tenures in your positions. 

As you move forward, I would just like to remind you of the difficult lessons learned—and Senator Sarbanes talked about it; both 

of us have been on this Banking Committee a long time—when 

thousands of thinly capitalized banks collapsed during the 1980’s 

and early 1990’s. We were here. Therefore, before you do anything, 

be sure that what you are doing is right, that it is the right thing 

to do. 


jbell on DSKDVH8Z91PROD with HEARING
35 

I want to thank you again for testifying before us, and you are 

going to furnish some of the information for the hearing record. 

Senator Sarbanes, do you have anything else? 

Senator SARBANES. No. 

Chairman SHELBY. We will call up our next panel now: Mr. 

James Garnett, Head of Risk Architecture of the Citigroup on behalf of the American Bankers Association; Mr. Daniel Tarullo, Professor of Law at Georgetown University Law Center, and no 

stranger to this Committee; Ms. Kathleen Marinangel, Chairman, 

President, and CEO of McHenry Savings Bank on behalf of America’s Community Bankers; and, of course, Mr. William Isaac, 

former Chairman of the Federal Deposit Insurance Corporation, 

and now Chairman of the Secura Group. 

I want to thank all of you for appearing here today and for sitting through this protracted hearing. 

All of your written testimonies will be made part of the record 

in their entirety. 

Mr. Garnett, we will start with you, if you can briefly sum up 

this before we get a vote on the floor. Your entire written testimony, as I said earlier, will be made part of the record. 

STATEMENT OF JAMES GARNETT, HEAD OF RISK 

ARCHITECTURE, CITIGROUP 

Mr. GARNETT. Thank you, Sir. Chairman Shelby, Ranking Member Sarbanes and members of the Committee, my name is Jim Garnett. Thank you for the opportunity to testify today. 

I am responsible for the implementation of Basel II for Citigroup. 

I am here today on behalf of the American Bankers’ Association. 

The ABA has long supported capital reform and remains committed 

to the implementation of Basel II in the United States. 

Unfortunately, the Basel II proposal published yesterday by the 

Federal banking agencies would place U.S. banks at a competitive 

disadvantage with foreign competitors and would impose significant compliance costs on U.S. banks. 

These problems are due to differences between the proposed U.S. 

version of Basel II and the internationally approved Basel Accord. 

U.S. regulators have proposed provisions that reduces the risk sensitivity of Basel II and do not apply to foreign banks. These include, for example, longer transition floors, different definitions of 

default and special capital restrictions triggered by all Basel II 

banks in the aggregate. 

These new features which apply only in the U.S. frustrate the 

goal of aligning risk and capital and thus fail to create appropriate 

incentives for risk-taking. Therefore, we recommend that the U.S. 

version of Basel II be harmonized with the international accord. 

Doing so would better align risk in capital. It would prevent foreign 

banks from gaining a competitive advantage over U.S. banks and 

it would reduce compliance costs for U.S. banks. 

Moreover, to attain competitive balance within the American 

banking industry domestically, an appropriate update of capital 

rules is needed for all of the community and regional banks for 

which the more advanced elements of Basel II may not be appropriate. We also recommend that U.S. banks be given a choice of 

capital compliance options, giving all American banks, large and 


jbell on DSKDVH8Z91PROD with HEARING
36 

small, a choice of options has several benefits. Choices consistent 

with the international accord. Choice gives banks of all sizes access 

to simple and transparent methods for capital compliance. Choice 

assures a competitive domestic marketplace and choice reduces 

compliance costs. 

The compliance options might include Basel I, Basel IA, the 

Standardized, and Advanced. The Standardized Approach in particular is transparent and cost effective. It ties capital charges to 

factors such as credit rating of the borrower and strength of collateral. The Standardized Approach is part of the international accord 

and, as such, would help to achieve the benefits of harmonization. 

In summary, we urge the banking regulators to harmonize the 

U.S. version of the accord with the international accord and to give 

all U.S. banks, large and small, a choice of capital compliance options. Moreover, the agencies need to move quickly to revise general risk-based capital rules that will apply to banks not adopting 

the Basel II Advanced Approach. 

Furthermore, all options need to be implemented at the same 

time. This way, the entire industry can be prepared to follow standards that are competitively comparable. We also hope the Committee can support these objectives as the rulemaking process 

moves forward. 

Thank you very much. 

Chairman SHELBY. Thank you. 

Ms. Marinangel. 

STATEMENT OF KATHLEEN E. MARINANGEL, CHAIRMAN, 

PRESIDENT, AND CEO, McHENRY SAVINGS BANK 

Ms. MARINANGEL. Chairman Shelby, Ranking member Sarbanes, 

and members of the Committee, my name is Kathleen Marinangel. 

I appear today on behalf of America’s Community Bankers, where 

I serve on the board of directors. I am also Chairman, President, 

and CEO of McHenry Savings Bank, a community bank in 

McHenry, Illinois. We are a $275 million community bank focused 

on retail customers and small business owners. We compete headto-head with many large national and regional banks. 

Let me thank the Committee for its substantial oversight of the 

Basel rulemaking process. Your interest has been instrumental in 

the progress made to ensure that the banking industry in general 

and community banks in particular will be able to offer competitive 

services to the communities in which they do business. We also appreciate the thoughtful modifications by the agencies to the initial 

proposals. 

ACB, however, remains concerned about competitive and safety 

and soundness consequences that might arise from the rulemaking 

if it does not remain on track. First, Basel II should not be implemented until changes are made to Basel I to address the competitive needs of depository institutions not suited to the Basel II regime. Otherwise, we believe that Basel I banks would be left at a 

serious competitive disadvantage and would become possible acquisition targets for Basel II banks. We are pleased that the agencies 

will soon release a proposal on Basel IA intended to give these institutions the option to more closely align capital with risk. 


jbell on DSKDVH8Z91PROD with HEARING
37 

Second, we believe that an optional Basel IA standard must be 

designed to permit the majority of banks to more accurately manage their risks and capital requirements. This should include more 

risk buckets and a breakdown of some assets into multiple buckets 

to take into consideration collateral values, loan to value rations, 

credit scores, and other risk factors. We would like to stress the importance of addressing every asset on a bank’s balance sheet when 

finalizing the proposed formula for Basel IA. 

The ANPR addresses some of the assets but not all. Some of the 

missing assets that need to be addressed are commercial real estate loans, bank land and buildings, prepaid assets, and correspondent bank deposits. Credit guarantees and other mitigation 

measures also should be incorporated into the framework. In short, 

the system must result in banks of all sizes having equivalent capital charges against equivalent risk whenever possible. 

Third, we urge that capital standards be implemented in a manner that will not add significantly to regulatory burdens to ensure 

that smaller institutions who do not need complex risk management systems are not subjected to unnecessary regulatory burdens. 

We believe it essential to allow them to maintain the current Basel 

I capital regime as an option. 

Fourth, flexibility is key to creating a successful new capital regime. This flexibility should include the option for Basel II banks 

to choose between the Standardized Approach and the Advanced 

Approach as contemplated in the international Basel II accord. 

Fifth, we strongly support the regulators’ intentions to leave a leverage requirement in place. A regulatory capital floor must be in 

place to mitigate the imprecision inherent in internal ratings-based 

systems. ACB suggests that the precise level, however, of the leverage requirement should be open for discussion. 

Finally, as a community banker, I strongly believe that everyone 

would benefit if capital requirements better align capital with risk 

and if more risk-sensitive options were available. Advances in technology and the availability of more sophisticated software would 

make implementation of a new Basel IA relatively straightforward 

for many community banks. For my bank, there would be little 

burden and a lot of benefit to my institution and the community 

I serve. I need an effective Basel IA in order to compete. 

I thank the Committee for its attention to these important issues 

and I will be pleased to answer any questions. 

Chairman SHELBY. Mr. Isaac, welcome back to the Committee. 

STATEMENT OF WILLIAM M. ISAAC, CHAIRMAN, 

SECURA GROUP, LLC 

Mr. ISAAC. Thank you, Mr. Chairman, Senator Sarbanes. It is 

really a pleasure for me to be here. I know that you want to move 

on quickly, so, I will just try to summarize very briefly. Plus, I 

think some of my testimony has already been—— 

Chairman SHELBY. We have been quoting you all morning. 

[Laughter.] 

Senator SARBANES. Professor Tarullo ought to give us the benefit 

of your thinking here. 

Mr. ISAAC. Let me try to be quick here. 


jbell on DSKDVH8Z91PROD with HEARING
38 

First of all, I would commend the regulators for doing a lot of 

hard work for a long time on Basel II. Everybody is acting on good 

faith and trying to get the job done. And I am not here to criticize 

anybody. I do not like the result so far, as you know. 

In particular, the advanced modeling approach to Basel II is just 

not going to work. I am very concerned with it on a variety of 

fronts. 

Chairman SHELBY. Say that again. 

Mr. ISAAC. The advanced modeling approach under Basel II—— 

Chairman SHELBY. Is not going to work. 

Mr. ISAAC [continuing]. Is not going to work, in my opinion. 

There are a lot of problems with it. It is fundamentally flawed. If 

we are going to go forward with it as an option, I believe that, at 

a minimum, we must maintain the leverage ratio where it is. We 

must maintain prompt corrective action. And I believe we should 

maintain the percentage limitations on reductions in capital that 

the regulators have already put into the advanced notice. 

If Basel has enough bells and whistles on it, I do not think it can 

do a lot of harm. What I really worry about is that 5 or 6 years 

from now, or 7 or 8 years from now, when there are new leaders 

in the regulatory agencies who are further removed from the 1980s, 

they will change those safeguards. And our system could get into 

a lot of difficulty. That is a real concern that I have. 

I think that it makes all of the sense in the world to resolve our 

Basel II problems. Basel II has been stuck in a quagmire for the 

better part of a decade. I believe the regulations should allow the 

Standardized Approach. 

There is a huge consensus behind the Standardized Approach. It 

is less expensive to implement and maintain. It does not purport 

to deliver more reliability than can be delivered, while the Advanced Approach conveys a false sense of security and reliability. 

The Standardized Approach is far less intrusive than the Advanced 

Approach and will allow the banks more flexibility to manage 

themselves and update their models and not have to seek permission from regulators to change their own models. 

The Standardized Approach is much more transparent and much 

easier for all important users of the information to understand. 

That would include boards of directors, senior management, customers, investors, analysts, regulators, and the media. There are a 

lot of users of this information, and the Advanced Approach is not 

something that is user friendly. 

The Standardized Approach will produce a smaller disparity in 

capital ratios between large and small banks. Moreover, it will 

allow Basel II banks in the U.S. to be treated in the same fashion 

as Basel II banks throughout the world because the Standardized 

Approach is available throughout the world. 

If we were to allow the advanced modeling approach and the capital ratios of the large banks were to decline, that would lead to 

a competitive disparity between the large banks and the small 

banks. It would probably lead to faster consolidation of the industry, and more of it then we would otherwise experience. And I believe that, in the end, it could be very harmful to small businesses, 

because it would deny them more choices for their banking needs. 


jbell on DSKDVH8Z91PROD with HEARING
39 

I do not buy the argument that foreign banks have an advantage 

over the U.S. banks. We have the most profitable banks and the 

strongest banks in the world. If we are concerned about a competitive disparity, I endorse wholeheartedly the notion that we ought 

to be trying to get the countries around the world to impose a leverage ratio on their banks, rather than allowing the capital ratios 

of our banks to decline. 

Thank you, again, for having this hearing. It is a very important 

topic and I am pleased to be a part of the process of trying to deal 

with Basel II. Thank you. 

Chairman SHELBY. Dr. Tarullo, we are glad to have you back 

here. 

STATEMENT OF DANIEL TARULLO, PROFESSOR OF LAW, 

GEORGETOWN UNIVERSITY LAW CENTER 

Mr. TARULLO. Thank you, Mr. Chairman, Senator Sarbanes. 

In preparing for this testimony as we gather again here today on 

this topic, and in listening to the first panel, I thought what I 

would try to do is to sum up where I think things have changed 

in the last 10 months. 

Senator SARBANES. I think if you drew the mike closer, it would 

be helpful. 

Mr. TARULLO. Is that OK, Senator? 

Senator SARBANES. Yes, thank you. 

Mr. TARULLO. First, as Bill Isaac just intimated, and I think as 

your questioning of the first panel suggests, the big questions about 

the advanced internal ratings-based approach that we identified 10 

months ago have not been answered in the intervening time. 

We do not know what impact it would have, ultimately, on capital levels. We do not know what impact it would have on the ability of supervisors to monitor banks adequately. We do not know 

what impact it would have on the ability of our supervisors to monitor how supervisors in other countries are implementing it. We do 

not know what the impact on the competitive situation of small 

and medium-sized banks will be. And we do not know whether the 

cost of compliance for large banks is worth it. 

I do not know that everyone is prepared to jettison the advanced 

internal ratings-based approach conceptually, but I think most people have moved closer to that position. Most people, that is, except 

the regulators, who are trying, actually, to implement it. 

Second, how have the regulators changed in the last 10 months? 

Well, here I think we have seen some positive movement. And I, 

for one, detected a difference in tone this morning from that which 

we heard 10 months ago. That reflects, I think, more experience 

perhaps. It is definitely reflected in the notice of proposed rulemaking, where the regulators as a group have strengthened the 

safeguards which they will impose-precisely because of all those 

unanswered questions. The regulators themselves identified in the 

NPR the uncertainty about the effects of the A–IRB approach of 

Basel II. They identified the concerns that they have as a result 

of the fourth quantitative impact study. 

I think that was the proper response. There are serious questions 

about the methodology as a whole, but to the degree we are going 

to try to learn about it, we are not going to learn about it by drivVerDate Nov 24 2008 01:21 Nov 24, 2009 Jkt 050306 PO 00000 Frm 00043 Fmt 6633 Sfmt 6602 E:\HR\OC\A306.XXX A306

jbell on DSKDVH8Z91PROD with HEARING
40 

ing at 60 miles an hour around a hairpin turn in deep fog without 

knowing where we are going to come out on the other side. So we 

should have some rules, some limits, and some brakes applied. 

Third, where and how have the banks’ positions changed? Well, 

this is perhaps the most interesting development. I am not surprised that banks are still concerned that they be able to have 

lower regulatory capital levels. That is what they are usually after. 

They will set their own capital as they think they need to in the 

marketplace but, in terms of regulatory capital, their interest is almost always in having it lower. 

The interesting development, though, is the proposal of the four 

large banks to use the Standardized Approach. I think this reflects 

a recognition that, with the safeguards that are necessary in the 

A–IRB approach, it is not clear that they will get the big capital 

reductions that they had counted on based on the QIS studies. 

Having seen that, they have quite rationally said ‘‘Let us look at 

the other approach that is much less costly to implement, even 

though it is going to produce a much smaller decline in regulatory 

capital, and let us go that route.’’ And, as Bill pointed out, there 

are a lot of ancillary benefits for other banks that may come along 

with the adoption of the Standardized Approach. 

I would just make one further point. The object of Basel II, as 

with Basel I, was to create a common minimum approach to regulation, not a common maximum, a floor and not a ceiling. I do not 

think we want our regulators or our representatives in the Senate 

thinking that any time the regulators do anything different from 

what the Basel accord indicates that it is somehow inappropriate, 

that it somehow failed to harmonize properly. 

We are supposed to be providing a safe and sound banking system in the United States. We are using the Basel accord as a tool 

to assure at least a minimum such system in other countries, and 

that is the way that we should think about it. If there are problems—and I endorse Chairman Bair’s to move a leverage ratio forward internationally—if there are problems with implementation 

overseas of Basel II, if it is too lax, our representatives in the Basel 

Committee should point that out and should seek the kind of 

strengthening that will make the entire global financial system 

safer. 

Thank you. 

Chairman SHELBY. Mr. Isaac, I will start with you. 

We have received testimony suggesting that, unless U.S. banks 

can hold as little capital as foreign banks, U.S. banks will be placed 

at a competitive disadvantage versus their foreign competitor. 

Could you please discuss the relationship between the amount of 

capital a bank holds and its profitability? 

U.S. banks are presently very well capitalized and very profitable. Does this suggest that strong capital requirements do not adversely affect the competitiveness of banks? 

Mr. ISAAC. I believe that strong capital requirements are actually 

an asset. I think it is one of the great strengths of our banking system in this country. 

For one thing, it makes pricing in the banking industry more 

sane. If you have to earn a certain amount of return on your capital and if you are required to have more capital, you are going to 


jbell on DSKDVH8Z91PROD with HEARING
41 

price your products accordingly and you are not going to take 

undue risks. And I believe that during the 1980s, when our banks 

and thrifts did not really have enough capital, they were willing to 

take a lot of risks because they did not have that much at stake. 

Today, our banks are much saner about pricing their risks and 

what risks they take than they were in the 1970s and the 1980s. 

So, I think that having capital is a competitive advantage and it 

also makes our banks much more attractive partners for people 

around the world who need financing. 

Chairman SHELBY. Mr. Garnett, in your testimony you state that 

the changes that banking regulators have made in the Basel II 

NPR mean that banks will, quote—I am quoting you—realize few, 

if any, of the benefits that were anticipated at the inauguration of 

the Basel II exercise, end quote. 

Could you explain the types of benefits that banks expected to 

attain from Basel II but are now unlikely to realize? And if these 

benefits include capital reductions, how large must the capital reductions be for Basel II to be most effective for banks? 

Mr. GARNETT. I think it is—— 

Chairman SHELBY. What did they expect in the beginning? 

Mr. GARNETT. The objectives of the Basel II accord were very 

straightforward and simple and certainly the U.S. banks, certainly 

the large banks, supported those objectives. Very simply, those—— 

Chairman SHELBY. What were those objectives? 

Mr. GARNETT. Very simply those objectives were consistency of 

capital regimes globally, useability, in other words, let’s use as 

much of the internal systems as we can or develop capital requirements that, in fact, were useable to better manage risk internally. 

And aligning capital with risk was the primary impetus of why we 

are probably here today talking about Basel II. That was the primary objective. 

We support all of those objectives to this day. 

Chairman SHELBY. What are your concerns now? 

Mr. GARNETT. Let me also make one other point regarding the 

issue—— 

Chairman SHELBY. Sure. 

Mr. GARNETT [continuing]. Of our expectations of lower capital. 

I do not think there were any expectations whatsoever at the outset of Basel II. I think there was a lot of time spent, 6 or 7 years, 

with regulators trying to get the measurements to be useful and 

consistent and aligned with risk. 

There has been a lot of talk about the decline in capital that was 

discovered in the QIS–4, and rightly so. We believe very strongly 

in a safe and sound banking system. I would caution interpreting 

the QIS results to the extent that perhaps conclusions have been 

drawn today. 

First of all, that QIS study was performed in probably the most 

benign period, most favorably period in quite some time. When you 

have a risk-based capital process where risk is aligned with capital, 

when you are taking on less risk, as you would be, intuitively, in 

a very benign period, you would expect some decline in capital. 

To conclude that the declines that we saw and the magnitude of 

the dispersions that we say in the QIS–4 would have resulted if the 

entirety of the Basel II process had been completed. In other words, 


jbell on DSKDVH8Z91PROD with HEARING
42 

were these models validated? Was there substance behind the 

data? Was there adequate stress testing to ensure that there was 

capital in place in the event of a weak downturn? None of these 

other supervisory and management practices that are employed, 

not only with the regulators, but internally in the banks, were ever 

employed. 

So, we kind of did a quick look. I certainly think that the bank 

systems at the time were probably not in the greatest shape. A lot 

of work has been done since then, but, more importantly, we did 

not let the supervisory process play a role there. 

Chairman SHELBY. Do you believe that banks are presently overcapitalized? 

Mr. GARNETT. I do not know how to pick the magic number. 

Chairman SHELBY. Sure. 

Mr. GARNETT. We have decided that the current regime and the 

amount of minimum capital that is formulated from that regime, 

which, as I have said, we think is probably pretty broken. We are 

using that as a benchmark. 

I, unfortunately, cannot give you a better benchmark. I will tell 

you that, when it comes to the capital planning process, regardless 

of whether or not minimum capital will go down or go up—and by 

the way, under the Advanced Approach, I think if you look at what 

happens to the Advanced Approach minimum capital during a period of just moderate economic weakness, not to mention a severe 

weakness, in fact, the amount of capital is higher than what it 

would have been under Basel I. And there have been some very interesting studies that we can certainly share with you to demonstrate that conclusion. 

Capital management takes the form of a number of different factors. 

Chairman SHELBY. It does. 

Mr. GARNETT. Certainly, minimum capital is something that is 

an extremely important part of that process, but so is making sure 

that the amount of capital that banks hold today can provide the 

appropriate amount of cushion in the event of a downturn or in the 

event that balance sheets or risks could not be moderated or mitigated is also an important part of that process. 

Chairman SHELBY. You know, I have been on this Committee a 

long time. I do not know, myself, of any bank that has been well 

capitalized and well managed and has ever gotten in trouble. Mr. 

Isaac might have a different view because of his background, but 

if you are well capitalized and well managed, you are pretty sound, 

aren’t you? 

Mr. ISAAC. Generally speaking, that is right. 

Chairman SHELBY. Mr. Garnett, would you support an international leverage ratio as a way to address some of your concerns 

about the competitive problems raised by retaining the leverage 

ratio under Basel II? 

Mr. GARNETT. Mr. Chairman, the concept of an international leverage ratio is something that, quite frankly, we heard very, very 

recently. 

Since I am here today—— 

Chairman SHELBY. Would you explore it and talk to us about it? 


jbell on DSKDVH8Z91PROD with HEARING
43 

Mr. GARNETT. I have not had the opportunity to talk with the 

members. 

Chairman SHELBY. Sure. 

Mr. GARNETT. It is very clear by statements that have been made 

by your Committee, as well as the regulators that were here about 

half an hour ago that the leverage ratio is probably not going anywhere soon, even though it is a difference in regimes, if you would. 

So, if you will give us a little bit of time to learn more about that 

concept—— 

Chairman SHELBY. Yes. Let you learn more about it—— 

Mr. GARNETT [continuing]. I am sure that we would be more 

than happy—— 

Chairman SHELBY. Absolutely. 

Mr. GARNETT [continuing]. To respond to your question. 

Chairman SHELBY. Professor Tarullo, are the floors banking regulators have put in place on the amount capital can fall during 

transition periods and after implementation of Basel II sufficient to 

reduce the risk of proceeding with Basel II? 

Do you want me to say that again? 

Mr. TARULLO. Mr. Chairman, I, as you can tell, have serious 

doubts about the whole AIR–B approach. 

Chairman SHELBY. Sure. 

Mr. TARULLO. My preference would be that over time we not implement the A–IRB approach at all. 

Having said that, it is part of Basel II. I agree with Mr. Garnett 

on the need for choice for the banks that are confronted with this 

new regime. Therefore, I think the regulators have done a reasonable job of putting in place—retaining, really—one safeguard, 

which is reflected in congressional legislation, the leverage ratio. 

And second, they have put in place two other kinds of safeguards, 

one bank specific, and the other applying to all AIR–B banks. 

Might I have calibrated it a bit differently? Perhaps. But the regulators have a tough job and I think those proposals are reasonable. 

Chairman SHELBY. Ms. Marinangel. 

Ms. MARINANGEL. Marinangel. 

Yes. 

Chairman SHELBY. In your testimony, you support maintaining 

the leverage ratio as part of Basel II as a way to mitigate the imprecision inherent in a ratings-based capital requirement system. 

Would you explain why a ratings-based system is, quote, imprecise, 

and would you explain how maintaining the leverage ratio will help 

level the playing fields for community banks when they compete 

against banks that have Basel II, if that happens? 

Ms. MARINANGEL. Any system, any internal ratings-based system 

is, of course, only as precise as the data that you put into the system. And, as you know, any software program that you design for 

risk management includes subjective input. Therefore, there would 

be imprecision. 

The leverage ratio, I think, is important to maintain. I do not 

know if the current level is the right level but I think it does add 

stability. I would like to comment a little bit, as well, about the reduction in the required level of capital held when you risk weight 

assets. From a community bank’s point of view, and from my point 


jbell on DSKDVH8Z91PROD with HEARING
44 

of view, even before Basel II was being introduced, I guess I was 

very frustrated about the fact that the capital held for the assets 

did not truly reflect the risk. 

So, for many years I was working on trying to modify Basel I 

through the regulatory agencies and through the national trade 

groups. I actually have run the Basel IA model myself in my shop 

and there also is a reduction in the required capital level. And that 

is because some of the assets are, you know, a 90 percent loan-tovalue mortgage is weighted the same as a 20 percent loan-to-value 

mortgage and that does not make any sense. 

So, I am not too concerned about the drop in the level of capital 

required when you risk weight the assets. I guess from my point 

of view, in my small community and doing the small business 

loans, it would be helpful to have a reduction in the capital held 

for risk-based assets. It would allow me to make more small business loans, and, for example, a small business loan to a person who 

has a lot of collateral backing it, let’s say a guarantor that has a 

high net worth, would allow me to risk weight that loan lower in 

a lower bucket and hold less capital. Let’s say that you might even 

weight that commercial small business loan at 50 percent. It would 

allow me then to make more business loans in my community. And 

it is critical. 

So, I really am not as concerned—and we have talked a lot about 

Basel II, but it so important to talk about Basel IA for the 9,000 

community banks that will work this. And it can be Basel IA, it 

could be the Standardized Approach, but if I cannot risk weight 

those assets properly, then I am held back from making more 

loans. 

Also in my town, just for your information, I have 28 banks in 

my town of 24,000. I have many national banks, Citibank, J.P. 

Chase Morgan. I also have foreign banks in my town, Harris, LaSalle, Bank of Scotland. So, I have to be able to compete. I can 

make more loans if I can risk weight my assets. 

Chairman SHELBY. But if you can compete on a level playing 

field, you can—— 

Ms. MARINANGEL. Absolutely. I need to. Yes. I need to be able to. 

So, I am not as upset or concerned about the lowering of the capital when you risk weight even Basel II Advanced A–IRB Approach 

or in a Basel IA that allows me to risk weight. You will have a 

drop because these assets are not being reflected properly. So, I am 

not as concerned about it as everybody else, as long as all of us can 

truly reflect the assets so I can serve my community. 

Chairman SHELBY. Are a lot of your customers small businesses, 

startup companies, and everything? 

Ms. MARINANGEL. Well, we have some startup, but we also have 

some pretty established customers. We do a lot of consumer lending. We do indirect financing for auto and RV and boat dealers. So, 

my goal had been to diversify assets so that I can reprice—— 

Chairman SHELBY. Sure. 

Ms. MARINANGEL [continuing]. After the savings and loan—and 

I had been a State-chartered savings and loan, but now I am a savings bank charter. 

You know, we had to be able to diversify assets for repriceability. 

So, a lot of the commercial mortgages and real estate loans adjust 


jbell on DSKDVH8Z91PROD with HEARING
45 

with prime, and consumer loans, a third reprice annually. So, yes, 

we are very diversified and we feel we can compete as long as we 

have a level playing field. 

Chairman SHELBY. Senator Sarbanes. 

Senator SARBANES. Thank you very much, Mr. Chairman. 

I want to address these models that are being posited under 

Basel II. First of all, I understand the Basel II require that banks 

have a minimum of 5 years of data; is that correct? 

Mr. GARNETT. I am sorry, were you addressing that to me, Sir? 

Yes, that is—— 

Senator SARBANES. Yes, well, I think I should go to the bankers 

first. 

Mr. GARNETT. Yes, Sir. That is correct. 

Senator SARBANES. OK. 

Now, I am concerned about how confident we can be that banks 

have enough historical data in their internal risk-based models to 

provide accurate evaluation of risks. How many years of data do 

most banks have for building their models? 

I guess I should go to you again, Mr. Garnett, because you, essentially, I guess, speaking for the banks that were engaged in the 

process of building the models. 

Mr. GARNETT. Yes, Sir. I do not think that there is a single number I could give you. I could probably give you a range. There are 

banks that have as many as 30 years worth of data, other banks 

that may not have that much. 

Senator SARBANES. Are you giving away a propriety secret if I 

ask you how many years of data does Citi have in its model? 

Mr. GARNETT. I would prefer not to have to answer that question, 

if you do not mind, Sir. 

Senator SARBANES. I am told that the banks were told to put recession into their data, since we do not really have a recession over 

the last 15 years. So, if your bank’s data does not run for a period 

longer than 15 years, it is not factoring in a recession; is that 

right? 

Mr. GARNETT. That could very well be the case. I am not familiar 

with the term, building a recession into the data. What I am familiar with, and it is a very important part of Basel II, is Pillar 2 requirements with regard to stress testing. It is clearly very important to make sure that the capital levels that are required in both 

good and bad times is achievable. And by looking at stress tests, 

it is a very important way of making sure that there is a capital 

planning process if we happen to be doing this exercise in a good 

time, to make sure that there is a flexibility and a capacity for that 

organization individually to meet minimum capital requirements in 

the even of a downturn. 

Now, that could take the shape of various activities on the balance sheet. It is not just a capital, necessarily, action plan. But 

stress testing is an extremely important part of Basel II. And it 

gets at the point that--I agree 100 percent with you. You cannot 

simply assume that if we are operating with data that has been, 

you know, in very good times, that that will necessarily be the best 

predictor of what happens tomorrow. That is why Pillar 2 and 

Basel II are extremely important. 


jbell on DSKDVH8Z91PROD with HEARING
46 

Senator SARBANES. Well, let me ask you and Ms. Marinangel. 

Were you taken aback by the results of the fourth QIS, which 

showed these very substantial reductions in capital for some of the 

major banks? Did you expect that the models would produce that 

kind of result? 

Mr. GARNETT. Well, because—— 

Senator SARBANES. Let me preface that by underscoring the concern here because the regulators, from the very outset, in presenting their efforts on Basel II, and we have been following it for 

quite a while, but at the very outset said that this was not going 

to lead to any significant reduction of capital in the banking system. We were repeatedly told that. 

Ms. MARINANGEL. If I could answer first on this. 

I was not taken aback by that because I believe that, as I said 

before, assets are not risk weighted properly. I am also not as concerned. I feel that. 

Senator SARBANES. Well, let me just interrupt you right there on 

the weighting of the assets and evaluating the risk. 

As I understand it, the regulators now are considering issuing 

guidance to the banks with respect to commercial real estate. They 

are concerned about the developments in commercial real estate 

and therefore may provide some guidance and caution and so forth. 

Yet, under the Basel II advanced proposal, the commercial real 

estate basket, or however you want to call it, had a 30 percent drop 

in capital. Now, how do you square that? Here we are, if we had 

gone with Basel II this particular category had a 30 percent drop, 

and yet the regulators right now are about to issue, as I understand it, guidance to the banking industry. 

Ms. MARINANGEL. I think I, as Mr. Garnett said, historically, we 

have had a very healthy industry. 

Senator SARBANES. All right. Let us do that. You have a healthy 

industry. You come along and you do Basel II and the market deteriorates. Now, presumably the deterioration in the industry will 

occur more quickly than the adjustment in the Basel II standards. 

What do you do in that situation? 

I mean, things are going bad, you have less capital because you 

did these evaluations, and then, all of a sudden, you are out there 

on the end of the plank. What do you do about that situation? 

Mr. GARNETT. Again, I think the pillar 2 comments that I made 

just a minute ago address that concern. And that concern, Senator, 

is a very, very valid concern and should not be overlooked in any 

way. 

If you are using models that are picking up 5 years, 10 years, 

whatever many, 8 years, you are using, and you go into an economic downturn, it will take a while for those models to catch up 

and recognize the severity of the current situation. That is a 

known, I would not call it a weakness, but just an inherent part 

of the model. That is why the Pillar 2 supervisory oversight is so 

important. 

And as banks are now implementing internationally the Pillar 2 

oversight process, the stress testing, the rigorous validation and 

back testing that have to go along before you are even approved to 

use the Advanced Approach is a definite part of the accord that 

needs to be there. And again, I think that we need to be careful 


jbell on DSKDVH8Z91PROD with HEARING
47 

that we are not making assumptions too quickly about just Pillar 

1 results when it comes to the total picture. 

Senator SARBANES. Mr. Isaac, Mr. Tarullo, why don’t we hear 

from the two of you on this point? 

Mr. ISAAC. Which point, how far back the models go—— 

Senator SARBANES. Well, that, and also, if the model gives you 

a lower capital requirement and then the situation goes badly, it 

seems to me you are caught in a very difficult situation. How do 

you rectify that situation? If you put the pressure on the institution 

and raise its capital standards because things are going bad, of 

course they are, conceivably, are in a difficult situation as it is. So, 

they are confronted with an even more difficult problem. 

Mr. ISAAC. I have talked to a lot of Basel II banks—not all of 

them but a lot of them—and I do not know any bank that has data 

that goes back more than 10 years and most of them do not go back 

10 years. 

For one thing, the banks do not even look today like they looked 

10 years ago because there have been so many mergers and so 

many systems that have been crammed together. So, I do not believe the data will go back as much as 10 years in most of these 

banks. 

Senator SARBANES. Do you differ with that, Mr. Garnett? 

Mr. GARNETT. I think there are probably exceptions to what Mr. 

Isaac suggests. 

Mr. ISAAC. And I allow that there may be exceptions. 

Senator SARBANES. But that is the rule, I take it. What he said 

is basically the rule. 

Mr. GARNETT. Unfortunately, I know more about my own institution, and we agreed that we would not share that data publicly 

here, but I do what every other banking institution does. So, I 

apologize for not being more precise. 

Senator SARBANES. All right. 

Mr. ISAAC. I think the four banks have just made a huge contribution to the Basel II process by suggesting the Standardized 

Approach be made available in the U.S. because it is the way out 

of the quagmire we are in. My basic problem with the Advanced 

Approach is that I do not believe any models should be relied on 

so extensively. You should not place all of your faith in them. We 

have got to have absolute floors below which nobody can go. 

There was a lot of talk until about a year ago that Basel II was 

going to supplant the leverage ratio. I heard speeches made by regulators saying that. 

Senator SARBANES. Oh, yes. 

Mr. ISAAC. That would have been a terrible mistake, in my judgment. Look, for example, at long-term capital management. It was 

run by world famous economists and mathematicians who believed 

they had the perfect models. I am sure we could all come up with 

example after example where models just cannot predict everything. 

So, my main concern is that we not place too much faith in models. They are not foolproof. We have to make sure that they are not 

so complex that nobody can understand them. I want boards of directors of banks, managements of banks, analysts, investors, the 

Congress, and the regulators to be able to understand how the 


jbell on DSKDVH8Z91PROD with HEARING
48 

models are working. I think pretty much everyone can get a handle 

on the Standardized Approach. 

Whatever we use, we have got to put floors under it. If the rest 

of the world wants to have lower floors, or no floors, then so be it. 

We need to be focused on making sure that our banks are the best 

banks in the world. They are right now, and I do not want to see 

us do anything to change that dynamic. 

Senator SARBANES. Professor Tarullo. 

Mr. TARULLO. Senator, I think your last question raises the issue 

of what a minimum capital rule is supposed to do. And what I 

think a capital rule should do is, first, to provide, as Bill just said, 

a floor, a genuine floor. But second, it has got to be a floor that 

has meaning, that is stable, and that gives a signal fairly quickly. 

If you have got lags before the model takes things into account, 

the model is not going to be providing the supervisor with the 

warning signal that some intervention needs to be made in the 

bank. So I think that the virtue of the leverage ratio in the United 

States under the prompt corrective action system that the Congress 

instituted about 15 years ago has been—notwithstanding its simplicity and, frankly, its bluntness—that it does serve as a clear and 

very difficult to manipulate floor, which, when a bank drops below 

it, sets off alarm bells here in Washington and tells supervisors 

that intervention is necessary. 

The other point that I think we should reiterate—I think it has 

been lost a bit—I certainly do not have the view that the leverage 

ratio is the only tool for supervision that a regulator should use. 

To the contrary, I think that Mr. Dugan’s stated aim last year and 

this year of making sure that he can get his arms around the risks 

that a bank is actually assuming is a very important aim. And 

models, internal credit risk models, are an important tool that the 

banks use to figure out what is going on in their institution and 

that regulators can use to figure out what is going on in that institution. That is not the same thing as saying that they should be 

used to set minimum capital standards. 

Mr. ISAAC. I want to particularly endorse the last statement. I 

agree with everything Professor Tarullo said, but that last statement is very important. The models have a good use; it is just not 

for setting minimum capital standards. 

Mr. TARULLO. And Senator, one other thing—I really do not want 

our banks to have to spend a lot of money on a duplicative process 

that they do not find particularly useful for internal risk purposes 

and that is not a particularly good standard for the regulators to 

use, either. That is why I think Bill and I both—to some degree— 

endorse the banks’ approach with the standardized option. 

Senator SARBANES. I might note that I spared Ms. Bies’ today 

her quote, in which she said that the purpose of this exercise—that 

eventually they would get rid of the minimum capital leverage 

ratio. But you know I am greatly influenced by evaluating proposals by, sort of where you say, well, I know where you are coming from. That has been one of the difficulties here, particularly 

with the Feds—— 

Mr. Garnett, I just wanted to put a couple—I am just curious. 

What prompted you and the other three banks to take this public 

position? 


jbell on DSKDVH8Z91PROD with HEARING
49 

I gather in the end, you ended up meeting, going to OMB—you 

were the only one who went, as I understand it. Of course that ran 

the risk of bringing down on you the ire of the regulator. So, it was 

not, sort of a, it seems to me, sort of a run of the mill decision. So, 

what was it that prompted you to do that? 

Mr. GARNETT. I think it was said very clearly this morning. If we 

are setting the rules for how risk will be priced globally through 

the Basel II or other versions of it, whether it is Basel I or Basel 

IA, I think it is extremely important to get it right. 

We need to get it right for safety and soundness reasons. We 

need to get it right for competitive reasons. We are not dismissive 

of the differences that exist in the NPR versus the international 

text. We are very supportive of floors during a transition period. 

We would just like the floors to be consistent with those floors that 

are put there for safeguards by the international community. 

The importance of getting it right led us to believe that we needed to make sure that the OMB was—we shared our thoughts with 

that agency as we are permitted to do and probably are expected 

to do. 

With regard to introducing the Standardized Approach, there 

were two reasons for that. First of all, we realized that we had a 

domestic issue on our hands. If we were going to permit 12 to 20 

banks to use a risk-sensitive, capital aligned with risk approach 

and have the rest of the community banks, or small banks, or even 

fairly large banks on a Basel I non-risk-sensitive approach. 

Senator SARBANES. Well, it would be everybody else—— 

Mr. GARNETT. Everybody else—— 

Senator SARBANES [continuing]. Except the 12 to 20 banks, right? 

Mr. GARNETT. Correct. 

We realized, and perhaps—we being, probably, predominantly 

the largest banks, we realized a little bit late that that competitive 

domestic disadvantage was being created. 

So, one of the reasons that we introduced options, and they could 

go well beyond Standardized, and Basel IA is another example of 

an option that could be a very viable approach for banks in this 

country. We have yet to see what it really looks like. 

So, that was reason No. 1. Reason No. 2 was that we saw in the 

NPR revisions that, in our view, were going to cost the industry an 

enormous amount of money, millions of dollars, to have to adjust 

to, particularly the internationally active banks, where we are, as 

we speak, implementing Basel II practically everywhere but here. 

So, if we are forced, based on revisions from the international accord, to spend more money on data, different calculations, on systems—that did not seem to be a good use of our money. 

Senator SARBANES. Are you implementing it internationally according to the Standardized Approach which is available, as I understand it? 

Mr. GARNETT. I am going to make it less personal. There are 

banks, U.S. banks, international U.S. banks, implementing Standardized and Advanced via the international accord overseas. 

Senator SARBANES. OK, thank you Mr. Chairman. 

Chairman SHELBY. Thank you. 

Professor Tarullo and former Chairman Isaac, Chairman 

Bernanke stated to this Committee this past summer that he had 


jbell on DSKDVH8Z91PROD with HEARING
50 

reservations about the appropriateness of the Standardized Approach to large global banks because it did not, in his opinion, adequately address the types of risk they assume. Do you agree with 

this view? And, if so, why should large banks be allowed to adopt 

a capital requirements regime that does not fit their business? 

Mr. ISAAC. I am not sure what Chairman Bernanke had in mind 

and so I cannot really address his remarks. I believe that models 

are a very important management tool in identifying, pricing, and 

managing risk in a large, complex institution. 

I believe that the regulators, to the extent that large banks are 

not focused on modeling their risks, and I think they all are, but 

to the extent that they are not, the regulators ought to be pushing 

them. 

But we are not talking about that here. We are talking about 

what tool should the regulators use to regulate capital, to put floors 

on capital in the system. I believe that the Standardized Approach 

is vastly superior to the advanced modeling approach. All we are 

doing when we go to the advanced modeling approach is forcing the 

large banks to run two systems. They are going to have to run 

their own system and they are going to run the regulatory system, 

or they are going to run one system that they cannot change unless 

and until the regulators say they can. And so I think we are just 

heaping expense on top of expense and I believe the Standardized 

Approach is superior by a long shot. 

Chairman SHELBY. Professor. 

Mr. TARULLO. Mr. Chairman, on the first point, is the Standardized Approach sufficient to regulate large, complex banking institutions? Absolutely not, for the reasons that we have stated previously. 

But you always have to look at what your viable alternatives are. 

And with all the questions about the advanced internal ratingsbased approach, some of which I detailed earlier, I think it is an 

enormous heroic leap of faith by anyone to say that it currently 

constitutes a viable alternative. Policy-making is always a choice 

among your viable alternatives, not among some idealized view 

that you hope you can realize. 

Chairman SHELBY. We better know where this road leads, had 

we now, Mr. Isaac? 

Mr. ISAAC. I agree. 

Chairman SHELBY. And I do not think we know today where this 

road will take us to in the financial service industry. 

Thank you for your testimony. Thank you for your participation 

in this issue. You can tell that we still have a lot of concerns on 

this issue. The Committee is adjourned. 

[Whereupon, at 12:47 p.m., the hearing was adjourned.] 

[Prepared statements, responses to written questions, and additional material supplied for the record follow:] 


jbell on DSKDVH8Z91PROD with HEARING
51 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 137 here 50306A.003
52 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 138 here 50306A.004
53 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 139 here 50306A.005
54 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 140 here 50306A.006
55 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 141 here 50306A.007
56 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 142 here 50306A.008
57 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 143 here 50306A.009
58 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 144 here 50306A.010
59 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 145 here 50306A.011
60 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 146 here 50306A.012
61 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 147 here 50306A.013
62 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 148 here 50306A.014
63 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 149 here 50306A.015
64 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 150 here 50306A.016
65 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 151 here 50306A.017
66 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 152 here 50306A.018
67 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 153 here 50306A.019
68 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 154 here 50306A.020
69 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 155 here 50306A.021
70 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 156 here 50306A.022
71 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 157 here 50306A.023
72 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 158 here 50306A.024
73 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 159 here 50306A.025
74 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 160 here 50306A.026
75 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 161 here 50306A.027
76 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 162 here 50306A.028
77 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 163 here 50306A.029
78 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 164 here 50306A.030
79 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 165 here 50306A.031
80 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 166 here 50306A.032
81 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 167 here 50306A.033
82 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 168 here 50306A.034
83 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 169 here 50306A.035
84 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 170 here 50306A.036
85 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 171 here 50306A.037
86 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 172 here 50306A.038
87 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 173 here 50306A.039
88 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 174 here 50306A.040
89 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 175 here 50306A.041
90 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 176 here 50306A.042
91 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 177 here 50306A.043
92 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 178 here 50306A.044
93 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 179 here 50306A.045
94 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 180 here 50306A.046
95 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 181 here 50306A.047
96 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 182 here 50306A.048
97 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 183 here 50306A.049
98 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 184 here 50306A.050
99 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 185 here 50306A.051
100 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 186 here 50306A.052
101 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 187 here 50306A.053
102 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 188 here 50306A.054
103 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 189 here 50306A.055
104 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 190 here 50306A.056
105 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 191 here 50306A.057
106 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 192 here 50306A.058
107 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 193 here 50306A.059
108 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 194 here 50306A.060
109 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 195 here 50306A.061
110 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 196 here 50306A.062
111 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 197 here 50306A.063
112 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 198 here 50306A.064
113 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 199 here 50306A.065
114 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 200 here 50306A.066
115 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 201 here 50306A.067
116 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 202 here 50306A.068
117 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 203 here 50306A.069
118 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 204 here 50306A.070
119 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 205 here 50306A.071
120 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 206 here 50306A.072
121 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 207 here 50306A.073
122 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 208 here 50306A.074
123 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 209 here 50306A.075
124 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 210 here 50306A.076
125 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 211 here 50306A.077
126 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 212 here 50306A.078
127 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 213 here 50306A.079
128 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 214 here 50306A.080
129 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 215 here 50306A.081
130 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 216 here 50306A.082
131 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 217 here 50306A.083
132 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 218 here 50306A.084
133 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 219 here 50306A.085
134 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 220 here 50306A.086
135 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 221 here 50306A.087
136 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 222 here 50306A.088
137 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 223 here 50306A.089
138 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 224 here 50306A.090
139 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 225 here 50306A.091
140 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 226 here 50306A.092
141 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 227 here 50306A.093
142 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 228 here 50306A.094
143 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 229 here 50306A.095
144 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 230 here 50306A.096
145 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 231 here 50306A.097
146 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 232 here 50306A.098
147 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 233 here 50306A.099
148 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 234 here 50306A.100
149 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 235 here 50306A.101
150 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 236 here 50306A.102
151 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 237 here 50306A.103
152 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 238 here 50306A.104
153 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 239 here 50306A.105
154 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 240 here 50306A.106
155 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 241 here 50306A.107
156 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 242 here 50306A.108
157 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 243 here 50306A.109
158 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 244 here 50306A.110
159 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 245 here 50306A.111
160 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 246 here 50306A.112
161 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 247 here 50306A.113
162 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 248 here 50306A.114
163 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 249 here 50306A.115
164 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 250 here 50306A.116
165 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 251 here 50306A.117
166 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 252 here 50306A.118
167 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 253 here 50306A.119
168 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 254 here 50306A.120
169 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 255 here 50306A.121
170 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 256 here 50306A.122
171 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 257 here 50306A.123
172 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 258 here 50306A.124
173 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 259 here 50306A.125
174 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 260 here 50306A.126
175 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY 

FROM JOHN C. DUGAN 

Q.1.a. Your agency had previously decided that Basel II banks 

would be allowed to use only the Advanced Approach. Why did 

your agency originally decide not to allow banks to use the Standardized approach? 

A.1.a. In the United States, the Agencies chose not to subject all 

US. banks to Basel II, but instead to focus on only the largest and 

most internationally active banks. There were four primary reasons 

for not subjecting all U.S. banks to mandatory application of Basel 

II, which by definition was designed for applicability to internationally active banks. First, a very large number of U.S. banks, particularly smaller institutions, maintain capital well above any regulatory minimums or PCA requirements, and changes to risk-based 

capital rules for these institutions impose a regulatory burden in 

exchange for very little, if any, supervisory benefit. We have heard 

this message repeatedly from the industry in response to earlier 

regulatory capital proposals. Second, in our assessment, Basel II’s 

Standardized Approach for credit risk offers only marginal improvements in risk sensitivity. Perhaps the most significant improvement in the Standardized Approach is the introduction of 

rules to capture the risks of securitizations, which is notably absent 

from the 1988 Accord, but which the United States has had in 

place for many years. Consequently, the relative improvement in 

the Standardized Approach versus current rules is much less in the 

United States than in many Basel Committee member countries. 

Third, the Standardized Approach to credit risk was calibrated on 

the premise of an accompanying charge for operational risk. The 

OCC remains strongly opposed to a specific charge for operational 

risk for most U.S. banks, which have neither the ability nor the 

need to measure operational risk under the Advanced Measurement Approaches. Finally, because some of the changes in Basel II, 

such as charges for securitizations or operational risk, result in 

capital charges where none previously existed in some countries, 

the Basel Committee was under great pressure to make compromises to ease the burden on countries adopting new charges for 

the first time. That resulted in risk weights for some specific exposure types, such as, for example, retail and small business exposures, that we believe are inappropriately low. 

In contrast to the simpler approaches of Basel II, the Agencies 

believed that the advanced methodologies—that is, the Advanced 

Internal Ratings Based (AIRB) and Advanced Measurement Approach (AMA)—were the most appropriate approaches for calculating credit and operational risk capital requirements for the largest and most complex internationally active U.S. banks. 

We proposed that the largest banks be required to use the Advanced Approaches for the following reasons: (1) the Advanced Approaches are the most consistent with—although certainly not 

identical to—large bank practices in the areas of risk management 

and risk measurement, and (2) the risks that large banks take warrant the application of more advanced risk measurement and management techniques to better ensure the safety and soundness of 

these institutions. 


jbell on DSKDVH8Z91PROD with HEARING
176 

Q.1.b. Why have you now decided to re-evaluate this decision? 

A.1.b. Prior to the official U.S. publication of the Basel II notice of 

proposed rulemaking (NPR) the Agencies received comments from 

numerous interested parties requesting additional options for Basel 

II implementation. These requests most often cited competitive equity issues, especially in an international context. We have been 

and remain concerned about competitive equity issues raised by the 

implementation of Basel II, and because these unsolicited comments clearly generated a great deal of interest in the industry, we 

felt it appropriate to specifically solicit a wider range of comment 

on this particular issue. 

Q.1.c. What factors will you consider when deciding whether to 

allow banks to use the Standardized Approach? Given that Fed 

Chairman Ben Bernanke during his last appearance before the 

Banking Committee expressed concerns about whether the Standardized Approach is appropriate for large, global banks, is the 

Standardized Approach a realistic alternative for our biggest 

banks? 

A.1.c. Like Chairman Bernanke, we question whether the Standardized Approach would be appropriate for the largest and most sophisticated banks. Nonetheless, as noted above, we are open to 

comments on that question. Ultimately, a decision whether or not 

to provide the largest and most sophisticated U.S. banks with the 

option of the Standardized Approach will depend on further analysis of the extent to which U.S. banks’ competitors are likely to use 

that approach, and more importantly, whether it can in fact provide an appropriate measure of capital adequacy at the most sophisticated banks we supervise. 

Q.2. The Basel II NPR has been criticized by several banks because 

it deviates from the international Basel II accord by imposing floors 

on the amount capital can fall. As a result, some banks maintain 

that the Basel II NPR would not be cost effective for them to adopt. 

A.2. The Basel Committee’s June 2004 publication (the ‘‘New Accord’’ or ‘‘Basel II’’) includes transitional floors on the amount that 

an individual bank’s minimum required capital can fall in each of 

the first two years of implementation. The U.S. NPR also incorporated temporary floors on the amount capital may fall, with a 

three-year transitional period. In addition to lengthening the transitional period by one year, the Agencies modified the floor calculation in a way that made the floor a more effective measure than 

the calculation contained in the New Accord. We did so because of 

the safety and soundness concerns that arose as the result of our 

fourth quantitative impact study (QIS–4), where we saw significant 

dispersion and drops in capital requirements. Authorities in several 

other countries do not anticipate similar reductions in required 

capital under Basel II. Because the underlying calculations of the 

Basel II capital requirements are generally not affected by these 

broad, bank-level and system-wide floors, it is not clear how the removal of the U.S.-specific floors would make the U.S. implementation more cost effective (apart from the fact that the level of required capital would be decreased). We believe that the underlying 

calculations of the U.S. NPR are entirely consistent with both the 

international implementation of Basel II and with bank risk manVerDate Nov 24 2008 01:21 Nov 24, 2009 Jkt 050306 PO 00000 Frm 00180 Fmt 6602 Sfmt 6602 E:\HR\OC\A306.XXX A306

jbell on DSKDVH8Z91PROD with HEARING
177 

agement practices, and that the U.S. deviations from the Basel II 

Framework reflect a prudent approach to implementation in the 

United States. 

Q.2.a. Do you believe that these concerns about the costs of Basel 

II as set forth in the NPR are justified? 

A.2.a. We believe these concerns may be overstated. They focus 

only on the perceived private ‘‘benefit’’ of a reduction in required 

capital for individual Basel II banks, and ignore other legitimate 

public policy considerations. It may be natural that banks would 

prefer not to incur costs that do not result in a direct benefit to the 

bank or its shareholders. It is also fair to say that some banks believe a more risk-sensitive regulatory capital regime should lower 

their capital requirements—in some cases, lower than we will allow 

under Basel II. While we recognize the significant expenditures required of banks (and tried to limit these costs by designing Basel 

II requirements to reflect existing risk management systems and 

processes to the extent possible) these costs must be weighed 

against the benefits of greater safety and soundness of the banking 

system, which, by their nature, are much more difficult to quantify. 

Ultimately, decisions about capital regulations cannot be based on 

bank-by-bank evaluations of costs and benefits or ‘‘cost effectiveness,’’ since much of the benefit may not accrue to individual 

banks. However, as with all aspects of this proposal, we are interested in hearing the views of all interested parties on the cost-benefit tradeoffs. 

Q.2.b. Could you please give us a comparison of the estimated costs 

to implement Basel II versus the expected benefits of Basel II for 

a typical bank? 

A.2.b. The OCC considered the costs and benefits to implement 

Basel II as part of our regulatory impact analysis. Our analysis of 

the proposed rule identified the following potential benefits, some 

of which accrue to individual banks, others to the banking system 

or to the public more generally. 

1. Better allocation of capital and reduced impact of moral hazard through a reduction in the scope for regulatory arbitrage. 

2. Improves the capital measure as an indicator of capital adequacy. 

3. Encourages banking organizations to improve credit risk 

management. 

4. More efficient use of required bank capital. 

5. Incorporates and encourages advances in risk measurement 

and risk management. 

6. Recognizes new developments and accommodates continuing 

innovation in financial products by focusing on risk. 

7. Better aligns capital and operational risk and encourages 

banking organizations to mitigate operational risk. 

8. Provides for enhanced supervisory feedback. 

9. Enhanced disclosure promotes market discipline. 

10. Preserves the benefits of international consistency and coordination achieved with the 1988 Basel Accord. 


jbell on DSKDVH8Z91PROD with HEARING
178 

11. The ability to opt in offers long-term flexibility to nonmandatory banking organizations. 

As for costs, because banking organizations are constantly developing programs and systems to improve how they measure and 

manage risk, it is often difficult to distinguish between expenditures explicitly caused by adoption of the proposed rule and costs 

that would have occurred irrespective of any new regulation. Nevertheless, we included several questions related to compliance costs 

in QIS–4. Based on figures supplied by 19 QIS–4 respondents (out 

of 26 total QIS–4 participating banks) that provided estimates of 

their implementation costs, we estimate that organizations will 

spend roughly $42 million on average to adopt the proposed rule. 

We expect to receive additional information on implementation 

costs in the NPR comment process. 

Q.2.c. What impact will the deviations from the international Basel 

II accord have on the global competitiveness of U.S. banks? 

A.2.c. Our intent is to have a regulatory capital framework that 

enhances the safety and soundness of the U.S. banking system 

without compromising its competitiveness, either internationally or 

domestically. Data show that large U.S. banks have more capital 

and are more profitable than their European Union counterparts, 

so it is clear that strong capital positions can be fully consistent 

with strong performance and profitability. We do not believe that 

there is a trade-off between safety and soundness and competitiveness. In particular, we have not yet seen evidence that the absence 

of the option of the Standardized Approach for U.S. mandatory 

Basel II banks will impair their ability to compete with their foreign counterparts. Large U.S. banks and almost all large foreign 

banks would be using the Advanced Approaches. Our understanding is that the largest foreign banks plan on using the Advanced Approaches, even though many of them technically have 

the option of using the less sophisticated Standardized Approach. 

While there are certainly differences in how these Advanced Approaches are being implemented in the United States, many of 

these differences are temporary. For example, the biggest difference is that the U.S. proposal has a limit on the amount that 

capital requirements may drop during the first three years of implementation. We felt this was needed to ensure that safety and 

soundness is not compromised. There are other technical differences as well, and we will use the comment process to further 

evaluate these. 

While harmonization of regulatory capital rules will advance the 

goal of a level playing field, there are limits to how much consistency we can achieve on an international basis due to differences in 

accounting regimes and significant differences in the process of 

bank supervision. However, even with existing differences, including difference in capital requirements, U.S. banks are extremely 

competitive internationally. 

Q.3. Are banks presently over-capitalized? Please explain how you 

arrive at your conclusion. 

A.3. We do not believe that the U.S. banking system is overcapitalized. Various independent indicators of bank soundness—such as 


jbell on DSKDVH8Z91PROD with HEARING
179 

bank failure rates, external ratings of debt issued by banking institutions, and credit spreads on bank debt—are reasonably aligned 

with historical norms for the U.S.; they are neither especially high 

nor especially low. These indicators suggest that, at least in very 

broad terms, both market forces and regulatory requirements are 

achieving appropriate levels of bank capital. However, we believe 

that the current regulatory capital regimes need improvements to 

better reflect risks that banks are taking. Basel II does that for the 

most sophisticated U.S. banks, and through the Basel IA NPR we 

are exploring improvements in the risk-based capital rules that 

might apply to other banks. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR SARBANES 

FROM JOHN C. DUGAN 

Q.1. What is the ratio of tangible equity to assets at the 15 largest 

bank holding companies? Would it be appropriate to allow this 

ratio to drop substantially? What floor if any would you place 

under this ratio? Should it go below 5%? 

A.1. 

TABLE 1. CAPITAL RATIOS FOR LARGE U.S.-OWNED BANK HOLDING COMPANIES JUNE 30, 2006 

BHC Name Tier I Leverage Ratio (%)* Tangible Equity Ratio (%)** 

Citigroup .................................................................................................. 5.19 4.56 

Bank of America Corp. ............................................................................ 6.13 3.73 

JPMorgan Chase ...................................................................................... 5.85 4.60 

Wachovia .................................................................................................. 6.57 4.59 

Wells Fargo .............................................................................................. 6.99 6.29 

U.S. Bancorp ............................................................................................ 8.23 5.52 

Countrywide Financial ............................................................................. 6.96 7.04 

Suntrust Banks ........................................................................................ 6.82 5.88 

National City ............................................................................................ 6.89 6.66 

BB&T ........................................................................................................ 7.26 5.50 

Bank of New York .................................................................................... 6.22 4.99 

Fifth Third ................................................................................................ 8.38 6.94 

State Street .............................................................................................. 5.46 4.39 

PNC Financial .......................................................................................... 7.71 5.24 

Keycorp ..................................................................................................... 8.82 6.71 

* Tier 1 Leverage ratio equals regulatory tier 1 capital divided by average total assets. 

** Tangible Equity ratio equals GAAP equity, less intangibles (except mortgage servicing assets that have an identifiable stream of income) 

divided by average total assets. 

The OCC has no intention of allowing bank capital requirements 

to drop precipitously. Our experiences in the late 1980s and early 

1990s, and the role that capital played in the subsequent resurgence of the industry’s survivors, reinforce our belief in strong capital. Moreover, the leverage ratio is a crucial element of our current 

regulatory capital and prompt corrective action frameworks, and 

has coexisted with the risk-based regime for many years now. We 

are not proposing any changes to the leverage ratio requirements. 

Q.2. We have been led to believe that the goodwill and other intangibles represent roughly one-third of the U.S. industry’s equity. Is 

that correct? 

A.2. In June 2006, there were 7,559 insured commercial banks. In 

the aggregate, the ratio of these banks’ intangible assets to equity 

was 30.5 percent. Note that, in forming a bank’s tier 1 ratio for regulatory capital purposes under 12 CFR Part 3, the largest portion 


jbell on DSKDVH8Z91PROD with HEARING
180 

of these intangibles (i.e., goodwill and core deposit intangibles) are 

deducted from the measured amount of tier 1 capital. Thus, the 

Agencies, in effect, assign a dollar-for-dollar requirement on these 

intangibles. Because the regulatory measure of the tier 1 capital 

ratio deducts these intangibles first, before dividing by assets, we 

are confident that the measured ratios reflect a sound regulatory 

standard. 

Q.3. At this point, only the U.S. and Canada have minimum leverage ratio requirements. Should U.S. bank regulatory agencies be 

comfortable with an international system for bank capital that does 

not impose such requirements in other countries? With the subjectivity involved with the Advanced Approach of Basel II, does this 

lack of a leverage ratio requirement concern you from the perspective of international financial stability? 

A.3. The issue of an international leverage ratio is currently being 

discussed internationally. From these discussions it appears that 

other countries use tools other than a leverage ratio to provide a 

capital cushion. The Basel Committee’s Accord Implementation 

Group has surveyed the countries that participate on the Basel 

Committee to determine what other mechanisms are being used to 

ensure capital adequacy above the regulatory minimums. 

Q.4. The Standardized Approach would (1) be less costly than the 

Advanced Approach for both banks and agencies, (2) be less likely 

to substantially reduce capital requirements, and (3) have a lower 

chance of opening competitive disparities between U.S. banks of 

different sizes. Under these circumstances, why should the agencies not allow such an approach for any U.S. bank? 

A.4. The Standardized Approach and the Advanced Internal Ratings-Based Approach (AIRB) share a primary goal—improved risk 

sensitivity in the risk-based capital regime. The crucial distinguishing factor between the two efforts turns on (1) the need for 

improved measurement and management of complex risks in the 

largest banks, and (2) the need to avoid both complexity and expense in the Standardized Approach to the maximum extent possible. AIRB is designed for the systems that very large, complex organizations should be capable of building and can afford to develop 

and operate. 

In our assessment, Basel II’s Standardized Approach for credit 

risk offers only marginal improvements in risk sensitivity for the 

United States. Perhaps the most significant improvement in the 

Standardized Approach is the introduction of rules to capture the 

risks of securitizations, which is notably absent from the 1988 Accord, but which the United States has had in place for many years. 

Consequently, the relative improvement in the Standardized Approach versus current rules is much less in the United States than 

in many Basel Committee member countries. Moreover, the Standardized Approach to credit risk was calibrated on the premise of an 

accompanying charge for operational risk. The OCC remains 

strongly opposed to a specific charge for operational risk for most 

U.S. banks, which have neither the ability nor the need to measure 

operational risk under the Advanced Measurement Approaches. Finally, because some of the changes in Basel II, such as charges for 

securitizations or operational risk, result in capital charges where 


jbell on DSKDVH8Z91PROD with HEARING
181 

none previously existed in some countries, the Basel Committee 

was under great pressure to make compromises to ease the burden 

of countries adopting new charges for the first time. That resulted 

in risk weights for some specific exposure types, such as, for example, certain retail and small business exposures, that we believe 

are inappropriately low. 

In the Basel II NPR we asked for comment on whether the largest U.S. banks should be given the option of choosing the Standardized Approach and are open to evaluating the responses. Ultimately, a decision whether or not to provide the largest and most 

sophisticated U.S. banks with the option of the Standardized Approach will depend on further analysis of the extent to which U.S. 

banks’ competitors are likely to use that approach, and more importantly, whether it can in fact provide an appropriate measure 

of capital adequacy at the most sophisticated banks we supervise. 

Q.5.a. The Advanced Approach of Basel II has been touted as addressing safety and soundness concerns related to hidden and 

undercapitalized risks that large, complex banks now take under 

the current rules. In the results of QIS–4, what was the aggregate 

change in minimum risk-based capital requirements for securitized 

exposures? 

A.5.a. The minimum required capital (MRC) for securitization exposures decreased 17.9% from Basel I to Basel II. Note that this 

change includes all securitization exposures, rather than solely offbalance sheet exposures. As we have noted in other contexts, we 

have proposed measures in the U.S. Basel II NPR to limit potential 

declines in regulatory capital during an extended transition period. 

We also note that for a number of reasons, highlighted in our interagency release of QIS–4 results, the results of QIS–4 should not be 

considered definitive indicators of expected results upon full implementation of Basel II. Finally, it should be recognized that unlike 

the United States, many countries currently have no specific framework for securitizations. 

Q.5.b. For other off-balance sheet exposures? 

A.5.b. The aggregate MRC for other off-balance sheet exposures decreased by 10%. 

Q.5.c. If the current rules are insufficient to address these complex 

risks, is it because they require too much capital, or too little capital? 

A.5.c. We believe the current regulatory capital regime needs improvements to better reflect risks that banks are taking. For example, the current Accord assigns a 100 percent risk weight to the 

large majority of private sector borrowers. This single risk weight 

assignment is not at all reflective of the true differences in credit 

risk (i.e., the risk of default) across borrowers. Thus, from a supervisory perspective, the issue is not driven by a portfolio-by-portfolio 

assessment of whether the current rules require too much or too 

little capital; the strength of the Advanced Approach is its improved accuracy in the areas of risk management and risk measurement. The improvements in risk measurement—riskier assets 

will be assigned a higher risk weight, which is more reflective of 


jbell on DSKDVH8Z91PROD with HEARING
182 

the risk they pose to the bank—will result in a more risk sensitive 

bank specific capital requirement. 

Q.6. If the goal is to encourage sophisticated risk measurement and 

management at our largest banks, why can’t they be encouraged 

adequately through pillar 2’s supervisory guidance and pillar 3’s 

transparency through public disclosure? 

A.6. The Agencies considered requiring large banks to implement 

advanced risk management systems without tying those requirements to minimum regulatory capital. However, this approach was 

rejected because of the need to have a more risk sensitive regulatory capital framework that: (a) reflects the sophistication and 

complexity of modern day risk measurement systems and practices; 

(b) more closely aligns regulatory capital with actual risk taking; 

and (c) provides appropriate recognition to credit risk mitigation 

techniques in order to provide an incentive for risk mitigation behavior and pro-active risk management on the part of banks. In addition, Basel II is expected to greatly facilitate the use of a common 

set of credit-risk measurement metrics that will enhance the ability 

of the OCC and other regulators to conduct benchmarking and 

early warning analysis across the population of large complex 

banks. 

Q.7. If the mandatory banks operate under the Advanced Approach 

and other banks operate under Basel IA, how much do you expect 

capital requirements to change on average for the two groups of 

banks? Will that affect the competitive position of banks not using 

the Basel II Advanced Approach? 

A.7. As a general matter, the OCC does not believe that the U.S. 

implementation of the Basel IA or the Basel II framework will likely result in a material reduction in aggregate minimum required 

capital. However, the relative impact on minimum capital required 

for various products and institutions may differ. One concern with 

any regulatory change is the possibility that it might create a competitive advantage for some organizations relative to others, a possibility that certainly applies to a change with the scope of Basel 

II. 

The OCC has considered various ways in which competitive effects might be manifest, and has examined the limited available 

evidence related to those potential effects. We reviewed research on 

the potential impact on competition in the residential mortgage 

market, in small business lending, and in the credit card market, 

as well as the potential competitive effects of introducing explicit 

capital requirements for operational risk. We also reviewed research on the issue of whether Basel II might affect mergers and 

acquisitions. Overall, this body of recent economic research does 

not reveal persuasive evidence of any sizeable competitive effects. 

For many financial products, it is reasonable to think that competitive effects would be limited; capital is one of many factors influencing an institution’s ability to offer products competitively. 

Knowledge of customer needs, knowledge of the risks associated 

with the product and with the customer, cost of funding, and efficiencies of operation all contribute significantly to an institution’s 

pricing and offering of many products. 


jbell on DSKDVH8Z91PROD with HEARING
183 

Nonetheless, we recognize that a number of banks and industry 

groups are concerned that banks operating under Basel II might 

gain a competitive edge over banks not governed by Basel II. One 

of our motivations for undertaking the Basel IA exercise concurrently with Basel II was to reduce potential competitive effects between large and small U.S. banks by making improvements to the 

risk sensitivity of the current U.S. capital rules. While we believe 

that the combination of Basel II and Basel IA will result in limited 

competitive issues across the U.S. banking sector, we are very interested in industry comment on this issue. To facilitate comment, 

we plan to have an overlap in the comment periods of the proposals 

so that interested parties can look at the capital treatments side 

by side in making their assessment of potential competitive effects. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY 

FROM SHEILA C. BAIR 

Q.1.a. Your agency had previously decided that Basel II banks 

would be allowed to use only the Advanced Approach. Why did 

your agency originally decide not to allow banks to use the Standardized Approach? 

A.1.a. ,When the banking agencies developed the Basel II ANPR in 

August 2003, the prevailing view was that only the Advanced Approaches would be appropriate for large, internationally active 

banks. In our judgment there were three main reasons for this 

view: 

• Only the Advanced Approaches were thought sufficient from a 

safety and soundness perspective to address large banks’ complex risks; 

• The largest banks were thought to have robust and accurate 

internal risk measurements that would provide a suitable 

basis for capital regulation; and 

• Tying regulatory capital to internal models was thought necessary to encourage large banks to develop and refine these 

models. 

Many large banks endorsed these views and encouraged the development of the Advanced Approaches in their comment letters to 

the Basel II ANPR. 

Q.1.b. Why have you now decided to re-evaluate this decision? 

A.1.b. the FDIC has decided to re-evaluate this issue because more 

recent evidence, including the results of the fourth Quantitative 

Impact Study (QIS–4), casts doubt on the premises for the original 

decision. 

• Absent significant safeguards, the Advanced Approaches could 

undermine banks’ safety and soundness by substantially lowering the bar on capital requirements, including for the most 

complex risks. 

• The robustness and accuracy of internal risk models is in 

doubt based on wide dispersion in capital requirements for 

similar or identical exposures. 


jbell on DSKDVH8Z91PROD with HEARING
184 

• Comment is needed on whether tying internal models to regulatory capital would improve or interfere with the evolution of 

banks’ internal capital models for management purposes. 

In addition, a number of core banks, industry trade associations, 

regulators, and other commentators have recently requested that 

the banking agencies allow banks to compute their regulatory capital using the Standardized Approach contained in the international Basel II framework. 

Q.1.c. What factors will you consider when deciding whether to 

allow banks to use the Standardized Approach? Given that Fed 

Chairman Ben Bernanke during his last appearance before the 

Banking Committee expressed concerns about whether the Standardized Approach is appropriate for large, global banks, is the 

Standardized Approach a realistic alternative for our biggest 

banks? 

A.1.c. The FDIC is open to considering some version of the Standardized Approach as an alternative for any U.S. bank. We will review the comments on this issue with an open mind. 

In reaching a decision on whether to allow banks to use the 

Standardized Approach, we will consider the attributes that need 

to be present in any regulatory capital system. 

• A regulatory capital system must require banks to hold adequate capital to avoid costly draws on the federal banking safety net. The Standardized Approach avoids the potential for 

substantial reductions in bank capital requirements inherent 

in the Advanced Approaches. 

• A regulatory capital system should avoid undue burden on the 

banking industry. The Standardized Approach is simpler and 

less costly to implement than the Advanced Approaches. 

• A regulatory capital system should not tilt the playing field in 

favor of one group of banks over another. The Standardized 

Approach does not appear to pose the same potential for competitive inequities across banks of different sizes as does the 

Advanced Approaches. 

• A regulatory capital system should not interfere with innovation or the evolution of risk management. Some believe it is 

necessary to base regulatory capital on internal models in 

order to encourage sound risk management. The FDIC will be 

attentive to comments on this point. 

There also are a number of more technical issues that would 

need to be addressed if the banking agencies chose to allow large 

internationally active banks to use a version of the Standardized 

Approach. A notable example is the issue of capital requirements 

for operational risk. The agencies are seeking comment on how to 

address this and other technical issues with the Standardized Approach as we decide whether it would provide an appropriate 

framework for capital regulation in the United States. 

Q.2.a. The Basel II NPR has been criticized by several banks because it deviates from the international Basel II accord by imposing floors on the amount capital can fall. As a result, some banks 

maintain that the Basel II NPR would not be cost effective for 


jbell on DSKDVH8Z91PROD with HEARING
185 

them to adopt. Do you believe that these concerns about the costs 

of Basel II as set forth in the NPR are justified? Could you please 

give us a comparison of the estimated costs to implement Basel II 

versus the expected benefits of Basel II for a typical bank? 

A.2.a. The FDIC believes that the Advanced Approaches of Basel 

II would be costly for banks to implement. Some evidence on the 

costs of implementation was provided by banking organizations 

participating in the QIS–4. As the Office of the Comptroller of the 

Currency reported in their Regulatory Impact Analysis, the average expected cost reported by the QIS–4 banks for implementing 

the Basel II rules was approximately $42 million per bank. However, of that $42 million, banks reported that an average of $21 

million would likely be spent absent the implementation of Basel 

II. Therefore, according to QIS–4 data, the incremental cost of implementing Basel II would average $21 million per bank for the 26 

banking organizations participating in QIS–4. Additionally, the 

QIS–4 banks estimated that the recurring annual expense associated with Basel II would average $2.4 million per year per banking 

organization. More recent information suggests these cost estimates may be understated. 

The benefits of Basel II are more difficult to quantify. Some suggest that the ‘‘benefit’’ to banks of the Advanced Approaches is the 

reduction in capital requirements they would realize. The FDIC 

does not believe that substantially reducing bank capital standards, as compensation for implementing a costly and burdensome 

regulatory framework, is wise policy. From a public policy perspective, a substantial reduction in bank capital standards could prove 

to be simply an increase in the implicit subsidy provided to banks 

by the federal government. 

Another possible source of indirect financial benefits to banks 

that implement Basel II would be if it reduced their future deposit 

insurance premiums. Specifically, each bank might benefit indirectly from a more safe and sound banking system, by virtue of not 

having to pay substantial premiums to cover the cost of resolving 

problems at a large bank. Whether the Advanced Approaches 

would in fact enhance the safety and soundness of our banks is a 

key question, and as outlined above, there are difficult and unanswered questions in this regard. 

Q.2.b. What impact will the deviations from the international 

Basel II accord have on the global competitiveness of U.S. banks? 

A.2.b. For 15 years, the U.S. has had in place a dual framework 

of capital regulation, consisting of risk-based rules and a leverage 

requirement that capital exceed specified ratios of balance sheet assets. During this 15-year period, U.S. banks have been required to 

hold more capital than foreign banks. There is no indication that 

our framework of capital regulation has hurt the competitive position of U.S. banks. Quite the contrary, our dual framework of capital regulation has supported the safety, soundness, and resilience 

of the U.S. banking system. Our banks enjoy not only strong capital but high profitability, and there is no evidence that our capital 

framework has constrained banks’ ability to extend credit. 

Going forward, the Advanced Approaches of Basel II clearly point 

to reductions in risk-based capital requirements. The U.S. has proVerDate Nov 24 2008 01:21 Nov 24, 2009 Jkt 050306 PO 00000 Frm 00189 Fmt 6602 Sfmt 6602 E:\HR\OC\A306.XXX A306

jbell on DSKDVH8Z91PROD with HEARING
186 

posed safeguards to ensure that such reductions are moderate and 

consistent with explicit goals stated in the international Basel II 

agreement. Other Basel Committee countries have no explicit 

mechanisms to constrain the potential reductions in their banks’ 

capital requirements. This opens up the possibility of reductions in 

capital requirements for their banks far in excess of what was contemplated in the international agreement. 

This difference in posture is consistent with long-held U.S. views 

on the importance of a strong private sector banking system that 

does not become a source of economic or fiscal weakness through 

over reliance on implicit or explicit safety net supports. We believe 

the U.S. approach will ensure that strong capital will remain a 

competitive strength of the U.S. banking system, as it has been in 

the past. 

Q.3. Are banks presently overcapitalized? Please explain how you 

arrive at your conclusion. 

A.3. No, we do not believe that U.S. banks are overcapitalized. 

The level of capital at U.S. banks should be evaluated from at 

least three perspectives: their ability to prosper and compete; their 

ability to provide credit to fund economic growth; and the government’s interest in avoiding costly draws on the federal banking 

safety net. The FDIC does not believe banks are overcapitalized by 

any of these standards. 

During the 10-year period 1995–2005, FDIC-insured banks’ 

growth in loans, assets, and net income significantly outpaced the 

growth of the broader economy (see table below). Insured banks 

have had record profits in 13 of the last 14 years, topped by the 

most recent net income of $134 billion in 2005. This suggests that 

capital levels have not hindered banks’ ability to prosper and compete or their ability to extend credit to fund economic growth. : 

TABLE A. BANK GROWTH AND PROFITABILITY OUTPACE THE BROADER ECONOMY 

[Average annual percent growth in nominal dollars, 1995–2005] 

FDIC-insured institutions U.S. economy 

Assets Loans Net income GDP 

7.5% 7.5% 9.1% 5.3% 

Source: Calculations are based on information from FDIC ‘‘Statistics on Banking’’ (http://www2.fdic.gov/SDI/SOB/) and data compiled by the 

Bureau of Economic Analysis. 

The FDIC also does not believe banks are overcapitalized from 

a safety net protection standpoint. While current industry capital 

is adequate, substantial reductions in that capital would not be 

prudent from a safety and soundness perspective. Capital serves an 

important shock absorber function by ensuring that unforeseen economic events, significant errors in model assumptions or accounting methodologies, or other undetected problems do not cause serious problems for banks. Banking problems, especially at our largest 

and most systemically important banks, can impose costs on the 

broader economy and financial system, on the deposit insurance 

funds, and on the fiscal position of the U.S. government. Appropriate levels of bank capital need to reflect the government’s interest in avoiding such costs. 


jbell on DSKDVH8Z91PROD with HEARING
187 

1This number was calculated using the ‘‘Tangible tier 1 leverage ratios’’ as reported on in the 

Federal Reserve’s Bank Holding Company Performance Report (BHCPR) for each of the top 15 

bank holding companies. In the BHCPR user’s guide, the Federal Reserve defines ‘‘Tangible tier 

1 leverage ratio’’ as ‘‘Tier 1 capital, net of intangible assets, divided by average assets for the 

latest quarter, net of intangible assets.’’ This number does not include mortgage servicing assets, 

which are intangible assets that may be included in the Tangible equity ratios of insured 

depository institutions, subject to certain limitations. The User’s Guide for the Bank Holding 

Company Performance Report can be found at http://www.federalreserve.gov/boarddocs/ 

supmanual/bhcprl03-05ltotallaccess.pdf. The largest 15 bank holding companies were determined using the FFIEC list of the largest bank holding companies, which can be found at 

http://www.ffiec.gov/nicpubweb/nicweb/Top50Form.aspx. This list includes both domestic and 

foreign-owned bank holding companies operating in the United States. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR SARBANES 

FROM SHEILA C. BAIR 

Q.1. What is the ratio of tangible equity to assets at the 15 largest 

bank holding companies? Would it be appropriate to allow this 

ratio to drop substantially? What floor, if any, would you place 

under this ratio? Should it go below 5%? 

A.1. The weighted average ratio of tangible Tier 1 equity capital to 

assets for the 15 largest bank holding companies was 4.66 percent 

as of June 30, 2006.1

While we believe current industry capital is adequate, the FDIC 

does not believe substantial reductions in that capital would be 

prudent from a safety and soundness perspective. Our experience 

with insured banks is that as core capital measures begin to fall, 

the margin for error for both banks and supervisors can narrow 

dramatically. The lower a bank’s capital relative to its overall volume of business as measured by assets, the greater the likelihood 

that unforeseen economic events, significant errors in model assumptions or accounting methodologies, or other undetected problems might create serious problems for the bank. For a large, systemically important bank, such problems could have important 

spillover costs for the broader economy, the deposit insurance 

funds, or the fiscal posture of the United States. 

It is therefore appropriate that the agencies have established 

floors for certain core capital ratios and that these floors strictly 

limit the type and amount of intangible assets that banks can include in regulatory capital. For example, to be considered well-capitalized, insured banks must maintain a ratio of Tier 1 capital to 

assets of at least 5 percent. Tier 1 capital excludes goodwill, the 

banking industry’s most significant intangible asset by dollar volume. 

Since this question pertains specifically to bank holding companies, it is important to note that bank holding companies have different regulatory capital standards than do insured banks. This includes a less conservative definition of Tier 1 capital and lower requirements for the leverage ratio. Also, statutory Prompt Corrective Action applies to insured banks, not bank holding companies. 

The FDIC does not have any safety and soundness concern with 

the current regulatory and supervisory framework for bank holding 

companies. 

Q.2. We have been led to believe that the goodwill and other intangibles represent roughly one-third of the U.S. industry’s equity. Is 

that correct? 


jbell on DSKDVH8Z91PROD with HEARING
188 

A.2. For all FDIC-insured institutions, about one-third of GAAP equity is composed of goodwill and other intangibles, as illustrated 

below. 

TABLE B. ABOUT ONE-THIRD OF GAAP EQUITY IS COMPOSED OF GOODWILL AND OTHER 

INTANGIBLES 

[All FDIC-Insured Institutions, June 30, 2006] 

Percent of equity 

Total Equity Capital ($ millions) ............................................................. $1,183,807 ........................................

Goodwill .......................................................................................... 280,889 23.7% 

Other Intangible Assets .................................................................. 109,536 9.3% 

Total Percent of Goodwill and Other Intangible Assets .......................... ........................................ 33.0% 

Source: FFIEC Quarterly Reports of Condition and Income. 

It is important to note that these intangibles make up a much 

smaller proportion of regulatory capital, since regulatory capital 

does not include goodwill and imposes limits on the amount of 

other intangible assets that can be counted as regulatory capital. 

For FDIC-insured institutions, 9.43 percent of Tier 1 capital is composed of intangibles. 

Q.3. At this point, only the U.S. and Canada have minimum leverage ratio requirements. Should U.S. bank regulatory agencies be 

comfortable with an international system for bank capital that does 

not impose such requirements in other countries? With the subjectivity involved with the Advanced Approach of Basel II, does this 

lack of a leverage ratio requirement concern you from the perspective of international financial stability? 

A.3. The FDIC is concerned about the lack of explicit mechanisms 

in other Basel Committee countries to constrain potentially substantial reductions in bank capital requirements. Therefore, the 

FDIC supports the idea of an international leverage ratio. A simple 

capital to assets measure is a critically important complement to 

risk-based capital regulations. The leverage ratio provides U.S. supervisors with comfort that banks will maintain a stable base of 

capital in good times and in bad times. The establishment of an 

international leverage ratio would go far in strengthening the 

soundness and stability of the international banking system and 

would help to ensure that differences in capital requirements do 

not lead to competitive inequality among internationally active 

banks. 

In addition, because the Advanced Approaches of Basel II clearly 

point to reductions in risk-based capital requirements, the U.S. has 

proposed safeguards to ensure that such reductions are moderate 

and consistent with explicit goals stated in the international Basel 

II agreement. Most other Basel Committee countries have no explicit mechanisms to constrain the potential reductions in their 

banks’ capital requirements. This creates the possibility of reductions in capital requirements for their banks far in excess of what 

was contemplated in the international agreement. 

Our analysis suggests that reductions in bank capital requirements under the Advanced Approaches could be more pronounced, 

by a large margin, than has been reported in any of the recent 

quantitative impact studies. There also is a large and possibly irreVerDate Nov 24 2008 01:21 Nov 24, 2009 Jkt 050306 PO 00000 Frm 00192 Fmt 6602 Sfmt 6602 E:\HR\OC\A306.XXX A306

jbell on DSKDVH8Z91PROD with HEARING
189 

ducible element of subjectivity in how banks and supervisors will 

calculate and validate those capital requirements. 

A substantial reduction in bank capital requirements worldwide 

would increase the likelihood of problems in the global banking system and financial instability. In an increasingly world-wide economic and financial marketplace, the U.S. economy and banking 

system could not expect to be insulated from problems in the global 

banking system. 

Q.4. The Standardized Approach would (1) be less costly than the 

Advanced Approach for both banks and agencies, (2) be less likely 

to substantially reduce capital requirements, and (3) have a lower 

chance of opening competitive disparities between U.S. banks of 

different sizes. Under these circumstances, why should the agencies not allow such an approach for any U.S. bank? 

A.4. The agencies have sought comment on allowing the Standardized Approach for any U.S. bank. As noted in the question, there 

are a number of attractive features of the Standardized Approach 

as compared with the Advanced Approaches. We also are aware of 

the argument that only the Advanced Approaches would adequately encourage the development of risk management systems at 

large banks. The FDIC will review the comments on the availability of the Standardized Approach with an open mind. 

Q.5.a. The Advanced Approach of Basel II has been touted as addressing safety and soundness concerns related to hidden and 

undercapitalized risks that large, complex banks now take under 

the current rules. In the results of QIS–4, what was the aggregate 

change in minimum risk-based capital requirements: For 

securitized exposures? 

A.5.a. Observers of the Basel II process frequently point to 

securitization as an example of a regulatory capital loophole not 

adequately addressed under current rules. However, the Advanced 

Approaches would result in lower capital requirements for these exposures. According to QIS–4 data, minimum required capital under 

the Advanced Approaches would fall by approximately 17.9 percent 

for securitization exposures. 

Q.5.b. For other off-balance sheet exposures? 

A.5.b. The QIS–4 exercise suggested that participating banks’ aggregate capital requirement for off-balance sheet exposures would 

decline by about 10 percent compared to the current rules. The 

QIS–4 data reflected a total decline in capital requirements for offbalance sheet exposures, despite showing a significant increase in 

the capital requirements for over-the-counter (OTC) derivatives. 

However, subsequent to the requirements for over-the-counter 

(OTC) derivatives. However, subsequent to the completion of QIS– 

4, regulators added to Basel II the expected positive exposure 

method for computing capital requirements for OTC derivatives. 

Recent evidence suggests that when this new methodology is in 

place, capital requirements for OTC derivatives would fall substantially. 

Q.5.c. If the current rules are insufficient to address these complex 

risks, is it because they require too much capital, or too little capital? 


jbell on DSKDVH8Z91PROD with HEARING
190 

A.5.c. A frequent criticism of current risk-based capital rules is 

that they are ‘‘insufficient’’ to address complex risks. It is not generally understood, however, that the current rules require, in aggregate, substantially more capital for the complex risks undertaken by large banks than would be required under the Advanced 

Approaches of Basel II. 

Q.6. If the goal is to encourage sophisticated risk measurement and 

management at our largest banks, why can’t they be encouraged 

adequately through pillar 2’s supervisory guidance and pillar 3’s 

transparency through public disclosure? 

A.6. Large banks measure and manage risk for their own internal 

management purposes and supervisors are actively engaged in the 

review of these processes. Banks make a substantial volume of 

risk-related disclosures in reports filed with both the Securities and 

Exchange Commission and the federal banking agencies. There is 

a case to be made that bank risk measurement systems would 

evolve satisfactorily using the current system of supervisory review 

and market disclosures without tying regulatory capital to these 

systems. Others believe that the lack of an explicit regulatory capital calculation based on banks’ internal credit risk estimates 

would be detrimental to the long-term evolution of risk-management. This will be an important issue to resolve, and the FDIC will 

view the comments with an open mind. 

Q.7. If the mandatory banks operate under the Advanced Approach 

and other banks operate under Basel IA, how much do you expect 

capital requirements to change on average for the two groups of 

banks? Will that affect the competitive position of banks not using 

the Basel II Advanced Approach? 

A.7. Risk-based capital requirements under Basel II’s Advanced 

Approaches would probably be much lower than would be available 

under Basel 1A, as indicated below. 

TABLE C. CREDIT RISK WEIGHTS WOULD FAVOR BASEL II ADOPTERS 

Exposure type 

Risk weights based on: 

Basel II ANPR (%) Basel II advanced QIS–4 (median) (%) 

Small business loans: 

Retail .............................................................................................. 100 61 

Other ............................................................................................... 100 74 

Commercial real estate: 

High volatility ................................................................................. 100 70 

Other ............................................................................................... 100 48 

Other commercial .................................................................................... 100 47 

Typical 1–4 residential mortgage ........................................................... 35 16 

Typical home equity loan ........................................................................ 100 19 

Credit cards ............................................................................................. 100 117

Other retail loans .................................................................................... 100 56 

AAA-rated Fannie or Freddie MBS ........................................................... 20 7 

Source: Summary Findings of the Fourth Quantitiative Impact Study and additional calculations. 

Notes: Advanced Approaches median risk weights come from Summary Findings of the Fourth Quantitative Impact Study. Tables B and C. 

The 7 percent risk weight on Fannie Mae and Freddie Mac mortgage-backed securities is based on the Basel II NPR proposals. Advanced Approaches capital requirements for credit cards are likely understated in this table because of the large importance of capital requirements for 

undrawn lines, requirements that are not present in the Basel IA ANPR. 

Community banks are steadily losing market share in certain retail lending businesses that are becoming commoditized. For example, residential mortgage loans, auto loans, and other consumer reVerDate Nov 24 2008 01:21 Nov 24, 2009 Jkt 050306 PO 00000 Frm 00194 Fmt 6602 Sfmt 6602 E:\HR\OC\A306.XXX A306

jbell on DSKDVH8Z91PROD with HEARING
191 

volving credit are becoming scale businesses that are increasingly 

dominated by the largest lenders. Community banks have responded by concentrating increasingly on small business lending— 

often the loans are secured by commercial real estate. 

Thus far, the competitive fortunes of banks of different sizes 

have been driven by the economics of the various businesses and 

not by differences in capital requirements. There is no precedent, 

however, for large differences in capital requirements across U.S. 

banks such as those illustrated above. While the competitive effects 

of these large differences in capital requirements are unclear, the 

potential exists for such differences to cause industry consolidation 

to accelerate. 

The FDIC believes the capital rules for large and small banks 

need to be decided together. One of our important goals for any 

overall package of regulatory capital changes is to avoid tilting the 

competitive playing field substantially in favor of one group of 

banks over another. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY 

FROM SUSAN S. BIES 

Q.1. Your Agency had previously decided that Basel II banks would 

be allowed to use only the Advanced Approach. Why did your agency originally decide not to use the Standardized Approach? Why 

have you now decided to re-evaluate this decision? What factors 

will you consider when deciding whether to allow banks to use the 

Standardized Approach? Given that Fed Chairman Ben Bernanke 

during his last appearance before this committee expressed concerns about whether the Standardized approach is appropriate for 

large, global banks, is the Standardized approach a realistic alternative for our biggest banks? 

A.1. In the August 2003 Basel II Advance Notice of Proposed Rulemaking (ANPR), the U.S. banking agencies (Agencies) proposed (i) 

to require only the largest, most internationally active U.S. banking organizations to adopt Basel II and (ii) to mandate that the 

largest, most internationally active U.S. banking organizations 

adopt Basel II’s advanced internal ratings-based approach to credit 

risk and advanced measurement approaches to operational risk. 

The Agencies decided to take this limited approach to U.S. implementation of Basel II because the Agencies felt the Basel II approaches would be too burdensome for most smaller U.S. banks, 

and that the Basel II Standardized Approach would be insufficiently risk sensitive for the largest, most complex U.S. banks. The 

comments on the ANPR generally did not criticize the Agencies for 

failing to make available to U.S. banking organizations the simpler 

approaches of Basel II, nor did those comments advocate making 

the Standardized Approach available to U.S. banks. 

Further, the Agencies indicated in October 2005 that they would 

make amendments to the existing Basel I-based capital rule to 

make it more risk sensitive and to reduce potential competitive impacts from Basel II. This revised version of Basel I is now popularly known as Basel IA. The NPR for Basel IA was just approved 

by all the agencies for release for comments. Basel IA is intended 

to apply to all U.S. banks that do not use Basel II and gives banks 


jbell on DSKDVH8Z91PROD with HEARING
192 

a choice to stay on Basel I or adopt a slightly more risk sensitive 

option. 

In the spring and summer of 2006, the Agencies received comment letters from a number of banks, trade associations, and other 

interested parties that requested that the Agencies consider the 

merits of allowing all U.S. banking organizations to use the simpler 

approaches available in Basel II. Because of the significant interest 

in the Basel II Standardized Approaches, the Agencies requested 

further comment in the Basel II NPR and Basel IA NPR on whether and, if so, how the Basel II Standardized Approaches might be 

applied in the United States. The Agencies continue to consider 

this issue and will carefully consider public input on this question. 

Chairman Bernanke has indicated his concern that the Basel II 

Standardized Approach would not appropriately reflect the risks 

that large, complex, internationally active banks take. In designing 

the Basel II Advanced Approaches, banking supervisors sought to 

improve the risk sensitivity of our risk-based regulatory capital 

framework, remove opportunities for banks to conduct regulatory 

capital arbitrage, improve supervisors’ ability to evaluate a bank’s 

capital adequacy, improve market discipline on banks, and ultimately enhance the safety and soundness of the banking system. 

These objectives cannot fully be met with the Basel II Standardized 

Approach. 

The Basel II Standardized Approach was designed for small, noncomplex, and primarily domestic banking institutions and is somewhat more risk sensitive than Basel I. It was intended to be used 

in those countries where, after the implementation of Basel II, 

Basel I would no longer be available. In contrast, the U.S. Agencies 

have not expected to eliminate Basel I-based rules for most of our 

banks and have not heretofore considered the Basel II Standardized Approach as an option for U.S. banks because of the additional 

costs and only marginal benefits expected. 

In deciding whether to allow our large, internationally active 

banks to use the Basel II Standardized Approach, the Agencies will 

have to carefully weigh the advantages and disadvantages of doing 

so. The disadvantages of Basel II standardized include (i) limited 

risk sensitivity—for example, first lien mortgage loans would generally be assigned a 35 percent risk weight, other retail loans 

would generally get a 75 percent risk weight, and unrated corporate loans generally would get a 100 percent risk weight, in each 

case regardless of the creditworthiness of the borrower; and (ii) 

lack of meaningful connection between capital regulation and risk 

management. 

Q.2. The Basel II NPR has been criticized by several banks because 

it deviates from the international Basel II accord by imposing floors 

on the amount capital can fall. As a result, some banks maintain 

that the Basel II NPR would not be cost effective for them to adopt. 

Do you believe that these concerns about the costs of Basel II as 

set forth in the NPR are justified? Could you please give us a comparison of the estimated costs to implement Basel II versus the expected benefits of Basel II for a typical bank? What impact will the 

deviations from the international Basel H accord have on the global 

competitiveness of U.S. banks? 


jbell on DSKDVH8Z91PROD with HEARING
193 

A.2. The NPR contains a summary discussion of the costs and benefits of Basel II as part of ’the Executive Order 12866 requirement. 

In particular, it notes that cost and benefit analysis of changes in 

regulatory capital requirements entails considerable measurement 

problems. On the cost side, it can be difficult to attribute particular 

expenditures incurred by institutions to the costs of implementation because banking organizations would likely incur some of 

these costs anyway as part of their ongoing efforts to improve risk 

measurement and management systems. On the benefits side, 

measurement problems are even greater because the benefits of the 

proposal are more qualitative than quantitative and as is the case 

with many regulations, the benefits accrue to the U.S. society in 

terms of a healthier financial system and better risk management 

at our largest banking institutions. Measurement problems exist 

even with an apparently measurable benefit like lower regulatory 

capital requirements because lower regulatory capital requirements 

do not necessarily mean that a bank’s actual capital will fall. 

Healthy banking organizations generally hold an amount of capital 

well above regulatory minimums for a variety of reasons, and the 

effect of reducing the regulatory minimum is uncertain and may 

vary across institutions. 

Among the expected benefits of Basel II are enhanced risk sensitivity (resulting in more efficient use of regulatory capital by banks 

and a reduction in the scope for regulatory capital arbitrage); a 

closer relationship between capital regulation and bank internal 

risk measurement and risk management processes; enhanced ability of the regulatory capital framework to incorporate future product innovation and future advances in risk measurement and risk 

management; and enhanced capacity for supervisory feedback and 

improved market discipline. All of these benefits would strengthen 

the safety and soundness of the banking organizations subject to 

the Basel II NPR and of the U.S. financial system as a whole. 

As noted in the Basel II NPR, based on estimates provided by 

those institutions that responded to the QIS–4 question on cost, on 

average, a banking organization would spend approximately $42 

million to adapt to capital requirements implementing the Advanced Approaches in Basel II. Not all of those respondents are 

likely mandatory institutions. Responses further indicated that 

roughly half of organizations’ Basel II expenditures would have 

been spent on improving risk management anyway. These numbers 

should be viewed only as very rough estimates since not all participants responded, the data are more than two years old and in 

many cases were difficult to compare across institutions due to the 

qualitative nature of the responses. However, at this time, no other 

estimates from the banks are generally available. 

The Basel II NPR includes three transitional floor periods that 

would limit the amount by which a bank’s risk-based capital requirements could decline over a period of at least three years. The 

Basel II Mid-Year Text issued in July 2005 (New Basel Accord) includes only two transitional years, with somewhat lower floors. The 

U.S. transitional floor periods are designed to provide a smooth 

transition to the Advanced Approaches and will help the Agencies 

evaluate both the overall functioning of the Advanced Approaches, 

and the impact of the Advanced Approaches on specific portfolios 


jbell on DSKDVH8Z91PROD with HEARING
194 

and overall capital requirements, before Basel II becomes fully 

operational. Preserving the safety and soundness of the U.S. banking system is the Agencies’ primary motivation for implementing 

Basel II, and the transitional floor periods would help ensure that 

safety and soundness are maintained as banks transition to the 

new capital framework. Similarly, a desire to ensure the continued 

safety and soundness of the U.S. banking system motivated the 

Agencies’ statement in the preamble of the Basel II NPR that a 10 

percent or greater decline in aggregate minimum risk-based capital 

requirements, compared to minimum risk-based capital requirements under the existing rules, would serve as a benchmark and 

may warrant modification to the framework. 

Some significant differences do exist between the United States 

and other countries in the proposed implementation of Basel II’s 

Advanced Approaches, beyond the transitional safeguards. National 

differences in capital regulation are not unique to the Basel II capital regime, and some of the existing differences would carry over 

into Basel II. For example, the U.S. banking agencies currently impose a leverage ratio and Prompt Corrective Action requirements 

on U.S. banks that are more conservative than the Basel I capital 

accord (and would continue to do so under Basel II), yet U.S. banking organizations are among the most profitable and competitive in 

the world. Nevertheless, early comments on the Basel II NPR suggest that, whatever the merits of these international differences in 

rules, they are likely to add to implementation costs and raise 

home-host issues, particularly for globally active banks operating 

in multiple jurisdictions. Before the Federal Reserve issues a final 

rule, we will carefully consider any differences in the implementation of Basel II that could adversely affect the international competitiveness of U.S. banks. 

Q.3. Are banks presently overcapitalized? Please explain how you 

arrive at your conclusions. 

A.3. My response will focus on the large, complex U.S. banking organizations that would be subject to Basel II’s Advanced Approaches under the recently issued Basel II NPR. Clearly, there is 

a natural tension between the private interests of these banks in 

maximizing shareholder profits, on the one hand, and the public interest in protecting the federal safety net, maintaining a safe and 

sound banking system, and promoting financial stability, on the 

other hand. As bank regulators, we seek to strike the right balance 

between public benefit and private burden. In particular, it is in no 

one’s interest to set capital requirements too high, so as to impair 

the banking system’s financial health, competitiveness, or ability to 

efficiently provide the credit and other financial services necessary 

for a growing economy, nor too low, so as to undermine safety and 

soundness and financial stability. 

Within this context, I do not believe that, in the aggregate, current U.S. regulatory capital requirements are excessive in relation 

to banking risks or that the general level of capital requirements 

impairs the overall competitiveness of U.S. banks. In evaluating 

this issue, one needs to be careful to appropriately consider the 

competitive impact of regulatory capital requirements within the financial services industry. Competition in this arena is affected by 


jbell on DSKDVH8Z91PROD with HEARING
195 

1See Myron L. Kwast and S. Wayne Passmore, ‘‘The Subsidy Provided by the Federal Safety 

Net: Theory and Evidence,’’ Journal of Financial Services Research, Vol. 16, Numbers 2/3, (September/December 1999), pp. 125–146. 

many factors besides formal regulatory capital requirements, such 

as tax policies, economies of scale and scope, risk management 

skills, and the ability to innovate. Moreover, banks’ actual capital 

levels generally exceed the regulatory minimums by considerable 

amounts, reflecting not only market discipline from rating agencies, liability holders, and counterparties, but also explicit decisions 

to build capital buffers in order to weather unanticipated events or 

facilitate the pursuit of future investment opportunities. 

Some insight into the relationship between regulatory capital requirements and bank competitiveness is possible by observing that, 

even under Basel I, there have been significant differences in capital regulation across countries. The United States generally has 

been viewed as having one of the most rigorous and conservative 

capital regimes among major countries, reflecting the minimum leverage ratio requirement; prompt corrective action; the definition of 

regulatory capital—particularly our insistence that losses be recognized promptly by banks; and the willingness of the federal banking Agencies to set risk-based requirements above Basel I levels for 

certain higher-risk activities. Significantly, the greater rigor and 

conservatism in our capital rules under Basel I does not appear to 

have created international competitiveness problems for our major 

banking organizations. Quite the contrary: even though U.S. banks 

have generally been among the most strongly capitalized internationally, they are consistently also among the most profitable. 

Nor do strong overall U.S. capital standards appear to impair the 

competitiveness of U.S. banks relative to nonbank competitors. 

Owing to limited data on profit rates across lines of business, one 

cannot directly compare relative profitability across these institutions on a risk-adjusted basis. However, research suggests that, at 

the margin, the federal safety net provides a significant positive 

net subsidy for U.S. banks, a subsidy which obviously is unavailable to nonbanks operating outside the safety net,1 One manifestation of this subsidy is the ability of large banking organizations to 

operate with substantially lower capital ratios than their nonbank 

competitors. 

While the general level of current U.S. capital standards does not 

impair the overall competitiveness of our largest and most complex 

banking organizations, it would be inappropriate to conclude that 

current capital standards provide an adequate framework for promoting bank safety and soundness. Capital regulation is the cornerstone of our efforts to maintain a safe and sound banking system. However, the lack of risk sensitivity in our Basel I-based capital framework means that it cannot distinguish between those 

banks that have taken on greater risk and those that have not. As 

a result, current capital rules do not provide supervisors with an 

effective framework for assessing overall capital adequacy in relation to risks, for judging which institutions are outliers, and for assessing how capital adequacy may evolve over time. Nor does it 

provide banks with appropriate incentives for improving their 

measurement and management of risk. The Basel II framework is 

intended to address these shortcomings. 


jbell on DSKDVH8Z91PROD with HEARING
196 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR SARBANES 

FROM SUSAN S. BIES 

Q.1. What is the ratio of tangible equity to assets at the 15 largest 

bank holding companies? Would it be appropriate to allow this 

ratio to drop substantially? What floor if any would you place 

under this ratio? Should it go below 5%? 

A.1. The chart below lists the tangible equity and the tier 1 leverage ratios for the top 15 U.S. owned bank holding companies 

(BHCs). 

RATIOS FOR TOP 15 U.S. OWNED BHCS, AS OF JUNE 30, 2006 

[In percent] 

BHC Tier 1 leverage ratio * 

Tangible equity 

ratio% ** 

Citigroup .................................................................................................. 5.19 4.56 

Bank of America ...................................................................................... 6.13 3.73 

JPMorgan Chase ...................................................................................... 5.85 4.60 

Wachovia .................................................................................................. 6.57 4.59 

Wells Fargo .............................................................................................. 6.99 6.29 

U.S. Bancorp ............................................................................................ 8.23 5.52 

Countrywide ............................................................................................. 6.96 7.04 

Suntrust ................................................................................................... 6.82 5.88 

National City ............................................................................................ 6.89 6.66 

BB&T ........................................................................................................ 7.26 5.50 

Bank of N.Y. ............................................................................................ 6.22 4.99 

Fifth Third ................................................................................................ 8.38 6.94 

State Street .............................................................................................. 5.46 4.39 

PNC Financial .......................................................................................... 7.71 5.24 

Keycorp ..................................................................................................... 8.82 6.71 

* Tier 1 Leverage Ratio is equal to regulatory tier 1 capital divided by average total assets. 

** Tangible Equity Ratio is equal to GAAP equity, less intangibles (except mortgage servicing assets, which have an identifiable stream of income), divided by average total assets. 

Source: Federal Reserve Y–9C Reports. 

Neither U.S. banks nor U.S. BHCs are subject to a minimum 

capital ratio based on tangible equity as defined in the chart above. 

They are, however, subject to a minimum tier 1 leverage ratio. 

While tangible equity and tier 1 capital are similar, they are not 

identical. Tier 1 capital includes elements not included in tangible 

equity and vice versa. The minimum tier 1 leverage ratio is 3 percent for all BHCs that are rated a composite ‘‘1’’ under the Federal 

Reserve’s BHC rating system or that have implemented the market 

risk amendment. The minimum tier 1 leverage ratio for all other 

BHCs is 4 percent. Although banks and thrifts also are subject to 

a minimum tier 1 leverage ratio of 3–4 percent, banks and thrifts 

obtain important regulatory privileges by maintaining a 5 percent 

tier 1 leverage ratio in order to be deemed ‘‘well capitalized’’ for 

purposes of the prompt corrective action framework and the financial holding company provisions of the Gramm-Leach-Bliley Act. 

Prompt corrective action does not apply to BHCs, so there is no 

‘‘well capitalized’’ tier 1 leverage ratio threshold. 

The Federal Reserve believes that constraining the overall leverage of a BHC helps ensure that the holding company does not pose 

a threat to the financial health of its subsidiary insured depository 

institutions. 

The BHC supervision manual directs examiners to consider a 

BHC’s tier 1 leverage ratio as a supplement to its risk-based capital ratios when assessing the BHC’s capital adequacy. However, 


jbell on DSKDVH8Z91PROD with HEARING
197 

the tier 1 leverage ratio is only one of several indicators used to 

assess the capital strength of a BHC and should not be used in isolation. For example, Federal Reserve examiners also analyze the 

composition and quality of the BHC’s capital instruments, the 

BHC’s asset quality, and the BHC’s exposure to interest rate risk, 

concentration risk, liquidity risk, and operational risk. Depending 

on all the factors that Federal Reserve staff takes into consideration when reviewing the capital adequacy of a BHC, a tier 1 leverage ratio below 5 percent could be acceptable for certain BHCs 

while for other BHCs a tier 1 leverage ratio above 5 percent could 

be appropriate. 

Q.2. We have been led to believe that the goodwill and other intangibles represent roughly one-third of the U.S. industry’s equity. Is 

that correct? 

A.2. Intangibles, including goodwill but excluding mortgage servicing assets, which have an identifiable stream of income, represent 

approximately 30 percent of the total equity of U.S. commercial 

banks. (See chart below.) 

U.S. COMMERCIAL BANKS INTANGIBLES TO EQUITY DATA AS OF JUNE 2006 

Group of banks Number of banks Weighted average% of 

intangibles to equity 

Under $250m ........................................................................................... 5,584 4.83 

$250m–$500m ........................................................................................ 994 6.87 

$500m–$1b ............................................................................................. 495 13.77 

$1b–$5b .................................................................................................. 342 20.11 

Greater than $5b ..................................................................................... 144 35.55 

All Banks ........................................................................................ 7,559 30.53 

Almost all of these intangibles are deducted from the calculation 

of regulatory Tier 1 capital, as are excess amounts of mortgage 

servicing assets. The vast majority of intangibles are in the form 

of goodwill and, as a result, intangibles are greater as a percentage 

of equity in the larger banks, which have been most active in acquisitions. As long as tangible capital levels are strong, a significant percentage of intangibles to capital does not pose a supervisory concern. 

Q.3. At this point, only the U.S. and Canada have minimum leverage ratio requirements. Should U.S. bank regulatory agencies be 

comfortable with an international system for bank capital that does 

not impose such requirements in other countries? With the subjectivity involved with the Advanced Approach of Basel II, does this 

lack of a leverage ratio requirement concern you from the perspective of international financial stability? 

A.3. The Basel Committee and national authorities will continue to 

monitor the impact of Basel II Pillar 1 capital requirements during 

the transition period of the Basel II framework and thereafter. 

Countries on the Basel Committee indeed want to ensure as much 

consistency as possible in implementing Basel II, and obviously 

agree on the goal of promoting financial stability more broadly. 

However, there are important legal, market, and cultural differences across countries that require a certain amount of national 


jbell on DSKDVH8Z91PROD with HEARING
198 

discretion for the Basel II framework to be suitable for each individual country. This is not a new development; national discretion 

has been applied since the initial implementation of Basel I, and 

many differences exist today across countries in the application of 

capital rules. 

In all Basel member countries, Basel II’s Pillar 1 risk based capital standard is being implemented in conjunction with other measures under Pillars 2 and 3 to ensure that banks maintain adequate 

capital levels. Some countries impose supplementary minimum capital standards, such as the leverage ratio requirements imposed by 

the United States and Canada. However, other countries employ 

different approaches, tailored to their specific institutional and supervisory regimes to ensure their comfort with banks’ overall capital levels. Because Basel member countries are committed to identifying potential differences across countries in their capital adequacy frameworks and the potential effects of those differences, 

members of the Accord Implementation Group (AIG) are sharing 

information on supervisors’ Pillar 2 techniques to assess banks’ 

capital cushions over the regulatory minimum. In this context, the 

AIG is collecting information on a variety of supplementary measures of capital adequacy that members may be employing in their 

jurisdictions, and plans to report back to the Committee. In the 

case of the United States, the leverage ratio has served as a very 

valuable complement to the risk-based capital rules, and we believe 

it should continue to do so under Basel II. 

Q.4. The Standardized Approach would (1) be less costly than the 

Advanced Approach for both banks and agencies, (2) be less likely 

to substantially reduce capital requirements, and (3) have a lower 

chance of opening competitive disparities between U.S. banks of 

different sizes. Under these circumstances, why should the agencies not allow such an approach for any U.S. bank? 

A.4. The financial costs to a bank associated with implementing a 

much more simplistic framework would be lower than under the 

Advanced Approaches. But many of the costs being incurred by 

banks under the auspices of the Basel II Advanced Approaches are 

in our view costs associated with improving risk management more 

generally. In fact, the desire to avoid unnecessary regulatory costs 

is one reason why we have limited the number of banks that are 

required to be on Basel II and have tried to build Basel II on what 

banks are already doing. In contrast, the Standardized Approach 

bears little resemblance to what large, complex banks actually do 

to manage their risk. 

The concern that Basel II will unfairly tilt the competitive playing field is something that we and the other U.S. agencies take 

very seriously. Some have argued that the bifurcated application of 

Basel II within the United States could allow domestic banks that 

adopt the framework both lower minimum required capital charges 

on certain activities and lower minimum required capital requirements compared with other domestic banks. Lower minimum required capital charges would, it has been argued, translate into a 

cost advantage for adopters that would place non-adopters at a 

competitive disadvantage. In addition, some fear that adopters 


jbell on DSKDVH8Z91PROD with HEARING
199 

would use any newly created excess regulatory capital to acquire 

smaller banks. 

In part to address these concerns, the banking agencies proposed 

revisions to the existing Basel I-based capital rules (so-called Basel 

IA) that would aim to mitigate potential competitive inequities. 

Furthermore, we want to emphasize that during the comment period for Basel II and Basel IA NPRs, we urge interested parties to 

give us specific advice regarding what else we may need to do to 

reduce any unintended consequences of Basel II. 

The Basel II Standardized Approach was designed for small, noncomplex, and primarily domestic banking institutions and is somewhat more risk sensitive than Basel I. It was intended to be used 

in those countries where, after the implementation of Basel II, 

Basel I would no longer be available. In contrast, the U.S. Agencies 

have not expected to eliminate Basel I-based rules for most of our 

banks and have not heretofore considered the Basel II Standardized Approach as an option for U.S. banks because of the additional 

costs and only marginal benefits expected. 

In deciding whether to allow our large, internationally active 

banks to use the Basel II Standardized Approach, the Agencies will 

have to carefully weigh the advantages and disadvantages of doing 

so. The disadvantages of Basel II standardized include (i) limited 

risk sensitivity—for example, first lien mortgage loans would generally be assigned a 35 percent risk weight, other retail loans 

would generally get a 75 percent risk weight, and unrated corporate loans generally would get a 100 percent risk weight, in each 

case regardless of the creditworthiness of the borrower; and (ii) 

lack of meaningful connection between capital regulation and risk 

management. 

In the Standardized Approach, the relatively crude method of assigning risk weights to assets, as well as an emphasis on balancesheet risks as opposed to other risks facing financial firms, limits 

the overall responsiveness of capital requirements to risk, which 

renders that framework inadequate for supervising the largest and 

most complex banking organizations. It is quite telling that none 

of the largest foreign institutions signaled an intention to adopt the 

Standardized Approach in the QIS–5 study (see below). 

Number of observations in each cell classified as ‘‘most likely’’ Standardized 

approach FIRB approach AIRB approach 

G10 Group 1 ............................................................................................... 0 23 33 

Source: Federal Reserve calculations based on ‘‘Results of the Fifth Quantitative Impact Study,’’ Table 3, BCBS 

Note: Group 1 consists of the largest institutions, namely those that have tier 1 capital in excess of Ö3bn, are diversified, and are internationally active. This table differs from the one in the BCBS study in that US banks are excluded. 

Q.5. The Advanced Approach of Basel II has been touted as addressing safety and soundness concerns related to hidden and 

undercapitalized risks that large, complex banks now take under 

the current rules. In the results of QIS–4, what were the aggregate 

changes in minimum risk-based capital requirements for (a) 

securitized exposures, and (b) other off-balance sheet exposures? If 

the current rules are insufficient to address these complex risks, is 

it because they require too much capital, or too little capital? 

A.5. Relative to the current risk-based rules, the aggregate QIS– 

4 change in minimum required risk-based capital (MRC) for securVerDate Nov 24 2008 01:21 Nov 24, 2009 Jkt 050306 PO 00000 Frm 00203 Fmt 6602 Sfmt 6602 E:\HR\OC\A306.XXX A306

jbell on DSKDVH8Z91PROD with HEARING
200 

itization exposures was ¥17.9%, while that for all other off-balance 

sheet exposures (including operational risk) was +40.3%. In addition to the general caution that should be exercised when interpreting QIS–4 results, several specific factors should be considered 

in the context of results for securitization exposures and other offbalance sheet exposures. 

Special Considerations When Interpreting QIS–4 Results for 

Securitization Exposures 

First, with regard to securitization exposures, it should be noted 

that some key elements of the Basel II treatment are already incorporated into the current risk-based capital rules as a result of revisions the agencies made to the U.S. rules in 2001 to address risk 

sensitivity and capital arbitrage concerns. These revisions were not 

adopted at the time by other countries, implying that U.S. banks 

faced more conservative risk-based capital charges against most 

securitization exposures than their foreign competitors. With the 

adoption of Basel II, the U.S. and foreign treatments for 

securitization exposures will be brought into alignment. Based on 

QIS–5 results, it is estimated that the Basel II treatment of 

securitization exposures will produce approximately a 10% increase 

in risk-based capital charges for non-U.S. Group I banks, relative 

to Basel I. 

Second, most of the ¥17.9% change in risk-based capital charges 

for securitization exposures in QIS–4 appears to reflect lower riskweights under Basel II, compared to the current rules, for very 

highly-rated (e.g., AAA or AA) asset-backed securities held mainly 

in banks’ securities (ABS) portfolios. In QIS–4, this category also 

included residential mortgage-backed securities issued by Fannie 

Mae and Freddie Mac. Under Basel II, these very low-risk ABSs 

typically receive risk-weights ranging from 7% to 15%, compared 

with 20% under current risk-based capital rules. These Basel II 

risk-weights will better reflect the actual credit risks of these 

ABSs, and will provide more appropriate risk-based capital incentives for banks to hold low-risk securities and maintain adequate 

liquidity. While below-investment-grade ABSs will receive much 

higher capital charges under Basel II compared to current rules, 

the QIS–4 respondents held relatively small amounts of such instruments. 

Lastly, the QIS–4 results do not reflect changes proposed in the 

recently issued Market Risk NPR that would increase risk-based 

capital charges for certain (unrated) high-risk, illiquid securitization exposures held in trading accounts. These revisions are intended, in part, to close an emerging loophole in our capital rules. 

In recent years, some banks have shifted such positions from the 

banking book to the trading account, where they currently incur 

much lower capital requirements. 

Special Considerations When Interpreting QIS–4 Results for Other 

Off-Balance Sheet Exposures 

With regard to off-balance sheet exposures (excluding securitization exposures) the aggregate 40.3% increase in estimated MRC 

under Basel II was driven largely by the operational risk capital 

charge. Operational risk is one of the most important of the hidden, 


jbell on DSKDVH8Z91PROD with HEARING
201 

off-balance sheet risk for which there is no explicit capital charge 

under the current risk-based capital rules. The estimated change in 

off-balance sheet credit exposures alone was ¥10.0%; inclusive of 

the 1.06 multiplier this change would have been around ¥5.3%. 

Q.6. If the goal is to encourage sophisticated risk measurement and 

management to our largest banks, why can’t they be encouraged 

adequately through Pillar 2’s supervisory guidance and Pillar 3’s 

transparency through public disclosure? 

A.6. Pillar 2 and Pillar 3 are indeed vitally important elements of 

the Basel II framework, and should not be overlooked. Their value 

is enhanced and strengthened by linking them with the advanced 

Pillar 1 approaches. Key advantages of the advanced Pillar 1 approaches of Basel II are that they: (i) encourage improvements in 

risk measurement and management at the participating banking 

institutions; (ii) facilitate the integration of minimum regulatory 

capital requirements with internal risk measurement and management processes; and (iii) provide a common risk measurement and 

management vocabulary for banks and supervisors to use. Another 

key objective of Basel II is to improve risk sensitivity of risk-based 

capital requirements at the largest U.S. institutions. 

In developing the Basel II NPR, the U.S. agencies did consider 

whether they should simply encourage risk management improvements at these large institutions and not tie those practices directly to regulatory capital. But it became clear that for safety and 

soundness reasons the relative riskiness of these banks’ positions 

needed to be included in minimum regulatory capital measures, 

that is, in the advanced Pillar 1 approaches. Just looking at risk 

measurement practices and models (Pillar 2) does not provide the 

appropriate backstop that actual capital does; in turn, minimum required capital measures at the largest institutions lack meaning 

when they are not risk sensitive. Additional disclosure of risk 

measurement and management (Pillar 3) without a discussion of 

the advanced Pillar 1 approaches would not necessarily represent 

an improvement over traditional risk management disclosures. We 

believe the Pillar 1 measures, when complemented by Pillars 2 and 

3, provide a sound framework for bankers, supervisors, and market 

participants to assess how capital and risk evolve over time. 

Q.7. If the mandatory banks operate under the Advanced Approach 

and other banks operate under Basel IA, how much do you expect 

capital requirements to change on average for the two groups of 

banks? Will that affect the competitive position of banks not using 

the Basel II Advanced Approach? 

A.7. At this point in the implementation process, we cannot estimate accurately what the average change in capital requirements 

would be for banks operating under the Basel II Advanced Approaches and those operating under Basel IA. As you know, the 

Basel II proposal is now in the formal comment period. Under current implementation plans, we have overlapping comment periods 

for the two proposals so that commenters will be able to assess the 

potential effect of both proposals on their minimum required capital positions and provide meaningful information to the agencies 

about the overall impacts of the proposals as well as identify areas 

of potential competitive pressure. 


jbell on DSKDVH8Z91PROD with HEARING
202 

As we review and analyze public comments on both proposals, 

one objective we will keep in mind is to mitigate, to the extent possible, areas of demonstrated negative competitive impact. However, 

we must also keep in mind the fundamental point that the Basel 

II Advanced Approaches are designed to be as risk-sensitive as possible and the Basel IA proposal currently under interagency discussion is intended to fit within the structure of the existing broadbrush risk-based capital framework without imposing undue regulatory burden on smaller financial institutions. It is inevitable that 

under the two frameworks similar exposures may be subject to different minimum risk-based capital charges. As we move forward 

with implementing Basel II, we will continue to be mindful of potential competitive concerns and will propose and implement modifications to our capital rules as appropriate to address competitive 

issues. 


jbell on DSKDVH8Z91PROD with HEARING
203 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 294 here 50306A.127
204 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 295 here 50306A.128
205 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 296 here 50306A.129
206 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 297 here 50306A.130
207 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 298 here 50306A.131
208 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 299 here 50306A.132
209 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 300 here 50306A.133
210 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 301 here 50306A.134
211 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 302 here 50306A.135
212 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 303 here 50306A.136
213 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 304 here 50306A.137
214 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 305 here 50306A.138
215 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 306 here 50306A.139
216 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 307 here 50306A.140
217 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 308 here 50306A.141
218 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 309 here 50306A.142
219 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 310 here 50306A.143
220 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 311 here 50306A.144
221 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 312 here 50306A.145
222 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 313 here 50306A.146
223 


jbell on DSKDVH8Z91PROD with HEARINGInsert offset folio 314 here 50306A.147
224 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR SARBANES 

FROM DIANA L. TAYLOR 

Q.1. The Advanced Approach of Basel II has been touted as addressing safety and soundness concerns related to hidden and 

undercapitalized risks that large, complex banks now take under 

the current rules. In the results of QIS–4, what was the aggregate 

change in minimum risk-based capital requirements for securitized 

exposures? For other off-balance sheet exposures? If the current 

rules are insufficient to address these complex risks, is it because 

they require too much capital, or too little capital? 

A.1. 

Securitized Exposures 

The Banking Department (like other members of CSBS) has only 

seen the public report on the QIS–4 results, so we can’t provide any 

new information about the changes in minimum risk-based capital 

requirements for securitized exposures found in QIS–4. The paper, 

‘‘Summary Findings of the Fourth Quantitative Impact Study,’’ released by the federal agencies in February 2006, includes little specific mention of changes in capital for securitized assets, but does 

show weighted average and median changes in required capital in 

Table 4. The weighted average change in minimum regulatory capital for securitized assets at the QIS–4 banks was ¥17.9%, and the 

median change was ¥39.7%. However, there is no discussion of 

these median and average changes, nor of the types of securitized 

assets held by QIS–4 banks, in the text of the paper. 

Basel II proposes three different approaches to calculating capital for securitization exposures: the Ratings-Based Approach 

(RBA) for securitizations with external ratings, the Internal Assessment Approach (IAA) and the Supervisory Formula Approach 

(SFA) for unrated securitizations. Banks allowed to use the IAA approach map their own assessments of the credit risk of their 

securitization exposures to external ratings and then use the RBA 

risk weights. The reduction in risk-weighting for investment-grade 

rated securitizations, and those with inferred investment grade ratings, is significant under Basel II: 

REPRESENTATIVE RISK WEIGHTS FOR SECURITIZATIONS WITH EXTERNAL RATINGS (OR INFERRED 

RATINGS) 

Long-Term rating Current (%) Basel II RBA—senior positions (%) Basel II RBA—base (%) 

AAA .............................................................. 20 7 12 

AA ................................................................ 8 15 

A+ ............................................................... 50 10 18 

A .................................................................. 12 20 

A- ................................................................ 20 35 

BBB+ .......................................................... 100 35 50 

BBB¥ ......................................................... 60 75 

BBB ............................................................. 100 100 

BB+ ............................................................. 200 250 250 

BB ............................................................... 425 425 

BB¥ ........................................................... 650 650 


jbell on DSKDVH8Z91PROD with HEARING
225 

1 Banks report as a negative number the amortized cost of mortgage-backed and asset-backed 

securities that are rated one grade below investment grade in item RC–R 35 Col. B and RC– 

R 36 Col. B., in addition to the difference in fair value and amortized cost of their other securities. These items indicated securities rated BB in only two cases. 2 ‘‘Regulatory Impact Analysis for Risk-Based Capital Standards: Revised Capital Adequacy 

Guidelines,’’ http://www.occ.treas.gov/law/Basel%20II%20RIA.pdf 

REPRESENTATIVE RISK WEIGHTS FOR SECURITIZATIONS WITH EXTERNAL RATINGS (OR INFERRED 

RATINGS)—Continued 

Long-Term rating Current (%) Basel II RBA—senior positions (%) Basel II RBA—base (%) 

Below BB¥ ................................................ Deduct Deduct Deduct 

If most of the securitizations held by the QIS–4 banks were at 

least investment grade or could be inferred to be at least investment grade, then it is clear that these banks would report significant declines in required capital for their securitization portfolios. 

As mentioned above, the QIS–4 report contains no information 

about the portfolio breakdown for participating banks, although the 

QIS–4 worksheets and questionnaire requested extensive information about banks’ securitized asset portfolios: for example, the exposures for which each of the three capital calculation methods apply, 

the amount of credit risk mitigation (collateral and guarantees) 

that banks applied to each exposure type, and the amount of exposures that the early amortization requirement applied to. It is very 

difficult to understand the impact of the changes in capital treatment for securitizations without access to information from the 

QIS–4 submissions, and CSBS has requested such access. 

Some evidence of banks’ securitization holdings can be found in 

the current Call Report, as banks report BB-rated securitization 

amounts as a negative number on Schedule RC-R.1 We don’t know 

which banks participated in the QIS–4, but presumably the banks 

identified by the OCC as meeting the definition of mandatory 

bank 2 were among the participants. Reviewing the June 30, 2006, 

Call Reports for the ten banks identified by the OCC suggests that 

few of their securitized assets had low ratings, as only two of these 

banks show evidence of possibly holding securitizations rated BB. 

In both cases, the amount indicated as possibly representing BBrated securitizations was less than 5% of total privately issued 

securitizations. (The breakdown of deducted assets cannot be determined from the Call Report alone, as different types of deductions 

are lumped together.) The federal agencies have collected information that enables them to describe in detail the securitization portfolio at each of the 26 QIS–4 banks; understanding these portfolios 

is essential to interpreting the impact of Basel II. 

Banking Department 

It seems unlikely that the banks that participated in QIS–4 are 

currently holding large positions in poorly rated securitizations or 

unrated securitizations for which they are unable to infer ratings. 

The median change in capital requirements for securitization was 

¥39.7%, and it is hard to see how this decline would have resulted 

if there had been sizeable holdings that received double or triple 

risk-weighting, or had to be deducted. It seems probable that large, 

complex banks already tend to hold securitizations rated at least 


jbell on DSKDVH8Z91PROD with HEARING
226 

3http://www.bundesbank.de/download/bankenaufsicht/pdf/qis4/basellqisl 

laenderberichtldt.pdf 4http://www.bis.org/bcbs/qis/qis5results.pdf 

5 ‘‘Basel II: Bottom-Line Impact on Securitization Markets,’’ FitchRatings, September 12, 2005, 

www.fitchratings.com 

investment grade (or that can be inferred to be investment grade), 

and the net effect of Basel II on their securitization portfolio will 

be to reduce capital requirements. Basel II might even have the 

perverse effect of allowing banks to hold a greater percentage of 

poorly rated or unrated securitizations without increasing required 

capital, since the risk weights for investment-grade rated securities 

are so much lower than currently. 

The concept behind Basel II’s treatment of securitization is very 

close to that of current U.S. treatment. The major differences are 

in particular risk weight specifications and in allowing banks to 

use the Supervisory Formula Approach for some securitizations 

that previously would have been deducted from capital. It seems 

probable that the framers of Basel II felt that current treatment 

is inadequate because banks are required to hold too much capital 

for their securitization exposures. More detailed information about 

the QIS–4 securitization portfolios would help in determining if 

this is so. 

However, it’s interesting to note that the impact of Basel II’s 

treatment of securitization varies widely across countries that are 

adopting it, as current rules are very different. For example, German QIS–4 results included an increase of 153% in required capital 

for participating Group 1 banks (those with more than 3 billion 

euros in tier 1 capital) using the Advanced IRB approach. 3 The 

Basel Committee’s release 4 on results of QIS 5 reported that ‘‘The 

average change in minimum required capital from the securitisation portfolio for G10 Group 1 banks varies between ¥42% 

and +60% for the IRB approach. This seems to be the result of different types of positions and differences in current national regulations. Some countries have already under their current national 

regulation a stricter treatment than the current Accord provides 

(this affects in particular liquidity facilities and retained 

securitisation positions).’’ The U.S. is clearly one of these countries. 

The Department is also concerned with the potential incentives 

presented to banks through the Basel II revisions. A paper released 

last year by Fitch Ratings 5 discussed some of the capital incentives 

contained in Basel II’s treatment of securitized exposures. This report was published before the federal agencies released the Basel 

II NPR, which included changes in the treatment of securitized exposures from the earlier ANPR, but Fitch Rating’s analysis of the 

Basel II treatment of a sample portfolio of securitizations is still 

relevant. Fitch analysts found that Basel II banks would have differing incentives to securitize assets depending on portfolio type, 

and that Basel II could lead to inconsistencies in capital charges 

across different securitization deals and might influence deal structuring. These potential consequences need serious consideration before Basel II is implemented. 


jbell on DSKDVH8Z91PROD with HEARING
227 

6http://www.federalreserve.gov/boarddocs/press/bcreg/2006/20060224/qis4lattachmentl 

revised.htm 

Other Off-Balance Sheet Exposures 

The QIS–4 results reported in the Summary paper include the effects of credit risk mitigation, and group all types of exposure (both 

on- and off-balance-sheet exposures) so it is difficult to determine 

aggregate changes in capital requirements for off-balance sheet exposures. Although the A–IRB approach of Basel II requires banks 

to hold capital for undrawn commitments for which current requirements impose a 0% risk weight, this approach also allows 

banks to calculate capital based on their own estimation of the actual exposure at default, probability of default, and loss given default. In addition, Basel II includes a much broader recognition of 

the credit risk mitigation afforded by off-balance sheet exposures. 

The QIS–4 Summary paper provides too limited information to 

allow us to determine the impact on off-balance sheet exposures. 

The federal agencies have reported summary statistics for credit 

conversion factors (CCF) for the exposure at default (EAD) for 

undrawn lines in different portfolios, but have not reported PDs or 

LGDs for these undrawn lines, nor have they reported the exposure 

at default credit conversion factors for drawn lines, so comparison 

of on-balance sheet and off-balance sheet exposures is almost impossible. Again, the QIS–4 templates and questionnaire requested 

extensive information on off-balance sheet positions, and their use 

as credit mitigants. More detailed information on the QIS–4 results 

would allow us to determine the impact of Basel II on these exposures. 

The federal agencies did state, 6 however, that one of the factors 

that might have caused minimum capital requirements in QIS–4 to 

be understated was ‘‘the lack of incorporation of credit risk mitigation.’’ Further, they state, ‘‘The Agencies expect that as we move 

closer to implementation, systems will capture the information necessary to permit the assignment of lower risk weights to these exposures.’’ 

Q.2. If the goal is to encourage sophisticated risk measurement and 

management at our largest banks, why can’t they be encouraged 

adequately through pillar 2’s supervisory guidance and pillar 3’s 

transparency through public disclosure? 

A.2. We believe that supervisory guidance and public disclosure 

have proven to be very effective methods of encouraging improvements in risk management. Many institutions have found market 

recognition of sophisticated risk management a very valuable goal. 

We have utilized ‘‘best practices’’ discussions and supervisory guidance papers to help banks develop improvements in their risk management and modeling systems. Encouraging improvement is an 

integral part of supervision, either through peer analysis, benchmarking, or consultation. 

One of the complaints we hear from banks about Basel II is that 

the federal agencies have not released supervisory guidance on implementation, and this complaint highlights the need for Pillar 2. 

Another complaint that we’ve heard is that the Basel II supervisory 

formulas aren’t appropriate for large complex banking institutions. 


jbell on DSKDVH8Z91PROD with HEARING
228 

7http://www.banking.state.ny.us/rp0605.pdf 

Promoting improvements in risk management through Pillar 2 and 

Pillar 3 would have the advantages of allowing banks to pursue the 

quantitative modeling and data collection that best fits their own 

risk profile and allowing supervisors to assess each bank’s system 

without imposing constraints on their modeling efforts. Advanced 

research and data collection in credit and operational risk modeling 

are so new that development in this field might be improved if 

banks were not constrained by the Basel II supervisory models. 

However, supervisors would have to be assured that safe and 

sound capital requirements remained in place while this development took place. 

Q.3. If the mandatory banks operate under the Advanced Approach 

and other banks operate under Basel IA, how much do you expect 

capital requirements to change on average for the two groups of 

banks? Will that affect the competitive position of banks not using 

the Basel II Advanced Approach? 

A.3. We believe that overall risk-based capital requirements will 

fall at the mandatory banks, and are convinced that transitional 

floors and safeguards are necessary. Although the reductions in 

risk weights proposed under Basel IA are in some cases similar to 

the weighted average changes reported by the QIS 4 banks—QIS– 

4 banks reported a weighted average reduction in minimum capital 

requirements for small business loans of 26.6% and Basel IA suggests reducing the risk weight for small business loans to 75% from 

100%, a drop of 25%—in other portfolios, the weighted average 

change is much greater for QIS 4 banks. For example, QIS–4 banks 

reported a weighted average decrease in minimum regulatory capital for residential mortgages of 61.4% and a weighted average decrease of 74.3% for home equity loans. 

Our survey 7 of the change in capital requirements at several 

New York banks under Basel IA proposed risk weights, however, 

produced an estimate of 34% as the average risk weight for the 

banks residential mortgage portfolio, or a reduction of 30% from 

current risk weights. And even in the cases where Basel IA suggests a lower risk weight, the restrictions attendant on using the 

new risk weight are much greater than under Basel II. A case in 

point is the treatment of home equity loans, where Basel IA banks 

can only apply a risk weight based on LTV or other risk factors if 

the bank holds both first and junior liens. There is no such restriction for Basel II banks. It is unlikely that Basel IA banks will have 

many externally rated borrowers for commercial real estate loans; 

thus these loans will probably be risk-weighted at least at 100%. 

However, the weighted average change in minimum required capital for the riskiest commercial real estate loans at QIS 4 banks 

was a reduction of 33.4%. 

There is a great danger that if mandatory banks are allowed to 

hold less risk-based capital than Basel IA banks, then these IA 

banks will be at a competitive disadvantage. We believe that Basel 

IA banks and mandatory banks do compete in many of the same 

markets and offer many of the same products. Seven of the ten 

banks identified as meeting the definition of mandatory bank by 

the OCC have branches in New York State; these branches acVerDate Nov 24 2008 01:21 Nov 24, 2009 Jkt 050306 PO 00000 Frm 00232 Fmt 6602 Sfmt 6602 E:\HR\OC\A306.XXX A306

jbell on DSKDVH8Z91PROD with HEARING
229 

counted for 33% of New York insured bank branches and held 58% 

of total insured deposits in the state as of June 30, 2006. Nine of 

the ‘‘mandatory’’ banks reported originating small business loans to 

New York addresses in their 2005 CRA reports—these nine banks 

reported a significant share—close to half—of total small business 

loans reported in the state. We are well aware of the many services 

and products these banks provide for New York residents. However, we are uneasy when one group of banks with already substantial market power is provided—through regulation—with a 

competitive advantage over smaller banks that they compete with. 

We are particularly concerned when a substantial part of their capital advantage—much lighter risk weights for retail loans—comes 

from the great volume of their retail loan portfolios. Smaller banks 

cannot compete in volume with the large retail banks. 

In the U.S., if the large Basel II banks have an advantage over 

the smaller banks because their cost structure is so much more attractive, this could push acquisition of regional and community 

banks by the Basel II banks. Increased acquisition of Basel IA 

banks could leave local communities, which rely on their local 

banks for products and services that meet their specific needs, with 

access to a limited number of bank products; we could find ourselves in a situation in which it is no longer profitable to provide 

a range of financial services to small businesses in smaller communities. 

In other words, a business model in which smaller banks, by design, are at a competitive disadvantage to Basel II banks could 

have a significant negative impact on small businesses in the 

U.S.—the backbone of our economy. The impact of Basel II on competition in U.S. banking markets must be seriously assessed before 

implementation goes forward. 


jbell on DSKDVH8Z91PROD with HEARING
230 


jbell on DSKDVH8Z91PROD with HEARINGInsert graphic folio 322 50306A.148
231 


jbell on DSKDVH8Z91PROD with HEARINGInsert graphic folio 323 50306A.149
232 


jbell on DSKDVH8Z91PROD with HEARINGInsert graphic folio 324 50306A.150
233 


jbell on DSKDVH8Z91PROD with HEARINGInsert graphic folio 325 50306A.151
234 


jbell on DSKDVH8Z91PROD with HEARINGInsert graphic folio 326 50306A.152
235 


jbell on DSKDVH8Z91PROD with HEARINGInsert graphic folio 327 50306A.153
236 


jbell on DSKDVH8Z91PROD with HEARINGInsert graphic folio 328 50306A.154
237 


jbell on DSKDVH8Z91PROD with HEARINGInsert graphic folio 329 50306A.155
238 


jbell on DSKDVH8Z91PROD with HEARINGInsert graphic folio 330/500 50306A.156