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94–514 PDF 2004

S. HRG. 108–495

REVIEW OF THE NEW

BASEL CAPITAL ACCORD

HEARING

BEFORE THE

COMMITTEE ON

BANKING, HOUSING, AND URBAN AFFAIRS

UNITED STATES SENATE

ONE HUNDRED EIGHTH CONGRESS

FIRST SESSION

ON

THE NEW BASEL CAPITAL ACCORD PROPOSAL, WHICH WILL ADDRESS

AN AREA WHICH IS IMPORTANT TO THE SAFE AND SOUND FUNCTION OF OUR BANKING SYSTEM

JUNE 18, 2003

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

(

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

LINCOLN D. CHAFEE, Rhode Island

PAUL S. SARBANES, Maryland

CHRISTOPHER J. DODD, Connecticut

TIM JOHNSON, South Dakota

JACK REED, Rhode Island

CHARLES E. SCHUMER, New York

EVAN BAYH, Indiana

ZELL MILLER, Georgia

THOMAS R. CARPER, Delaware

DEBBIE STABENOW, Michigan

JON S. CORZINE, New Jersey

KATHLEEN L. CASEY, Staff Director and Counsel

STEVEN B. HARRIS, Democratic Staff Director and Chief Counsel

MARK F. OESTERLE, Counsel

MARTIN J. GRUENBERG, Democratic Senior Counsel

VINCENT MEEHAN, Democratic Counsel

JOSEPH R. KOLINSKI, Chief Clerk and Computer Systems Administrator

GEORGE E. WHITTLE, Editor

(II)

CONTENTS

WEDNESDAY, JUNE 18, 2003

Page

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

Opening statements, comments, or prepared statements of:

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

Senator Allard ................................................................................................... 3

Prepared statement ................................................................................... 53

Senator Reed ..................................................................................................... 3

Senator Sununu ................................................................................................ 3

Senator Corzine ................................................................................................ 21

WITNESSES

Roger W. Ferguson, Jr., Vice Chairman, Board of Governors of the Federal

Reserve System .................................................................................................... 3

Prepared statement .......................................................................................... 53

John D. Hawke, Jr., Comptroller of the Currency, U.S. Department of the

Treasury ................................................................................................................ 7

Prepared statement .......................................................................................... 71

Donald E. Powell, Chairman, Federal Deposit Insurance Corporation ............... 10

Prepared statement .......................................................................................... 83

James E. Gilleran, Director, Office of Thrift Supervision .................................... 11

Prepared statement .......................................................................................... 86

Maurice H. Hartigan, II, President and CEO, RMA—The Risk Management

Association ............................................................................................................ 33

Prepared statement .......................................................................................... 90

Micah S. Green, President, The Bond Market Association .................................. 35

Prepared statement .......................................................................................... 92

Edward I. Altman, Max L. Heine Professor of Finance, Leonard N. Stern

School of Business, New York University .......................................................... 36

Prepared statement .......................................................................................... 96

Karen Shaw Petrou, Managing Partner, Federal Financial Analytics, Inc. ....... 39

Prepared statement .......................................................................................... 98

D. Wilson Ervin, Managing Director, Credit Suisse First Boston, on Behalf

of the Financial Services Roundtable ................................................................. 41

Prepared statement .......................................................................................... 103

Kevin M. Blakely, Executive Vice President and Chief Risk Officer, KeyCorp . 44

Prepared statement .......................................................................................... 112

(III)

(1)

REVIEW OF THE NEW BASEL CAPITAL

ACCORD

WEDNESDAY, JUNE 18, 2003

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

The Committee met at 10:05 a.m. in room SD–538 of the Dirksen

Senate Office Building, Senator Richard C. Shelby (Chairman of

the Committee) presiding.

OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

Chairman SHELBY. The hearing will come to order.

I want to first thank the witnesses for coming here this morning.

The purpose of the hearing today is to consider the New Basel Capital Accord Proposal. This important proposal addresses an area

that is extremely important to the safe and sound function of our

banking system. With only a quick glance at the economic history

books, one can readily determine that thinly capitalized banks pose

huge risks to depositors, the banking system, and to the overall

economy, and perhaps to the taxpayers.

To protect against such risks, we have employed minimum capital requirements as a means to ensure that banks possess the financial integrity necessary to carry on banking activities. What

this really means is that bank capital, the bank owner’s money, is

‘‘on the line’’ with the other bank resources used to conduct business. Thus, bank losses translate to bank owners’ losses.

By ensuring the sharing of losses amongst bank depositors, creditors, and owners, capital requirements properly align the interests

of these groups, and alignment of these interests is crucial. Capital

is a very valuable thing. There is tremendous competition for it.

Those who provide it expect something in return for it. Those who

obtain it must protect it and must make sure it produces. Thus,

with their own capital in the breach, banks have developed very sophisticated risk identification, analysis, and management tools to

achieve these ends. Ultimately, the combination of capital requirements and risk management techniques have served us well.

Today, we are considering proposed changes to the current capital regime, changes which could have very serious effects on the

amount of risk-based capital banks are required to hold, on the risk

management techniques they employ, and even on the domestic

and international competitive landscapes.

Because of the significant nature of these issues, I believe this

Committee has a responsibility to closely scrutinize the proposal

2

and, at a minimum, become aware of its ramifications so that we

can draw our own conclusions regarding its merit.

I thank you for being here today, and I look forward to your testimony a little later.

Senator Sarbanes.

STATEMENT OF SENATOR PAUL S. SARBANES

Senator SARBANES. Thank you very much, Mr. Chairman.

First, I want to welcome this distinguished panel of regulators,

our line of defense, perhaps, for the Banking Committee this morning. And I want to commend Chairman Shelby for holding this

oversight hearing on the Basel Capital Accord which is now being

worked on.

The New Basel Accord is a highly complex proposal with potentially significant consequences for both the United States and the

international financial system, and I think it is appropriate for the

Committee to review its likely impact, in fact, before the agreement

is actually concluded and the process of implementing it begins.

The whole dynamic changes at that point, and if there are concerns

about it and what its implications are, I think it is important that

they be heard earlier rather than later. Otherwise, we run the risk

of examining what has been agreed upon, which is different from

examining something that has not yet been agreed upon.

The first Basel Accord, concluded in 1988 and fully implemented

by 1992, was an effort to establish international standards for the

measurement of bank capital in order to bring about greater uniformity of regulation and reduce risk in the international financial

system. I think it is generally acknowledged to have been a significant step forward, but there now appears to be agreement that the

system for measuring risk under Basel I may be inadequate today,

particularly for large, complex financial institutions. In fact, former

Federal Reserve Board Governor Laurence Meyer observed, ‘‘Large,

complex banking organizations now routinely structure their portfolios in ways that arbitrage around the current capital standard.

These banks can often lower their capital requirements with little,

if any, reduction in their actual risk taking. As a result, reported

capital ratios may, and often do, overstate a bank’s true financial

strength.’’ That is former Fed Board Governor Laurence Meyer.

The proposed Basel II Accord is an effort to capture in a more

sophisticated way the financial risks undertaken by banking institutions and to assign capital requirements appropriate to those

risks. There appears to be agreement about the broad goals of the

Basel II Accord, but press accounts report there are significant differences of view among the bank regulators about the agreement

itself and, indeed, within the American banking industry.

Most of the discussion is focused on whether the proposed Accord

would raise or reduce capital; whether it would place one set of

U.S. banking institutions at a competitive disadvantage to another;

or whether U.S. institutions generally would be placed at a disadvantage relative to foreign institutions; and, finally, whether the

agreement is too complex and difficult to implement.

These are very important questions. It seems to me appropriate

to have a public discussion about them. We need to have some

sense of the domestic and international impact of the Accord. One

3

of the key questions that will need to be addressed today is whether the regulators believe they have a sufficient grasp on the impact

of the proposed agreement to conclude it internationally and implement it domestically. I must say, having sat on this Committee for

a number of years, I would have concerns about any agreement

that would significantly reduce the capital held by large financial

institutions in terms of the safety and soundness of the system.

Mr. Chairman, I look forward to the testimony.

Chairman SHELBY. Thank you.

Senator ALLARD.

COMMENTS OF SENATOR WAYNE ALLARD

Senator ALLARD. Mr. Chairman, I would like to hear from our

panel, and to expedite that, I would like to just submit my comments for the record.

Chairman SHELBY. Without objection, it will be entered into the

record.

Senator ALLARD. And I thank them personally for being here,

and I look forward to their testimony.

Chairman SHELBY. Senator Reed.

COMMENTS OF SENATOR JACK REED

Senator REED. Mr. Chairman, I think Senator Allard set the

right direction. And I look forward to hearing the testimony.

Chairman SHELBY. Senator Sununu.

COMMENTS OF SENATOR JOHN E. SUNUNU

Senator SUNUNU. Thank you, Mr. Chairman. I have no opening

statement. I am looking forward to hearing from the witnesses.

Chairman SHELBY. Our first panel today, we have with us the

Honorable Roger W. Ferguson, Jr., who is the Vice Chairman of the

Board of Governors of the Federal Reserve System. He is no

stranger to this Committee. Welcome, Governor. The Honorable

John Hawke, Comptroller of the Currency, who has also spent a lot

of time with us. The Honorable Donald Powell, Chairman of the

FDIC, who has been here many times. And Honorable James

Gilleran, Director of the Office of Thrift Supervision.

Gentlemen, we welcome all of you. All of your statements will be

made part of the record in their entirety. You proceed as you wish.

Governor Ferguson, we will start with you.

STATEMENT OF ROGER W. FERGUSON, JR.

VICE CHAIRMAN, BOARD OF GOVERNORS

OF THE FEDERAL RESERVE SYSTEM

Mr. FERGUSON. Thank you, Mr. Chairman, and also Senator Sarbanes and Members of the Committee. It is certainly a pleasure to

be here before you today on behalf of the Board of Governors to discuss Basel II, which, as you have already indicated, is the evolving

New Capital Accord for internationally active banks. I appreciate

the fact that the full statement will be made part of the record.

Under Basel II, most of the banks in this country will remain

under the current capital regime. The operations of the vast majority of U.S. banks do not require the full panoply of sophisticated

4

risk management techniques involved in the advanced versions of

Basel II. And the simpler versions of the new accord will not provide our banks, with their current supervisory and disclosure requirements, much additional benefit.

We have an entirely different view of our largest and most complicated banking organizations, especially those with significant

operations abroad. A very important objective of the proposed Basel

II is to continue to promote consistency of capital requirements for

banks that compete directly in global markets. And the supervisors

of the industrial nations have agreed that banks operating across

national boundaries should be under common capital standards to

assure a competitive balance, and that standard will soon be

Basel II.

Supervisors also want to encourage the largest banking organizations in the world to continue to incorporate into their operations

the most sophisticated techniques for both the measurement and

the management of risk. Substantial difficulty at any one of those

entities could have significant effects on global financial markets.

In our view, prudential supervisors and central bankers would be

remiss if we did not address the evolving complexity of our largest

banks and ensure that modern techniques were being used to manage their risks.

In the United States, the supervisory agencies will be proposing

that to meet these objectives, banks with large foreign exposures

and/or banks that are large and complex should be in the set of

core banks that would be required to adopt Basel II. And the U.S.

supervisors have concluded that these banks should be required to

adopt the advanced versions of Basel II, the so-called Advanced Internal Ratings Based, or A–IRB, approach for measuring credit risk

and the Advanced Measurement Approaches, or AMA, for measuring operational risk. These approaches, which are described in

more detail in my written statement, are the most consistent with

best practice risk measurement and risk management.

Ten U.S. banks meet the proposed criteria to be core banks and,

thus, would be required under our proposal to adopt the A–IRB

and the AMA to measure their credit and operational risks, respectively. We would also permit any bank that meets the infrastructure requirements of the A–IRB and the AMA—that is, the ability

to quantify and develop the necessary risk parameters on credit exposures and also to develop measurement systems for operational

risk exposures—to choose Basel II.

We anticipate that about 10 or so large banks now outside of

that core group that I have discussed would choose to adopt Basel

II in the near term. Thus, in total, we expect about 20 banks to

adopt the advanced versions of Basel II before or shortly after implementation date.

Now, let me turn to three issues that some have raised, and, in

fact, these reflect some of the comments that you two raised, Mr.

Chairman and Senator Sarbanes, in your opening comments.

The first is competitive equity. While this concern takes several

forms, the most frequently voiced is the view that competitive imbalance might result from the so-called ‘‘bifurcated rules’’ requiring

Basel II for large banks while applying the current capital rules for

all other U.S. banks. The fear in this regard is that banks that reVerDate 11-MAY-2000 10:04 Jul 07, 2004 Jkt 000000 PO 00000 Frm 00008 Fmt 6633 Sfmt 6633 94514.TXT BANK1 PsN: BANK1
5

main under the current capital rules, with capital charges that are

not as risk-sensitive as those in Basel II, might be at a competitive

disadvantage compared to the Basel II banks that would get lower

capital charges on less risky assets.

We take this concern seriously and will be exploring it through

the upcoming Advanced Notice of Proposed Rulemaking. But without prejudging the issue, there are some reasons to believe that little, if any, competitive disadvantage will be brought to those banks

remaining under the current capital regime.

The basic question here is the role of minimum regulatory capital

requirements in the determination of the price and the availability

of credit. Our understanding of bank pricing is that it starts with

the capital allocations that the banks themselves make internally

within their own organizations, then factors in explicit recognition

of the riskiness of credit, and is then further adjusted on the basis

of market conditions and local competition from bank and nonbank

sources. In some markets, some banks will be relatively passive

price takers. In either case, regulatory capital, which is what Basel

II deals with, in particular, regulatory minimum capital, is mostly

irrelevant in the pricing decision and, therefore, unlikely to cause

competitive disparities.

Moreover, most banks, and especially the smaller ones, today

hold capital far in excess of the regulatory minimums for a variety

of reasons. Thus, changes in their own or their rival’s minimum

regulatory capital due to Basel II generally would not have much

effect on the level of capital that they choose to hold and would,

therefore, not necessarily affect internal capital allocations, which

are the allocations that drive, in part, pricing decisions.

Finally, the banks that most frequently express a fear of being

disadvantaged by a bifurcated regulatory regime have for years

faced capital arbitrage from larger rivals, who are able to reduce

their capital charges by securitizing loans for which the regulatory

charge was too high relative to either the market or economic capital charge. The A–IRB approach would provide, in effect, risk-sensitive capital charges for lower-risk assets that are similar to what

the larger banks have for years already obtained through capital

arbitrage. In short, competitive realities between banks might not

change in many markets in which minimum regulatory capital

charges would become more explicitly risk sensitive.

Let me repeat that I do not mean to dismiss competitive equity

concerns at all. Indeed, I hope that the comments on the Advanced

Notice of Proposed Rulemaking, the ANPR, might bring forth insights and analyses that respond directly to the issues, particularly

the observations I have just made. But, I really must say that, we

need to see reasoned analysis and not just assertions.

A second area of concern is the proposed Pillar 1 treatment of

operational risk. Operational risk refers to losses from failures of

systems, controls, or people. Capital charges for such risks have

been implicit under Basel I for the last 15 years. These risks will,

for the first time, be explicitly subject to capital charges under the

Basel II proposal.

Operational disruptions have caused banks to suffer huge losses

and, in some cases, failure both here and abroad. In an increasingly technologically driven banking system, operational risks have

6

become an even larger share of total risk. Frankly, at some banks,

they are probably the dominant risk. To avoid addressing them

would be imprudent and would leave a considerable gap in our regulatory system.

The AMA for determining capital charges on operational risk is

a principles-based approach that would obligate banks to evaluate

their own operational risks in a structured but flexible way. Importantly, a bank could reduce its operational risk charge by adopting

procedures, systems, and controls that reduce its risk or by shifting

the risk to others through measures such as insurance.

Some banks for which operational risk is the dominant risk oppose an explicit capital charge and would prefer that operational

risk be handled case-by-case through the supervisory review of

buffer capital rather than be subject to an explicit regulatory capital charge. The Federal Reserve believes that would be a mistake

because it would greatly reduce the transparency of risk and capital that is such an important part of Basel II, and it would make

it very difficult to treat risks comparably across banks.

The third concern I would like to discuss is the fear that the combination of credit and operational risk capital charges for those

U.S. banks that are under Basel II would decline too much for prudent supervisory purposes. Speaking for the Federal Reserve

Board, let me underline that we could not support a final Basel II

that we felt caused capital to decline to unsafe and unsound levels

at the largest banks. There will be several stages before final implementation at which resulting capital levels can and will be evaluated. At any of those stages, if the evidence suggested that capital

were declining too much, the Federal Reserve Board would insist

that Basel II be adjusted or recalibrated, regardless of the difficulties with bankers here or abroad or with supervisors in other countries. But let us keep this in mind. Supervisors can maintain the

same level of average capital in the banking industry, either by requiring each bank to maintain its current Basel I capital level or

by recognizing that there will be divergent levels among banks dictated by different risk profiles.

To go through the process of devising a more risk-sensitive capital framework, just to end, bank-by-bank with the same Basel I

results, I think would be pointless. There will be some greater dispersion and greater dispersion in required capital ratios, if that

reflects underlying risk, is an objective and not a problem to be

overcome.

Of course, I should add that capital ratios are not the sole consideration. The improved risk measurement and management and its

integration into the supervisory system under Basel II are also critical to ensure the safety and soundness of the banking system.

We are now in the middle of the comment period for the third

Basel Consultative Paper, and next month we will begin our comment period on the agencies’ Advanced Notice of Proposed Rulemaking. The comments on the domestic rulemaking as well as on

the third Consultative Paper will be critical in developing the negotiating position of the U.S. agencies and highlighting the need for

any potential modifications in the proposal. The U.S. agencies are

committed to careful and considered review of the comments received. The record already underlines that comments and dialogue

7

with bankers has had a substantive impact on the Basel II proposal, and that will continue. But at this stage of the proposal,

comments that are based on evidence and analysis are most likely

to be effective.

In conclusion, the Basel II framework is the product of extensive

multiyear dialogues with the banking industry regarding evolving

‘‘best practice’’ risk management techniques in every significant

area of banking activity. Accordingly, by aligning supervision and

regulation with these techniques, it provides a great step forward

in protecting our financial system and that of other nations to the

benefit of our citizens.

We now face three choices: we can reject Basel II, we can delay

Basel II as an indirect way of sidetracking it, or we can continue

the domestic and international process using the public comment

and implementation process to make whatever changes are necessary to make Basel II work effectively and efficiently. The first

two options require staying with Basel I, which is not a viable option for our largest banks. The third option recognizes that an

international capital framework is in our self-interest since our institutions are the major beneficiary of a sound international financial system. The Fed strongly supports that third option.

I will be happy to respond to your questions.

Chairman SHELBY. Mr. Hawke.

STATEMENT OF JOHN D. HAWKE, JR.

COMPTROLLER OF THE CURRENCY

U.S. DEPARTMENT OF THE TREASURY

Mr. HAWKE. Chairman Shelby, Senator Sarbanes, and Members

of the Committee, thank you for inviting the Office of the Comptroller of the Currency to participate in this important hearing.

I want to assure the Committee that the OCC, which has the

sole statutory responsibility for promulgating capital regulations

for national banks, will not sign off on a final Basel II framework

for U.S. banks until we have determined, through our domestic

rulemaking process, that any changes to our domestic capital regulations are practical, effective, and in the best interests of the U.S.

public and our banking system.

My written testimony provides a detailed discussion of the background and content of Basel II, and I appreciate, Mr. Chairman,

that it will be included in the record in its entirety. It discusses the

important issues with which this Committee is properly concerned.

I would like to use this time before the Committee today to make

four important points that may help to put today’s testimony in

proper focus.

First, all of the U.S. banking agencies share a concern about the

potential effect of Basel II on the capital levels of large U.S. banks.

Our banking system has performed remarkably well in difficult

economic conditions in recent years. I believe that is due in substantial part to the strong capital position our banks have maintained. While a more risk-sensitive system of capital calculation

might be expected to have the effect of reducing the capital of some

banks, we would not be comfortable if the consequence of Basel II

were to bring about very large decreases in required minimum capital levels. By the same token, if Basel II were to threaten signifiVerDate 11-MAY-2000 10:04 Jul 07, 2004 Jkt 000000 PO 00000 Frm 00011 Fmt 6633 Sfmt 6633 94514.TXT BANK1 PsN: BANK1
8

cant increases in the capital of some banks, it could undermine

support for the proposal and might threaten the competitiveness of

those banks. As things stand today, we simply do not have sufficiently reliable information on the effect of these proposals on individual institutions or on the banking industry as a whole. Before

we can make a valid assessment of whether the results are appropriate and acceptable, we have to know, to a much greater degree

of reliability than we now have, just what the results of Basel II

will be.

The OCC believes that significant additional quantitative impact

analysis will be necessary. Ideally, this should take the form of another study by the Basel Committee itself. But even if the Basel

Committee does not undertake such an additional study, I believe

that it is absolutely essential that the U.S. agencies make such an

assessment prior to the adoption of final implementing regulations.

I strongly believe that we cannot responsibly adopt final rules implementing Basel II until we have not only determined with a high

degree of reliability what the impact will be on the capital of our

banks, but have made the judgment that the impact is acceptable

and conducive to the maintenance of a safe and sound banking system in the United States.

I believe all of the U.S. banking agencies share that objective,

and we expect to work closely together to resolve any open issues.

Second, some have perceived there to be significant differences

among the U.S. banking agencies in their approach to Basel II and

have suggested that some external mechanism is needed to resolve

such differences. I do not think that is a correct conclusion.

On the contrary, I believe the agencies have worked exceedingly

well together on this project for the past 4 years and will continue

to do so. To be sure, we have not always agreed on every one of

the multitude of complex issues that Basel II has presented, but

that is no more than one would reasonably expect when a group

of experts have brought their individual perspectives to bear on difficult issues. Where there have been differences, we have worked

our way through them in a highly professional and collaborative

manner.

The Advance Notice of Proposed Rulemaking (ANPR) for implementation of Basel II in the United States that the agencies will

soon jointly issue is another example of a highly collegial and collaborative process. Our staffs have been laboring together diligently to get us prepared for this first round of rulemaking. In

addition, we are now in the final stages of internal review on draft

interagency guidance that we will jointly issue concurrently with

the ANPR to clarify and elaborate on our expectations for those of

our banks that will be subject to Basel II, and that guidance has

been developed in a process in which every agency had substantial

input. While reaching agreement on some of the proposed requirements was no small feat, I believe that every agency will concur

with the outcome.

Considerable consultation and deliberation still lie ahead before

we can even consider final adoption of the implementing regulations. But I have every confidence that the agencies will continue

to approach the issues in the same constructive and cooperative

spirit that has prevailed up to now.

9

Third, as I said earlier, I believe we are all committed to a process that has real integrity to it. The current Basel Committee

timeline presents a daunting challenge to both the U.S. banking

agencies and to the banking industry. While it is clearly necessary

to address the acknowledged deficiencies in the current Basel Accord, the banking agencies must better understand the full range

and scale of likely consequences before finalizing any proposal. We

have identified in our written testimony the milestones that the

agencies must meet under the current Basel II timeline. They include: Basel Committee consideration of comments received by it

on its latest Consultative Paper; the issuance of an ANPR and

draft supervisory guidance in the United States with a 90-day period for comments, which we expect to issue in mid-July; full consideration of those comments; the issuance of a definitive paper by

the Basel Committee; the drafting and issuance for comment in the

United States of a proposed regulation implementing the final

Basel paper; the conduct of a further quantitative impact study, as

I have just mentioned; consideration of the comments received on

the NPR; and, finally, the issuance of a definitive U.S. implementing regulation.

Each of these steps is critical in a prudential consideration of

Basel II in the United States, and the agencies will be working

closely together at every step. I anticipate that we will also be

working in close communication with committees of the Congress.

If we find that our current target implementation of January 1,

2007, is simply not doable—and my personal opinion is that realization of that target may be very difficult—we will take more

time. But it is too early to draw that conclusion yet. The important

point is that we will take great care not to let the time frame shape

the debate. Equally important is that the time frame will be secondary to our responsibility to fully consider all comments received

during our notice and comment process. If we determine through

this process that changes to the proposal are necessary, we will

make those views known to the Basel Committee, and we will not

implement proposed revisions until those changes are made.

Finally, some have viewed the New Basel II approach as leaving

it up to the banks to determine their own minimum capital, or, as

some have said, putting the fox in charge of the chicken coop. This

is categorically not the case. While a bank’s internal models and

risk assessment systems will be the starting point for the calculation of capital, bank supervisors will be heavily involved at every

stage of the process. We will publish extensive guidance and standards that the banks will have to observe. We will not only validate

the models and systems but will assure that they are being applied

with integrity.

In my view, the bank supervisory system that we have in the

United States is unsurpassed anywhere in the world in both its

quality and in the intensity with which it is applied, and we are

not going to allow Basel II to change that. In fact, if we do not believe at the end of the day that Basel II will enhance the quality

and effectiveness of our supervision, we should have serious reservations about proceeding in this direction.

Moreover, while Basel II has largely been designed by economists

and mathematicians, and while these so-called ‘‘quants’’ will play

10

an important role in our oversight of the implementation of Basel

II, the role of our traditional bank examiners will continue to be

of enormous importance. Such values as asset quality, credit culture, managerial competence, and the adequacy of internal controls

cannot be determined by mathematical models or formulas. Nor

can many of the risks that banks face be properly evaluated except

by the application of seasoned and expert judgment. I can assure

you that those national banks covered by Basel II will continue to

be closely monitored and supervised by highly qualified and experienced national bank examiners who will continue to have a fulltime, on-site presence. The new process will not replace them. It

will simply give them even better tools to assess the true nature

and measure of the risks confronting the banks for which they are

responsible.

I am pleased to have had this opportunity to provide our views,

Mr. Chairman, on this important initiative, and I would be happy

to answer any questions.

Chairman SHELBY. Mr. Powell.

STATEMENT OF DONALD E. POWELL

CHAIRMAN, FEDERAL DEPOSIT INSURANCE CORPORATION

Chairman POWELL. Thank you, Mr. Chairman and Members of

the Committee. I appreciate the Committee’s interest in the New

Basel Capital Accord.

I believe that Basel II ranks among the most important pieces

of proposed banking regulation in our Nation’s history. The FDIC

supports the goal of lining up capital regulation with the economic

substance of risks that banks take. Basel II encourages a disciplined approach to risk management, and it addresses important

weaknesses in our current capital rules. We applaud the intense

and prolonged efforts that have been made to address these important issues. We are approaching a crossroads where judgments will

need to be made on some critical issues. We have an interagency

process and a public comment period to help reach those judgments, and I am confident that our process will result in an appropriate outcome. My written testimony provides a broad overview of

some of the critical judgments that will need to be made before the

agencies commit to adopt Basel II in the United States.

The first key issue is capital adequacy. The Basel II formulas

allow, at least in principle, for significant capital reductions. The

proposals issued by the Basel Committee specify that after a phasein period, there would be no floor on the level of risk-based

capital that banks would be required to hold. The level of riskbased capital that banks actually hold would depend upon their

own internal estimates of risk—validated by their supervisors—and

on the demands of the marketplace. It is very difficult to predict

the ultimate effect of Basel II on overall bank capital, and we do

know that the formulas are forceful tools for affecting risk-based

capital requirements.

There is no question that Basel formulas would help the regulators differentiate risk. The formulas cannot stand on their own.

Banks face other risk besides credit risk and operational risk.

Lending behavior can change over time, causing losses to escalate

in activities perceived as low risk. The fact is that no one knows

11

what the future holds. For these and other reasons, the FDIC believes that Basel II must be supplemented by the continued application of existing regulatory minimum leverage capital and prompt

corrective action requirements. I am very gratified at the support

our fellow bank regulators have expressed for this conclusion.

We also understand that a leverage ratio alone cannot provide

protection without the support of sound risk-based capital rules. It

will be necessary to better understand the impact of the proposals

on the capital required for specific activities.

Maintaining capital adequacy under Basel II would be an ongoing task. Validating banks’ internal risk estimates would be a challenge. Doing so consistently across agencies would be a greater

challenge for which an interagency process would be needed. The

other key issue is competitive equity. Basel II has been expected

to provide some degree of regulatory capital relief. The banks that

stand to be directly affected by Basel II have expressed strong support for such capital relief. They have expressed concerns where

they believe Basel II capital was too high. The key policy question

is: What economic benefits and costs would come with changes in

regulatory capital requirements? Would the economic benefit of

lower-risk-based capital requirements for large banks enhance

their competitive posture or accelerate industry consolidation?

We recognize there are differences of opinion about the importance of competitive equity issues. That is why we need to pay

close attention to the comments we receive on this issue. The agencies received a number of comments on both sides of this issue at

a recent industry outreach meeting and this dialogue will continue.

In short, the ingredients of the success of Basel II continue to be:

Appropriate minimum capital standards; a consistent approach to

validating banks’ risk estimates; an adequate vetting of competitive

issues; and, time to address these and other policy issues as we finalize our views on this Accord.

We will continue to work closely with our fellow regulators to

work through these important issues and reach the right conclusions. We are committed to evaluating the costs and benefits of the

Basel II proposals and their impact on the U.S. banking industry

and the safety and soundness of the financial system.

Thank you for the opportunity to present the views of the FDIC.

Chairman SHELBY. Mr. Gilleran.

STATEMENT OF JAMES E. GILLERAN

DIRECTOR, OFFICE OF THRIFT SUPERVISION

Mr. GILLERAN. Chairman Shelby, Ranking Member Sarbanes,

and Members of the Committee.

My fellow regulators have outlined very well, I believe, all of the

risks that are inherent in Basel II, so just a couple of personal comments. I think that Basel II has moved the ball along very well in

trying to think through the question of risk versus capital, and I

think it has been a real contribution for all of us who are dealing

with capital all the time.

When you look at Basel I, you look at an idea that is very simple.

Everyone understands it. It is applied to all, and it has yielded

what everybody concludes is capital which seems to be sufficient.

In fact, we have come off of just 2 years of almost the best results

12

the financial services industry has ever had, and this year looks

very well, so the capital levels do not seem to have impeded the

results in the industry.

Basel II, while having a step forward in thought process, concludes with a very complicated, detailed system that applies to only

a few, and everybody believes will result in lower capital. Therefore, I think that your interest in this subject, and I believe the

work that has been done by my fellow regulators, must continue

so that we are all very sure that what we are doing in this next

step will be safe and sound.

Thank you very much.

Chairman SHELBY. Thank you.

Governor Ferguson, first I am going to read an excerpt from the

June 4, 2003 Wall Street Journal citing a recent Mercer Oliver

Wyman study.

‘‘The new accord will also change the amount of regulatory capital required from

banks for different types of lending, meaning that certain types of products such as

mortgages, lending to large corporations, and leasing will receive less back-up capital and could potentially be more profitable. Other types of lending, such as project

financing and lending to small businesses will require more capital and so could become less profitable. Oliver Wyman expects this will lead banks to move away from

products they cannot thrive in.’’

Governor, looking at the results of this study as reported in The

Wall Street Journal on June 4, I would conclude that the new accord will result in some winners and losers here, so to speak, in

different sectors of the economy. In other words, this proposal could

produce significant shifts in the economy. Inasmuch, it could be

said that we are not merely talking about reform of banking regulation alone, we are talking about in a sense, some people believe,

a proposal that involves policy decisions that will have significant

macroeconomic effects. What is your take on that?

Mr. FERGUSON. I would not reach that conclusion based on my

understanding of Basel II.

Chairman SHELBY. Do you believe that there will be winners and

losers? There are always winners and——

Mr. FERGUSON. By definition we are changing, if this goes

through, we are changing the status quo, and there will be those

who like that and those who do not. I do not think of any of them

as winners and losers, because what we are trying to do under

Basel II is to have regulatory capital that better reflects risk, and

I see no losers in that process.

Chairman SHELBY. Do you see small business as a possible loser?

This is what had turned this economy for years is the hiring of

probably 75 to 80 percent of our people. And if they are not in the

play like they have been, this could have a very significant impact

on our economy in the future.

Mr. FERGUSON. I do not think small businesses will be a loser in

the sense you are talking about.

Chairman SHELBY. Why?

Mr. FERGUSON. The reason is as follows. First, I am not sure that

Oliver Wyman had it just right on what is going to happen in

terms of risk-based capital for different portfolios. I would set that

to one side. These things are still being calibrated, et cetera.

Second, and more importantly, what we have seen is that small

businesses have found a very large number of sources of capital or

13

lending, some from large banks, some from small banks. None of

that is being driven, I believe, by regulatory minimum capital. I

think it is driven by a broader range of issues and regulatory minimum is relatively unimportant in that panoply of things that drive

the decision of banks to lend to small businesses.

Chairman SHELBY. Governor, do you have some studies that you

can share with the Committee that would back up what you are

saying here with some analysis, not just your opinion but some

other analysis?

Mr. FERGUSON. That is a fair question. I do not have studies at

this stage. What we will be doing though in the ANPR is asking

this question to get a greater sense of the information that you

have just talked about. In fact, broadly speaking, the entire issue

with respect to competition and different portfolios will be heavily

examined under the ANPR, which will give us a better fact base,

because I am looking at the same issue you are. As I said in my

opening remarks, I do not think, based on my analysis and based

on conversation with bankers, that anything other than economic

capital and market structure are the kinds of things that drive

these decisions. It is not, based on my current analysis, the regulatory minimum that determines pricing or availability.

I would also observe that the thing that has been driving small

business lending has been frankly more a question of technology,

and to some degree, pricing. As I have been on the Board and observed what is happening over the past many years——

Chairman SHELBY. In what way? Could you explain?

Mr. FERGUSON. Yes. I will explain both. What has happened in

small business is that it has historically been, for many, many

years the purview of local bankers, and those community bankers

still have a very strong role that they are playing with respect to

lending to small businesses.

Chairman SHELBY. They are the small business lender.

Mr. FERGUSON. Absolutely. That linkage still seems to hold true.

Chairman SHELBY. But will it hold true in the future, like my

colleague—I know my time is nearly up and we will have another

round, but Senator Sarbanes raised that question earlier, alluded

to that question.

Mr. FERGUSON. Right, he alluded to it.

Chairman SHELBY. It is very important.

Mr. FERGUSON. It is very important. I believe——

Chairman SHELBY. These are not accords that we should even

look at in a cursory manner, as the Comptroller of the Currency

said. The Basel II Accord has deep and broad ramifications.

Mr. FERGUSON. That is exactly why we are here today, and that

is why we commend you for holding this hearing.

I think it will continue to hold true going forward, because I do

not believe that banks choose to get into or out of a business based

on regulatory minimum capital. Indeed, we are trying to structure

regulatory minimum capital so that it does not impact the strategic

decisions of a bank to get into or out of a business.

Chairman SHELBY. My time is up, but I want to get this in, and

I will turn to Senator Sarbanes. Governor, who is responsible here?

In other words, this is a very basic question, but I think it is an

important practical concern, at least of mine, perhaps other MemVerDate 11-MAY-2000 10:04 Jul 07, 2004 Jkt 000000 PO 00000 Frm 00017 Fmt 6633 Sfmt 6633 94514.TXT BANK1 PsN: BANK1
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bers. I would like to know who is taking the sum total of this proposal, has digested it, and has a firm grasp of its entirety? I mean

this is far reaching. Who has?

Mr. FERGUSON. Personally, I have been working with this for a

year and a half. I have been heavily briefed.

Chairman SHELBY. I know you have. We have talked about it.

Mr. FERGUSON. I have worked through lots of the details. I believe I have a good grasp of the vast majority of the issues. There

are a few issues here that I would want to understand a little better. I think in each one of our agencies, each would give perhaps

a different answer.

Chairman SHELBY. We have some regulators here, the Comptroller, the FDIC Chairman, OTS Director, that voice other concerns, and they should. I would like to know who is ultimately

responsible for this and who is accountable for a success or failure.

Is it Chairman Greenspan? Is it the Fed? Is it the Comptroller? Is

it the FDIC Chairman? Is it the OTS Director?

Mr. FERGUSON. You have before you a panel of the regulators of

the major depository financial institutions. I think we have a collective responsibility, as both Comptroller Hawke and Chairman Powell have indicated, to work very closely together. Yes, these are

tough issues and there are places where by definition——

Chairman SHELBY. Profound issues, are they not?

Mr. FERGUSON. Absolutely profound. There are places where we

will initially disagree. We will come to a middle ground that we all

agree on, that we think is in the best interest of the United States,

and we have, I believe, a collective responsibility to you and to the

country to understand these implications of these profound

changes, and to give you our best judgment on the impact that they

will have. That is one of the reasons why I support what the Comptroller said with respect to the need to have ongoing quantitative

impact studies so that we have a factual evaluation of the impact

that this is likely to have in the U.S. banking industry.

Chairman SHELBY. We have this group, an ad hoc group of regulators, who have convened in Switzerland over the last few years.

They put this together. Ultimately, I believe that this Committee,

the Committee of jurisdiction in the Senate; as Senator Sarbanes

said, capital is very important. A lot of us have been on this Committee a long time, where we have visited the taxpayer on things

where there was not sufficient capital. This is going to lower some

capital standards. It is going to concern me and other Members.

Mr. FERGUSON. As I have said, I would not jump to conclusions

yet that it is going to lower capital overall in the industry. I think

it will create greater dispersion of capital because there will be

those banks that need to have higher regulatory minimum capital,

and there will be some that will need to have lower regulatory minimum capital. When this Basel Committee got started in this process, the goal was to keep capital at about the same level as it is

now, and thus far, first indications from early quantitative studies

suggest that indeed if it lowers capital, it will be a very small

amount, maybe about 6 percent or so. But as I said in my opening

remarks, and I think all of us would say the same, if we believe,

based on looking at the quantitative impact studies that we do

going forward, that capital is lowered to levels that are unsafe and

15

unsound, then we will have to go back and renegotiate, we will recalibrate, and I am sure your Committee would want to hear that

we will do that. You have heard my commitment that the Fed believes that, and I think that is consistently shared across all the

regulators before you.

Chairman SHELBY. Senator Sarbanes.

Senator SARBANES. Thank you, Mr. Chairman.

Am I correct that the schedule for concluding the international

agreement in Basel is the end of this year?

Mr. FERGUSON. That is the current schedule.

Senator SARBANES. Six months away?

Mr. FERGUSON. That is the current schedule, yes.

Senator SARBANES. We have the extent of concern or question, if

you do not want to label it disagreement, amongst the legislators

as reflected in their statements this morning, and we are only 6

months out; is that right?

Mr. FERGUSON. If I can continue to respond for myself, and allow

them to speak. I would say, what you have heard from the regulators I would not describe as disagreement. I think we understand

what the issues are.

Senator SARBANES. You may disagree on what should be done

about them.

Mr. FERGUSON. I think we will reach an agreement on what

should be done. This is certainly profound without question, but I

think we will continue as we have to date to have an honest discussion among ourselves of what the options are and to develop a middle ground. I share some of the nature of your concern, and I share

what Comptroller Hawke had to say. We have to give ourselves

sufficient time in the comment period before we go back and do the

final negotiations.

Senator SARBANES. Let me go to some of the basic concepts. The

Economist, on March 29 of this year, in an article said, amongst

other things, the following: ‘‘American regulators intend to apply

the new rules to fewer than a dozen other banks. This is a choker

for European regulators who see Basel II like Basel I, as a global

standard to be applied to all banks.’’

That raises the first question. What is the rationale for applying

Basel II to a limited number of banks?

Mr. FERGUSON. You are addressing that question to me, Senator?

Senator SARBANES. I do not know. Anyone on the panel who

wants to answer it.

Mr. HAWKE. Let me give my colleague a rest.

Mr. FERGUSON. Thank you.

[Laughter.]

Mr. HAWKE. I think the basic premise, Senator Sarbanes, in

Basel I, as in Basel II, was that these accords were intended to

apply to internationally active banks in order to achieve competitive equality on the international scene. The Basel Committee has

played a valuable role in trying to establish a framework for capital

that can be adopted by any banking system anyplace in the world.

Senator SARBANES. Did Basel I apply to all banks or a limited

number of banks?

Mr. HAWKE. We voluntarily decided to apply Basel I to all of our

banks.

16

Senator SARBANES. To all banks.

Mr. HAWKE. But the premise in Basel I, as in Basel II, was that

it was intended to be applied to internationally active banks. And

the 10 or 12 banks that we intend to apply it to constitute probably

95 percent or more of the international exposures of U.S. banks.

So, by selecting that group, we have, I think, kept faith with the

premise of the Basel Committee. We do not see any useful purpose

to be served in applying Basel II to the thousands of smaller banks

that we have in the United States which are already better capitalized than their larger counterparts, and, I think, significantly more

intensively regulated than comparably sized banks anyplace else in

the world.

Senator SARBANES. I gather one concern is that this will now enable their larger counterparts to have less capital vis-a`-vis the

smaller banks. Who determines which banks Basel II will apply, to

whom it will apply; who determines that?

Mr. HAWKE. We have, through a joint interagency process, established guidelines that look both at the size of the bank and the extent of its international exposures, and it was through that process

that we jointly selected the standard that resulted in 10 or 12 of

our largest banks being included in the mandatory category.

Senator SARBANES. Is it also the case that another 10 or 12

banks can voluntarily subject to the Basel Accord?

Mr. HAWKE. We did not include any numerical limit. Any bank

that can establish that it has the capacity to implement the systems that would be required can apply for regulatory approval to

come under Basel II.

Senator SARBANES. So, you can calculate what advantage it will

give you and decide to have that apply to you; is that correct?

Mr. HAWKE. That could be the case, yes.

Senator SARBANES. Well, what kind of regulatory system is that?

Let me ask this question. Is it the case that the models to determine the risk will be internal models of the banks themselves?

Mr. HAWKE. As I mentioned in my statement, Senator Sarbanes,

the banks will develop the models, but under very carefully defined

guidelines that we will set forth for them, and under intense validation procedures that we will follow, and under continuing supervision by us with respect to the application of those models.

Senator SARBANES. But they will develop the models themselves.

Mr. HAWKE. The models would be developed by the banks subject

to our validation and continuing oversight.

Senator SARBANES. That is a pretty tricky thing, is it not?

Mr. HAWKE. There are people who have expressed reservations

about that, the fox-guarding-the-chicken-coop syndrome, but I do

not think that is the case. First, as I said in my statement, the

basic nature of bank supervision is not going to change. We are

going to have full-time, on-site examiners in all of these large

banks, just as we do today. Second, a new breed of people will be

coming into the banks—mathematicians and economists who

helped construct these rules—and they will be validating the models and helping our examiners to oversee the integrity of the application of the models. While intuitively many of us have had exactly

that concern, I do not think this amounts to turning capital calculation over to the banks themselves.

17

Senator SARBANES. Another concern I have heard is the uncertainty of the impact of the proposed agreement on major U.S. financial institutions. Let me leave aside for a moment now the bifurcation, right, that it is only going to apply to a limited number

of financial institutions, with others able to choose to have it apply

if they decide it is to their advantage. I understand that three tests

have been done to measure the impact of the new agreement on the

largest U.S. financial institutions, and that no clear picture of the

impact of the agreement on the capital held by the largest U.S.

banks has emerged. In fact, and I want to just verify this factually,

that the latest test shows the capital of some U.S. institutions rising by 40 percent and the capital at other U.S. institutions declining by 35 percent. Is that correct?

Mr. HAWKE. I think that is an accurate reflection of what the socalled QIS–3 reported, but I think QIS–3 was severely flawed. That

is why we are insisting on a subsequent quantitative impact study

that is overseen by the regulators and carefully monitored. That

range would give me enormous concern.

Senator SARBANES. I would hope so.

Mr. HAWKE. At both ends of the spectrum.

Mr. FERGUSON. May I add one other point here, sir, on that? I

think you should also recognize that what you are talking about I

think is just the credit risk component of capital. There is also an

operational risk component as well to this whole accord, which in

most cases I think would end up reducing some of that range that

you just talked about. Again, you also want us to ask the question

of to what degree, if this is calibrated correctly, are we reflecting

underlying risk? I agree with Comptroller Hawke that obviously

going forward we will need to have more of these studies to try to

continue to get a better handle on these issues that you are raising.

Senator SARBANES. My time is up. Before I close, Mr. Powell and

Mr. Gilleran, you may want to add some observations on this discussion we have just been having here with Mr. Hawke and Mr.

Ferguson.

Mr. POWELL. I think, Senator, your comments call to attention a

strong view that the FDIC has, and that is, for minimum regulatory capital. That is very important to us at the FDIC. While I

can understand that there are those in the marketplace who believe this is an outmoded ideal, I think it has served us well in

good times and bad times over the years.

I would also make the comment that economic capital and market capital for the last 13 years has exceeded regulatory capital.

While these models are wonderful, I think the discussion that we

have had here shows some of the inconsistency in them. Now, I

believe in them, and we support that model, so we support that

capital should be based upon risk, but we strongly support also

minimum capital.

Senator SARBANES. Mr. Gilleran.

Mr. GILLERAN. Senator, I think that we also have probably misjudged the number of financial institutions that will be making application to have Basel II apply to them, and even though initially

it is believed that just a few large organizations will apply because

of the complexity and the need for computer programming and for

a history to be able to demonstrate that the programs work, I beVerDate 11-MAY-2000 10:04 Jul 07, 2004 Jkt 000000 PO 00000 Frm 00021 Fmt 6633 Sfmt 6633 94514.TXT BANK1 PsN: BANK1
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lieve that there are many consulting firms queuing up out there to

be able to provide the data and the support to much smaller institutions so they can make application to use Basel II concepts. So,

I believe the regulators will have many more organizations’ plans

to look at than some expect.

Chairman SHELBY. Senator Allard.

Senator ALLARD. Thank you, Mr. Chairman.

Basel II’s third pillar has a requirement that banks not only calculate the risk positions in capital requirements, but it also ensures that the calculations are disclosed for review by the markets.

I personally like to have disclosure for the markets because I think

the more informed the consumers are, the better. I am curious if

you have had any concerns brought to your attention about those

disclosure requirements? I know that in a competitive environment

banks sometimes have certain information that is proprietary in

nature that they do not want their competitors to know. Have you

received any comments in that regard?

Mr. FERGUSON. We have been working this for many years, and

in fact this pillar you are referring to, Pillar 3, has evolved over

time. It is clearly not intended to have any disclosure of competitively proprietary information. It is intended to have disclosure of

information that the market should know. This disclosure, by the

way, is part of the answer to some of the questions that have been

raised before by Senator Sarbanes, because it is not just simply our

judgment and validation of the inputs, but the market will be able

to look at the inputs to some degree and make some comparisons

under Pillar 3. So, we worked very hard to make sure that the disclosure regime under Pillar 3 avoids the kind of competitive issues

that you have talked about, while being sufficient to give the market the information that it needs to help us do the work that we

need to do with respect to validations.

Mr. HAWKE. If I could just add one quick point to that, Senator

Allard. One important function of Pillar 3, in addition to providing

the market with information, is to provide a basis for supervisors

and banks in different countries to help assure that Basel II is

being applied even-handedly by supervisors in different countries.

That kind of transparency is very important to the integrity of the

process.

Senator ALLARD. I would think that would be very important in

that regard.

Let’s say we have passed what you have recommended, and the

regulations have become effective and everybody agrees on them.

How do you make the transition from a Basel I to a Basel II bank?

That is a hypothetical, but I think it is something that would very

possibly happen in the future with the consolidation of the banks.

Two or three banks could consolidate, and suddenly they are big

enough to compete in the international market. How do you transition them into that arena once you have standards in place? What

are your plans for doing that? Maybe the Fed is making appropriate plans, or the other members of the panel have some

thoughts on that. I am curious as to how you see that happening.

Mr. HAWKE. Beyond that group of what we call the mandatory

Basel banks, the 10 or 12 that we will explicitly subject to Basel,

there may be 20 or more other banks that initially or over time will

19

come to us and try to demonstrate that they have the systems capacity and the sophistication to opt in to Basel II. It will start with

a judgment on the part of the bank as to whether they think it is

to their advantage, either in terms of market perception or for

other reasons, to come under the Basel II regime. We will have to

determine that they are capable of developing the systems that are

going to be necessary and that they have the kind of risk management and risk measurement capacity that will be necessary to deal

with the Basel II requirements. We will make that judgment on a

bank-by-bank basis.

Senator ALLARD. Mr. Gilleran.

Mr. GILLERAN. Senator, if a bank is rated under Basel II and it

has been deemed to have excess capital then, then it has to decide

what to do with it. Do you either pay it out to your shareholders

as a dividend? Do you take on additional risk in your portfolio to

utilize the capital, or do you acquire other financial institutions?

One of the things that may come out of the application of Basel

II to only larger banks is the fact that it might provide a number

of larger banks with excess capital to do many acquisitions within

the industry, and therefore, one of the questions long range is

whether or not there is a roll-up in the financial services industry

even greater than there has been. This, Senator Shelby, I think has

impact on small business lending because if you then have a rollup of community banks, then you would probably have an impact

on loans to small businesses. So that is an impact.

On your question on disclosure, Senator Allard, the problem that

I have is that the information in connection with Basel II provides

a tremendous amount of information. I am unconvinced yet though

that all of the disclosures will be really communicating the real

true risk in the institution, and I believe that is something that we

have to be careful about going forward, whether or not a lot of data

is there, but not enough disclosure of the real risks.

Senator ALLARD. I see my time is up.

Chairman SHELBY. You go ahead, proceed.

Senator ALLARD. Well, just one other thought, and it was brought

up by Mr. Hawke in his response. Basel II will require a significant

investment in systems and training, particularly in examiners. All

of you have admitted that Basel II is much more complicated than

Basel I. What difficulties do you see in both getting your examiners

trained and acquisition of equipment, if any?

Mr. HAWKE. That process has been ongoing now for quite a

while. Our conventional safety and soundness examiners have been

involved in the process. They are intimately involved, both within

our agency and on an interagency basis, with the implementation

process. So there is a great deal of ground laying that is going on.

We are attempting to expand our staff of quants, if you will, to deal

with Basel issues as well. We have all invested a lot in the preparations for Basel II.

Senator ALLARD. Thank you, Mr. Chairman.

Chairman SHELBY. Senator Reed.

Senator REED. Thank you very much, Mr. Chairman, and thank

you, gentleman.

Let me raise a series of questions. First, one of the key aspects

of the Basel II Accord is operational risk and it raises two quesVerDate 11-MAY-2000 10:04 Jul 07, 2004 Jkt 000000 PO 00000 Frm 00023 Fmt 6633 Sfmt 6633 94514.TXT BANK1 PsN: BANK1
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tions in my mind. First, whether a quantitative approach, a certain

level of capital, is the appropriate response or a qualitative approach of actually evaluating the systems that the institution has

and making adjustments or directions to the system is the best approach. Mr. Ferguson, Mr. Hawke, might you comment on that, Mr.

Powell and Mr. Gilleran.

Mr. FERGUSON. Well, I will start. We believe, and we have seen

some recent evidence, that it is indeed more possible now than it

was a few years ago to get a more quantified approach to operational risk. We had at the Federal Reserve Bank of New York, a

week ago more or less, a conference that brought in banks from

around the world, each one of which disclosed for the first time the

approaches they have used, and we were actually quite impressed

to see the degree to which progress has been made. What banks

are doing these days—this is again, leading edge banks, not all

banks but leading edge banks—are using both their internal operational loss information, external databases, scenario analysis, information from some insurance companies, for example, to come up

with a very solid quantified approach to operational risk. I can

name a few names. We have put the presentations on the website.

So, I think indeed our degree of confidence in the ability to do more

quantified approaches to operational risk has gone up, and it is a

sign of how quickly things have changed in the industry. Obviously, one of the things that is done in that regard is to think

about the impact of procedures, systems, backup sites, et cetera, on

the probability of an operational problem having an impact on the

ongoing day-to-day operations of the bank. So it does involve some

management judgment as well.

What Basel II calls for is that the approaches to doing the internal assessments of operational risk be things that we can replicate,

that they be systematic and not purely judgmental, that they be

based on data and facts that we can also evaluate. The good news

is, as I have said, things have moved very much in that direction,

and we have a pretty high degree—I think all of us, though it

might vary somewhat—a reasonably high degree of confidence that

indeed systems have moved in the right direction to make this

measure of operational risk more quantifiable than it was, let us

say, 5 years ago.

Senator REED. Mr. Hawke.

Mr. HAWKE. Senator, I have participated in the Basel Committee

for 41⁄2 years. Throughout that entire period I argued strenuously

that operational risk should be left to supervisory assessment

under Pillar 2, a qualitative assessment, because if you believe that

operational risk inheres in the strength of an institution’s internal

controls, that is inherently a qualitative type of judgment. We,

working together with the Fed and the other agencies, pursued the

development of the Advanced Measurement Approach (AMA),

which is a Pillar 1 approach, to the calculation of operational risk,

and it has a very high degree of supervisory judgment involved in

that process.

I think whether we put operational risk under Pillar 1 or Pillar

2 is not a consequential issue any more. I think that even if it were

under Pillar 2, we would still have to have a framework for determining what kind of operational risk charge we would apply. I

21

think the AMA approach that we have developed is flexible. It has

a lot of supervisory discretion and evaluation built into it, and I

think that is where we need to continue to work on perfecting it.

Senator REED. Mr. Powell.

Mr. POWELL. I just say supervisory oversight—I think the Comptroller said it well—is the key to this whole operational issue.

Mr. GILLERAN. I believe that the Comptroller is correct, that it

really does not matter whether it is in Pillar 1 or Pillar 2, as long

as it is recognized. The interesting thing about Basel I is that

Basel I implicitly recognizes operational risk, and that the Basel I

system has worked pretty well, and has recognized that risk because we have gone through several years of tough economic times,

and yet the banking system has held up. Therefore the implicit recognition has been a valid method.

Basel II does require this explicit recognition, which is a whole

different way of going about it, much more intellectual, but it remains to be seen whether it is better.

Senator REED. Thank you.

Chairman SHELBY. Senator Corzine.

STATEMENT OF SENATOR JON S. CORZINE

Senator CORZINE. Thank you very much, Mr. Chairman. I welcome the witnesses.

I will just say from my own personal experience that this is one

of the most difficult topics that needs to be dealt with, and the

complexity is almost mind-boggling. I want to understand what the

process of the oversight of the self-derived models are. How is that

foreseen to be certain? Are you going to certify different outside

consultants or is it only going to be an internally driven responsibility of the regulators to look at the models that the organizations

are putting together, and how do you see that process?

The second question is, I think one of the most talked about and

thought about risks are derivative risks. Is there any description

on how that process, that you could share with us, that is tractable,

that would be considered? And if we have time, I would love to

hear what you think the international implications of this are, competitive implications for Americans, financial system on a relative

basis, because there are some elements in here on assessment of

risk with regard toward legal exposures and other things that are

pretty significant and I would like to understand how those fit.

But I will go back to the complexity issue. How are we going to

assess the processes in a way that it is fair, consistent, in a way

that people will feel like the system is not rigged for those that

brightest quants?

Mr. HAWKE. Let me take the first question, Senator. First of all,

I can assure you we will not be certifying consultants. That is not

our intention at all. The validation process starts with the Basel

documents, which have very detailed standards for risk measurement and risk management systems built into them, and for the

kinds of models that will pass muster.

Senator CORZINE. How are those going to be tested?

Mr. HAWKE. The second step will be the validation of those models by our examiners and experts, who will come into the banks

and review the models, review their compliance with the Basel

22

standards and test them out. There will be an ongoing process beyond that where our examiners and experts will look at the application of the models to see how the models are actually working in

practice. This is going to be an ongoing process that starts with the

articulation of detailed standards by the Basel Committee itself.

Let me defer to Governor Ferguson on the derivatives question.

Mr. FERGUSON. You asked a question on derivatives. You will

see, when we come up to the ANPR, that we are going to ask some

questions in that regard. The reality is, I think you will hear later,

to broaden your question a bit beyond derivatives, to other products

that are much more technically intensive, that drive securitization,

for example. We have a number of very specific questions in the

ANPR to try to get to some of the issues that you are talking

about. The reality is that this is one of the areas that has been

most complicated. We are continuing to work on it. You will hear

from some people on the second panel, a range of issues and concerns. So at this stage I would say it is very much still being focused on, because it is, as you point out, very complicated.

Senator CORZINE. So with regard to those specific areas, it is still

a work in progress.

Mr. FERGUSON. It is still a bit of a work in progress. We have

a proposal, but all of these things are a work in progress, and we

are looking for comment. We have gotten feedback from a number

of the institutions. We have gotten feedback from the Bond Market

Association, for example, with specific questions that we want to

ask them to try to get some better input into these matters, because it is something that we still have to work through. This is,

by the way, an area in which the United States is the world leader,

as you know. We want to make sure that as we go down this path

we do not undercut our ability to continue to innovate in this regard, and that we have a much better handle on the risk profiles

that are starting to emerge.

Mr. HAWKE. If I could just add, Senator, we are about to put out

in mid-July, jointly, substantial supervisory guidance on this whole

internal ratings-based approach, and standards for the models and

our expectations for management capacity to deal with those models. That is going out for comment in a month or so. Right now it

runs about 130 pages.

Senator CORZINE. Is operational risk included in your derivative

formulation of measurement of risk?

Mr. FERGUSON. It is not at this point. I think this is an interesting question that we need to raise. We have thought of derivative risk and securitization risk more down the path of credit risk.

Obviously, there are some associated legal ramifications that might

emerge that would fall into operational risk, but at this stage we

are thinking of them separately. I think again it is something we

can question. But the reality, as you may have sensed, with respect

to operational risk in the areas of systems, regulations, et cetera,

is that it is already sufficiently complicated. We have not then

thrown in the derivative issues for a reason that I think you would

sympathize with and understand.

Mr. POWELL. I was just going to comment on your earlier question about validating the banks’ risk models. I think it is very important for consistency that that process should be interagency,

23

like the same approach that we have with the Shared National

Credits, because there obviously could be some potential inconsistencies, so it should be an interagency team effort.

Senator CORZINE. And is there every intent on having that?

Mr. POWELL. I think I have shared this with all of the gentleman

here at the table—there is a spirit of cooperation here, and the intent would be that there is consistency, yes.

Mr. GILLERAN. I think we have demonstrated over the last several years the very good cooperative effort through the FFIEC Act

and through other regulatory issues that we are capable of cooperatively dealing in most important areas. I think that will happen.

I think the question you raise on the international impact, I

think goes to the heart of whether or not the international regulation of banks is the same, and the United States clearly, in my

view, is the leader in bank regulation. I think that on an ongoing

basis, whether or not every country is looking at it the same way

that we are, as an important issue.

Senator CORZINE. Certainly is in the long run a competitive

issue. Capital is important actually on how you run your business.

So if somebody gets a leg up, whether it is smaller banks versus

larger banks or Swiss banks versus United States banks, whoever

the primary supervisor is, how they look at those various models

can end up potentially leading to disparities in how capital is applied to the various risks that are being taken. I am all for riskbased capital standards. It is just one heck of a complex issue.

Mr. FERGUSON. May I respond to the international question? We

are well aware of the need to keep the regulatory community looking at these issues pretty much in the same way. The Basel Committee has put together a group called the Accord Implementation

Group that brings together the regulators to share best practice

and findings and try to create that sense of commonality across

borders. By definition, no one can guarantee that any process is

going to be foolproof, but we have not left this issue unexamined.

We have created this entire process to get to some of the issues

that you have raised, Senator.

Senator CORZINE. Thank you.

Chairman SHELBY. Thank you, Senator.

The part of the proposal that will be applied to our banks, as I

understand it, relies a great deal on banks’ internal models. Do the

regulators have the personnel with the requisite expertise to conduct a thorough review of these systems? How can we know that

questionable practices or assumptions will be caught by the regulators before the models are in full operation? It is my understanding that modeling generally involves the use and analysis of

historical value. Please help us understand the value provided by

the use of modeling. Governor?

Mr. FERGUSON. I will start. I think we should take a step back

here because I think there is a point that is being missed. The concepts in Basel II are not things that the regulators thought of independent of the market. I would say, in fact, just the opposite. What

Basel II is trying to do at base is catch up with where leading edge

banks already are in the way they run their banks. Not all banks

are there. But we are trying to reinforce the decisions that banks

have already made and to encourage others to adopt some of these

24

techniques. So this is not brand new terra incognita to the banks.

They are not starting at ground zero.

The second point I make is on models. We have chosen not to

have capital under Basel II that is purely model driven. It is true

that the banks would provide some inputs into the formulas that

we have derived for determining capital. So you should not, Senator, have the impression that somehow or another there is going

to be a model that chunks away that no one understands and then

a number——

Chairman SHELBY. There is a model here. Excuse me. There is

a model here though, is it not?

Mr. FERGUSON. There are approaches and models the banks use

to determine some of the inputs, but the regulatory formulas take

those inputs and then determine what the capital is going to be.

Now, your question with respect to historical data. It is absolutely true that in order to evaluate your sense of a risk on probability of default or a loss given default, one of the inputs will be

historical experience. That works extremely well in some portfolios

for sure. There may be others in which it does not work as well.

Banks will add to that important judgments, for example, stress

testing. One of the things the regulators will look at is whether or

not indeed a model or an approach to estimating these inputs looks

across an entire cycle, so that banks are not just picking up the

good times, but also, frankly, the bad times.

Chairman SHELBY. That is where capital is imported though.

Mr. FERGUSON. One of the reasons that one wants to have stress

testing and a cross-cycle input is to get capital that deals with both

the good times and the bad times. I think you should be aware that

indeed one of the things we would be looking at is whether or not

the data that are being used cut across a broad swath of time and

not a short period that may or may not be representative, and also

whether or not there is stress testing, for example, to figure out in

the more extreme scenario what kind of loss a bank is likely to experience, what kind of exposures it is likely to have, et cetera.

You asked an important question that Comptroller Hawke has

answered, and I would endorse what he said. The regulators will

have to make investments in training and staff. I would add two

things that he did not say. One is that this entire process, at least

from the standpoint of my agency, has allowed us already to start

to build skills, just in the interaction over the last 4 years to do

this. And also—again this is the Fed maybe more than the other

agencies—we are blessed by already having, because of the nature

of what we do, a number of economists already trained in these

areas. Some of them have moved over to be the heads of supervision or senior members in supervision. We still have some way

to go. The banks are not at ground zero. Frankly, nor are we. By

definition, I do not want to overestimate or underplay the amount

of investment that we are going to have to undertake.

Chairman SHELBY. Mr. Hawke, you are the Comptroller. I would

like your views on this. This is important.

Mr. HAWKE. Let me say I envy their unlimited budget.

[Laughter.]

Chairman SHELBY. At the Federal Reserve.

Mr. HAWKE. At the Federal Reserve.

25

I think it is important to recognize that the use of models is not

something new or something that is going to be initiated by this

Basel process. Models have been used for years. Since 1997, banks

have been using models to measure value-at-risk or market risk, as

part of the Basel process. I think we at the OCC have been in the

forefront of using economists in the examination process, working

with banks and their models. The use of models as measurement

tools in the supervision process is not brand new with Basel II.

Chairman SHELBY. But you cannot just use the model. You have

got to have other means too, have you not, other than this model?

Mr. HAWKE. Oh, absolutely. As I said before, the role for conventional bank examiners will be undiminished. I view Basel II, if it

really works, as providing our examiners with better tools to do the

job that they already do.

Chairman SHELBY. We were told that the Long-Term Capital

Management used models developed by Nobel prize winning economists and their models failed. So as a comptroller, any model, you

will have to be looking at it closely to see if it does the job that

you want, right?

Mr. HAWKE. I can assure you, we will not hire any Nobel prize

winners at the OCC.

[Laughter.]

Mr. HAWKE. But I think it is also important to recognize that the

models in Long-Term Capital Management did not have the kind

of supervisory triangulation that we are going to bring to bear in

this process.

Chairman SHELBY. Mr. Powell.

Mr. POWELL. Senator, I think you bring a valid point. I think

models are important. I think models are necessary, and I agree

with what my fellow regulators have said. Models have been

around for some time, and I think they are useful tools. But I am

reminded of the old statement, junk-in, junk-out. I think models

are wonderful, but the input data is extremely important. That is

where the supervision, and where the oversight of the regulation

will be critically important—to look at those estimates going forward. But I think models are very useful.

Chairman SHELBY. Mr. Gilleran.

Mr. GILLERAN. Regulators have faced sophistication all along the

last decades because of data processing, and we are up to the task

I think from a technical point of view, and we will hire others if

we need them. But what regulators bring to the table is a gimlet

eye, and it is that gimlet eye that is a very important one in the

process, and I think that will continue to be the case.

Chairman SHELBY. From what I understand, this proposal involves taking the internal management practices of the banks, and

saying such practices will now largely inform the regulatory standards. Typically—and I will direct this to you, Mr. Hawke—is it not

Congress or at least the regulators who develop the policies which

banks then implement? Does this proposal turn this equation

around?

Mr. HAWKE. No, I do not think so, Mr. Chairman. We implement

the basic policies that Congress sets. Congress has given us at the

OCC the task of determining the rules under which the capital for

our banks will be determined and evaluating capital adequacy on

26

an ongoing basis. We are not turning over the policymaking function to the banks. The rules will be set in great detail, and there

will be very careful oversight.

Chairman SHELBY. It can probably be said that there are some

considerable differences between the markets of all the countries

that are participating in the New Basel II Accord. What considerations were made regarding these differences? In this country our

banks use very sophisticated methods of securitization. What impact will the proposal have on securitization in the United States?

Mr. HAWKE. That has been a great concern of mine, not only because U.S. banks do far more in the way of securitization than European banks, but also because national banks in particular are

very heavy into the securitization markets. So, we have tried to

make sure that the rules that emanate from Basel II on

securitization do not discriminate against U.S. banks.

There are other aspects of this whole structure that concern me

in terms of international comparability and that relate to the nature of supervision. Our large banks, including the 10 to 12 large

banks that will be covered by Basel II, have full-time, on-site resident examiners that are there day in and day out. Some of our

counterparts on the Basel Committee examine their banks once

every 2 years or once every 5 years. There is the potential for disparity here in application just because of the disparity in the nature of the supervisory functions from country to country.

Chairman SHELBY. Can we, just for the record, definitively establish the number and perhaps even the specific entities which will

be required to comply with this proposal? Is the number you cited

in your testimony, up to 20 banks definitive? I recall that Basel I

was intended to apply only to internationally active banks, but now

covers all U.S. banks.

Do you want to take that, Governor Ferguson?

Mr. FERGUSON. Well, I will start and my colleagues will chime

in and correct me if I am wrong.

The plan, as we have indicated, is to have about 10 banks that

will be mandatory banks. We think another 10 or so will want to

opt in early on in this process for a variety of reasons. The question

you ask puts us into a broader time frame though. The reality is,

not in the short term but I would expect over the intermediate

term, if indeed Basel II does what it is intended to do, which is to

create more risk-sensitive capital which gives a better signal to

management of what is going on, more banks will find it in their

interest to opt in. That will also occur as the cost of building some

of these systems and hiring some of these people comes down. So

over time, not in the short term but over the intermediate term,

almost regardless of what we as regulators do, I would expect, if

this is indeed beneficial in helping banks to run themselves by giving them a better sense of risk, that we will have more banks

gradually opt in.

We will also, I think, as banks grow, find that we as regulators

want more banks to come in because they will reach a larger scale

of domestic operations or international operations, but I do not

think that is going to be a short-term issue. I think it is more of

an intermediate-term issue.

Chairman SHELBY. Mr. Hawke.

27

Mr. HAWKE. Mr. Chairman, the standard by which we would determine which banks are and which are not mandatory is one of

the issues that will be addressed in the rulemaking. The standard

will take into account both size and international exposure. Right

now, our best estimate is that there will be about 10 banks that

will be included. Those 10 banks probably account for, as I said,

95 percent of the foreign exposures of U.S. banks, and if another

10 banks were to opt in, we expect that we would cover probably

99 percent of the foreign exposures of U.S. banks.

Chairman SHELBY. Mr. Powell.

Mr. POWELL. Senator, may I say one thing about the comment

on the role of Congress and the role of the regulator? Basel does

not do away with prompt corrective action that Congress implemented during the crisis, and that still will be part of it.

Chairman SHELBY. Mr. Gilleran.

Mr. GILLERAN. I must say too that Basel is not going to take

away the regulatory responsibility to be able to step up and tell

any bank that it feels it is operating in an unsafe and unsound

manner to have more capital. So therefore, this is a system for

measurement, but it does not take away our regulatory powers or

responsibilities.

Chairman SHELBY. Senator Sarbanes.

Senator SARBANES. That is interesting. I would like to follow up

on that comment of Mr. Gilleran right there.

Does that mean that if an agreement is concluded, our own regulators could then impose subsequently a higher capital requirement

on our banks? Is that the point you were making?

Mr. GILLERAN. That would be my conclusion if a bank adopts it,

but if we feel it has been adopted incorrectly or inappropriately, or

we feel our estimation of the risks are such that more capital is required, then it is our responsibility to ask for it and to get it.

Senator SARBANES. Is that right?

Mr. FERGUSON. Yes, that is right. You also should recognize, as

Chairman Powell has indicated, we already have some areas of

difference from foreign countries. We have prompt corrective action, for example. We have the leverage ratio. We have the various

legal requirements to become a financial holding company which

require that subsidiary banks be well capitalized. There is also the

market discipline. So there are a number of different tools that we

have in the United States, some that are legislative, some that

come from us as regulators, that are likely to increase the amount

of capital we have far above or somewhat above the regulatory

minimums. I should also mention the fact that banks themselves,

because they recognize the cyclical ups and downs, already hold,

and will continue to hold, a cushion of capital above the regulatory

minimum that we are talking about here.

Senator SARBANES. Now I want to address what is required by

the regulatory regime. If our regulators determine that what Basel

II produces is inadequate, to what extent are they constrained by

the agreement?

Mr. FERGUSON. Should I respond to that? The agreement already

has a number of places that have what is called national discretion,

where we can accept or reject some approaches. We also clearly

have said over time, and will continue to say, that as we get a betVerDate 11-MAY-2000 10:04 Jul 07, 2004 Jkt 000000 PO 00000 Frm 00031 Fmt 6633 Sfmt 6633 94514.TXT BANK1 PsN: BANK1
28

ter sense of the impact of this on capital and as best practice

changes over time, we will, if necessary, go back and we will renegotiate. We obviously, by definition, have the right and the authority to make, if you will, a step back from the agreement and

to make some unilateral changes if we have to. That would not be

the better approach. The better approach, for a variety of reasons,

is to make changes in the international context because we want

to make sure that we have some control over the way our banks

that are operating overseas are treated, and therefore having an

international agreement is the better approach. But we have not

given up national approaches here if we find that we are having

a great deal of difficulty with things that we think are important.

Senator SARBANES. All of this argues for making sure that we get

it right in the first place, does it not?

Mr. FERGUSON. I think it argues for two things. One, obviously,

making sure we get it right in the first place. Two, reinforcing the

message that I have just given you and that we have also given to

our negotiating partners, that as we see things evolve and change,

we have the authority and we reserve the right to go back and renegotiate in places where we have to renegotiate, but obviously, we

want to do the best we can to get it right the first time.

But we should also be mindful, Senator, that we, I think, all believe that Basel I is not sending the correct signals to us, to the

market, or to the banks about the capital that is being required.

While we want to get this right the first time, recognize that delay

is not necessarily holding onto a safe and sound system. Basel I is

outdated for our largest institutions, and so it is important for us

to continue to work for a common process, but to do it with a certain resolve so that we are not leaving large institutions on a capital framework that is not risk-sensitive and probably not fully

reflective of what is going on in those banks.

Senator SARBANES. I guess my concern is that you seem to be

very close to the concluding date, but not yet to have either worked

out a number of problems that everyone concedes are problems, or

to have developed, at least on our side, a full-scale consensus as to

what should be done.

Mr. HAWKE. Let me say, Senator Sarbanes, that there is a lot of

process to come here. We will be going out with an Advance Notice

of Proposed Rulemaking, which will be the first occasion where we

have officially solicited comments from the entire U.S. public, not

just the banks that would be affected, on Basel II. The Basel Committee’s schedule includes trying to finalize the Basel product by

the end of this year. I think that may be too tight a schedule, given

the need for us to analyze the comments that come in in response

to the ANPR and to feed that back into the Basel process. Following the Basel Committee’s decision, we are going to have another quantitative impact study, plus the potential for an economic

analysis that might be dictated by an Executive Order that applies

to rulemakings that have significant economic impact. We will have

the NPR process, which will be another opportunity for public comment. It will not be until all of those things have run their course

that we will be in a position to consider whether we are going to

adopt the Basel proposal finally. So there is a lot of process, a lot

of opportunity for input into this before the end of the day.

29

Mr. FERGUSON. May I add two other points to that? The final implementation for this is expected to be the end of 2006, very beginning of 2007. Before that we will have a year of parallel running

between Basel II and Basel I, which will give us another chance

to see if we are comfortable. Then in the first 2 years there are capital floors that are put in to make sure that if there are going to

be reductions, we understand the sources of them and that we are

comfortable with them.

In some sense, Senator, what we are looking at ultimately, before

we have an unfettered Basel II, is many years from now, not next

year. So, 2004 will be when we hope we get the basics all run. We

still have room to make adjustments.

Senator SARBANES. Once you close the agreement you are in a

different framework than before you close the agreement. I made

that point earlier, and I just want to repeat it.

Mr. Chairman, could I ask one final question?

Chairman SHELBY. You may proceed.

Senator SARBANES. In her written testimony, which will be on

the next panel, Karen Shaw Petrou, who has appeared before this

Committee a number of times and given us some very perceptive

and helpful testimony, poses a question, ‘‘Whether the complexities

in Basel II’s advanced models are so daunting that supervisors at

home and abroad will not be able to ensure that banks actually

comply with the new capital rules.’’

Before I put out my question I will just tell you a little story.

John Biggs of TIAA–CREF testified before our Committee when we

were working on the corporate and accountants responsibility legislation, and he told a story of one of his analysts who came in to

see him, his financial analyst, who told him that he just could not

see where Enron was making all this money, that he had been over

their statements again and again, and he just could not figure it

all out. And Biggs says to him, ‘‘Well, if you cannot figure it out,

we had better sell it.’’ And they sold it. This was a couple of years

before Enron took a nosedive and went into bankruptcy.

So my question to you is whether you have the necessary expertise and resources to implement Basel II and effectively supervise

the banks’ internal risk measurements. I mean, everyone says right

from the beginning, this is extremely complicated and complex.

Only the big banks can handle it, and so forth and so on. That obviously raises a concern about whether the system can be gamed.

Where are we on that rather important question?

Mr. HAWKE. I think that is a very important question, and I

think it does present us with some challenges in terms of training

and retention of people. I disagree with the suggestion that we are

not up to the task of evaluating the models that our banks are

going to be using. As I mentioned earlier, Senator Sarbanes——

Senator SARBANES. Who will evaluate the models that other

banks are using internationally, our competitors?

Mr. HAWKE. Their supervisors will be evaluating those models,

and that is certainly a cause for concern because the intensity of

the supervisory process in some of the Basel countries is quite different from ours. One of the purposes that the disclosure pillar, Pillar 3, is supposed to serve in this process is to provide as much

transparency as we can with respect to this process, so that there

30

can be some cross-checking from country to country, so that we can

look at what is going on in other countries and determine the integrity with which the process is being applied.

Mr. POWELL. Senator, I hope this is the last time I will say this,

but I think again you are raising lots of issues on the complexity

and the validation issues and the competition. Again, I would just

say that that is another reason for regulatory minimum capital.

Mr. FERGUSON. May I throw in a third if you will? A couple of

points I want to make. You are also going to hear on the second

panel from one of the bankers here who has a technical orientation

by his background, who if I recall his testimony, talks a little bit

about a set of models called VAR models, value-at-risk models,

which 10 years ago were brand new and went through exactly the

same degree of concern and uncertainty, and today we discover are

well-established. We understand them. So, yes, this is in some

sense relatively new, and I will come back to that point in a

minute. But these things do evolve our own understanding and

that of the banks does evolve.

The second point to make is in some sense we have no choice

here. We always can choose what we do, but what this is doing,

again, is reflecting what many leading edge banks are already

doing. It is reflecting what some of our regulators, some of our supervisors already have to come to grips with. It is making those

changes more visible. I agree with you it is certainly important. We

should not go into this being naive. We should not go into this

thinking that it is easy, but we should not refuse to go into it because it is new, because indeed it is already happening in many of

our leading edge banks. I will not underestimate the importance of

the complexity and the degree of concern and the caution that you

are raising, Senator, because they are extremely well thought out,

obviously. But I do not want to leave the impression that we are

stepping to terra completely incognita. We are, I think as regulators, doing what many of the leading edge banks are doing, we

are reflecting where the well-run have already gone.

You talked about the complexity allowing some gaming of Basel

II. The reality is that one of the reasons we are going down this

path is that—it is a quote that you heard from Larry Meyer—there

is, if you will, gaming—I know ‘‘gaming’’ sounds much too pejorative—there is capital arbitrage already going on. One of the

things we are trying to do is confront that directly by getting the

capital to reflect the risk because we now have a system in which

capital may well not be reflecting risk. Yes, this is complex for

sure, but we are not going to be naive about going into this. We

are not running into it with our eyes closed, if you will. But we also

know that in some ways we are doing only what the market has

already started to do.

Mr. GILLERAN. May I speak on this?

Senator SARBANES. Yes, sir.

Mr. GILLERAN. Senator, I believe that we will have the people

necessary to do probably the finest regulatory job that can be done

in connection with Basel II.

In answer to your question, any time that you would make a system variable based upon the institution’s own determinations of

risk, that you are going to have a system where mistakes will be

31

made, either intentionally or unintentionally, that has to be dealt

with in the regulatory scheme. So any time that you would come

up with a system like this, you are going to have to take into consideration that there will be mistakes made.

Senator SARBANES. Thank you.

Chairman SHELBY. Senator Allard.

Senator ALLARD. I just have one question regarding the origin of

needing to update Basel I. Did the Basel II proposal come about

because we had financial institutions in this country concerned

about the competitive environment, or did it arise from the regulatory community’s concern with safety and soundness issues? How

is it that the need to change the original Accord came up and was

brought to your attention?

Mr. HAWKE. I think a little bit of both. There was a growing recognition, as Governor Ferguson has said, and as Larry Meyer said

in the quote that was read earlier, that the old system was too

coarse, that in defining several risk buckets, it was not really accurately reflecting risk. That was becoming evident as time went on.

Senator ALLARD. That was a concern of yours.

Mr. HAWKE. Yes, Senator. And there was also a concern that we

needed a better system of oversight internationally, that Basel I

was not being applied in an even-handed way internationally.

Senator ALLARD. Regulators internationally share some of those

concerns?

Mr. HAWKE. Yes.

Mr. FERGUSON. I would like to add a third reason, which is a

sense from the leadership of our largest banks. They were observing that the way they were managing and thinking about internal

risk was diverging from what they had to do for capital purposes.

While by definition those things may not always be perfectly

aligned, I think all of us would recognize that there is probably a

benefit to having banks building their basic regulatory capital

under our guidance, supervision, validation, et cetera, in a way

that is at least consistent with the way that they manage themselves because they should be getting the same signals from their

own economic capital models and judgments, and also from what

they are doing with respect to regulatory capital, what the minimum regulatory capital is telling them.

Senator ALLARD. Are these large banks concerned about not

being able to compete because of the capitalization requirements

that we have here in the U.S. as compared to other countries?

Mr. HAWKE. Well, I have not heard that. I think that, as Governor Ferguson said earlier, regulatory capital requirements generally, frequently lag behind a bank’s economic capital. Banks are

maintaining higher regulatory capital than the regulatory minimums that are required.

Senator ALLARD. In this country?

Mr. HAWKE. In this country.

Senator ALLARD. How do U.S. banks view that requirement in regards to competing internationally with other banks that have not

had a base in other countries?

Mr. FERGUSON. I do not think they have seen that recently as a

disadvantage. To be fair, when the Basel process started back in

1988, there was some concern that perhaps some banks in some

32

nations were letting their regulatory capital slip to levels that were

really unreasonably low. I have not heard recently the kind of concern you are talking about, and the reason is that the banks that

we are talking about, the largest internationally active banks

around the world, compete with each other, but they also go to the

markets for funding. The markets really are, in addition to their

internal needs, demanding a certain level of capital. That is, for

reasons Comptroller Hawke indicated and other reasons, higher

often than the regulatory minimum. So, I had not heard from our

banks a sense that they were at a competitive disadvantage because of regulatory differences of this type. That had been true 20

years ago more or less, but that is not one of the incentives that

is driving this round of discussion with respect to Basel II.

Mr. HAWKE. Senator Allard, if I could just take a second to go

back to your earlier point. Under Basel I with the very few risk

buckets that cover all bank assets, it became clear that within a

particular risk bucket, there could be included assets of widely different risk characteristics, and yet they had the same capital

charge. One of the things that did was to encourage banks to invest

in the riskier assets because there was no differentiation in the

capital charge for those assets. So the current approach is to try

to more closely match the capital allocation to the risk of a particular asset.

Senator ALLARD. I see.

Thank you, Mr. Chairman.

Chairman SHELBY. Thank you.

Obviously, we have, and you have, a lot of unanswered questions.

We expect answers here on the Committee, and we feel that is our

obligation before things get finalized. In going forward, I hope that

you will provide some of the means to the Committee that we will

be kept abreast of changes in the proposal. All the Members have

raised serious questions here today, and we do not have all the answers yet, and I do not think you do.

But we are very interested in this. We appreciate, Governor Ferguson, you representing the Fed today, spent your morning here

with us; Comptroller of the Currency, John Hawke; Don Powell,

Chairman of the FDIC; James Gilleran, Director of the Office of

Thrift Supervision. It has been a long morning. Thank you for your

participation again before the Banking Committee.

Mr. POWELL. Thank you.

Mr. HAWKE. Thank you, Senator.

Mr. GILLERAN. Thank you.

Mr. FERGUSON. Thank you.

Chairman SHELBY. We will now, although we are in a late morning, going to call the second panel up, Mr. Maurice Hartigan, President and CEO, the Risk Management Association; Mr. Micah

Green, President of the Bond Market Association; Professor Edward Altman, Max L. Heine Professor of Finance, Stern School of

Business, New York University; Ms. Karen Shaw Petrou, Managing Partner, Federal Financial Analytics; Mr. Wilson Ervin,

Managing Director, Strategic Risk Management, Credit Suisse

First Boston, and he will be testifying on behalf of the Financial

Services Roundtable; and Mr. Kevin Blakely, Executive Vice President and Chief Risk Officer, Key Corporation.

33

All of your written testimony will be made part of the record. As

I said, you have been here all morning. You have heard all the regulators. We would like to move this hearing on as quickly as possible. All of your written testimony will be made part of the record

in its entirety.

Mr. Hartigan, we will start with you. If you can sum up your testimony as brief as you can. Thank you so much.

STATEMENT OF MAURICE H. HARTIGAN, II

PRESIDENT AND CEO

RMA—THE RISK MANAGEMENT ASSOCIATION

Mr. HARTIGAN. Good morning, Mr. Chairman, Senator Sarbanes,

and Members of the Committee. Thank you for inviting me to appear before the Committee.

I am the President and CEO of RMA, the Risk Management Association. RMA is a member-driven professional association whose

sole purpose is to advance the use of sound risk principles in the

financial services industry.

The main point I want to make to you today is that the New

Basel Accord will be a step forward for the United States and world

banking industries, provided it is modified as it is being finalized

and provided it is implemented flexibly. It will be a step forward

because it is directionally correct in improving the risk sensitivity

of regulatory minimum capital adequacy standards. But it must be

modified to ensure that it is not too conservative, that these are

truly minimum and not maximum capital standards, and to ensure

that it is not too prescriptive.

The 1988 Accord relied solely on a regulatory minimum capital

standard. In contrast, the new Accord will be grounded on three

principles or ‘‘pillars’’ as they are called: Capital requirements, enhanced supervision, and greater disclosure. This alone represents

a significant improvement.

Nonetheless, we have specific concerns in this area. Pillar 1,

which deals with the capital standard itself, must contain assurances that Basel will evolve toward a full models-based approach

for credit risk, and it must avoid arbitrary specificity. Pillar 2,

which deals with the implementation of the standard through the

process of supervision, must allow regulators enough discretion to

accommodate the diversity of best practices in risk management

today. Pillar 3, which requires increased disclosure in order to provide greater market discipline, must ensure that comparability is

meaningful across the varying international accounting regimes.

Our research to date suggests that the new Accord, as proposed

in the Third Consultative Paper, will require more overall capital

than many banks’ internal risk-rating systems require today, even

though for some banks and some portfolios, the new overall requirement will be somewhat less than under the old Accord. This

will often be inappropriate.

The new Accord should represent a true minimum capital requirement. For well-run banks in normal times, this implies that

regulatory capital levels should be set below a bank’s economic capital based on best practice internal risk measurement procedures.

Given the newness of the fields of study surrounding credit and

operational risk management, it is natural that regulators should

34

be prone to conservatism. But too much capital is just as bad as

too little capital. Too much capital will drive down the risk-adjusted rates of return on a particular business line and cause bankers to lend less than they otherwise would and should. This is not

a good thing either, for the shareholders of the bank, the loan customers, or the general economy.

The next point I wish to make is that the process to reform the

1988 Accord has had a positive impact on the development of risk

measurement and management procedures in the financial services

industry. Moreover, the dialogue between the industry and its regulators surrounding Basel reform, while not without frustration on

both sides, has been useful and productive. While outstanding

issues clearly remain, some quite significant, continued discussion

with the industry is ongoing, and I would expect this to be the case

throughout the reform process, and into the implementation stage

as well. Indeed, it may not be possible to resolve a number of specific issues without an active two-way dialogue between regulators

and the industry as the implementation process takes place. Further discussion can only help promote innovation and investment

in best practices throughout the industry.

It is for this reason that the reform process must continue. However, it must be framed as a work in progress. There cannot be a

prescribed end state for sound risk management practices. Otherwise, the ink on the new Accord would not be dry before it became

obsolete, much like the 1988 Capital Accord.

The quantitative analysis supporting sound credit risk measurement and management are still evolving. Many of these emerging

practices were born out of the last economic downturn. The resilience of the financial services industry over the past 3 years should

not go without comment. Many have credited the industry success

to the better risk management practices established over the past

decade. I clearly agree.

Furthermore, in our own review of Basel II, we find that some

of the new requirements are written in a very prescriptive fashion

that does not lend itself to allowing individual banks to employ a

diversity of best practices. Without such diversity we cannot have

continued evolution of best practices, and without evolution we

could not have had the improvements in risk measurement that

have occurred over the past decade.

In the interest of time, I redirect your attention to my written testimony for a fuller treatment of two more technical points

which are of great importance, in essence, that the internal risk

ratings-based approach must be followed with a full internal models approach to capital; and second, capital is required only for unexpected loss known as UL, not for expected loss, as the current

version of the Accord argues. RMA has additional technical concerns specific to the Third Consultative Paper which we will address in the formal response.

To conclude, I would like to reiterate RMA’s belief that the reform process has helped advance the practice of sound risk measurement and management within the industry. RMA is hopeful

that the New Capital Accord can be structured to encourage and

enhance continued industry innovation and that it will recognize

the benefit that diversity of practice within the industry provides.

35

Thank you, and I would be happy to answer any questions that

you may have.

Chairman SHELBY. Thank you.

Mr. GREEN.

STATEMENT OF MICAH S. GREEN, PRESIDENT

THE BOND MARKET ASSOCIATION

Mr. GREEN. Thank you, Chairman Shelby and Members of the

Committee, for the opportunity to testify today on the Basel Committee on Banking Supervision’s proposed New Capital Accords, or

Basel II. My name is Micah Green, and I am President of the Bond

Market Association, which represents securities firms and banks

active in the United States and global bond markets. Association

member firms account for at least 95 percent of all bond market

activity in the United States, in addition to much of the bond underwriting and trading in the rest of the world. Together with our

affiliates, the American and European Securitization Forums, we

represent a majoirity of the participants in the growing securitization markets in the United States and Europe. The following

comments focus only on those issues related to Basel II that are

most important to our membership.

First let me say the association supports the Basel Committee’s

overall goal of rationalizing the current risk-based capital regime

and aligning regulatory capital requirements more closely with actual credit risk. We are grateful to the Federal Reserve Board and

the other banking regulators, in particular, Vice Chairman Roger

Ferguson, for working with us to address the issues presented by

the proposed capital accord revisions that are important to our

membership. We are still concerned, however, that if not amended,

Basel II will diminish the economic benefits derived from large and

growing sectors of the capital markets, benefits which accrue to

consumers, as well as businesses.

I will first make one general comment on the direction of Basel

II and then focus on the two areas most important to us:

Securitization and repurchase, or repos, and securities lending

transactions.

With regard to Basel II broadly, we believe it is important that

this agreement not be viewed as the last word on regulatory capital. Risk management techniques are continually evolving, and the

financial markets need a regulatory capital accord that evolves

with them. Basel II must, therefore, be crafted in a way that ensures that it can better adapt to changing market products and developments. Ultimately, the global financial community will need

to move toward a broader reliance on internal risk models to determine appropriate capital levels.

Securitization is the process of converting illiquid financial assets, like loans and other receivables, into securities, which can

then be traded in the capital markets. It is a large and growing

market with tremendous economic benefits for consumers and businesses. Securitization lowers borrowing costs for consumers and

others, improves risk management, and draws new sources of capital to the lending markets. Consumers benefit from these efficiencies with lower interest rates and lower prices.

36

Just to summarize the size of the securitization market, in the

United States over the last 5 years it has increased 5-fold, to $2.7

trillion. In Europe, it has increased 20-fold over that same period

of time, to a much lower level overall but still $151 billion of outstanding securities. And in Asia, where the marketplace is just

getting started in the last 7 years, the marketplace has increased

510-fold, to a level right now of $51 billion, and it is anticipated

it will grow quite rapidly.

Financial institutions participate in securitization as issuers and

investors and as part of the risk management functions. For

securitization generally under Basel II, the proposed risk weights

for securitization positions held by banks are too high in light of

the actual credit risk presented by these products. The proposed

rules use unrealistically conservative assumptions that, cumulatively, would require financial institutions to set aside excessive

levels of capital. And considering who ultimately benefits from a vibrant securitization market, consumers of homes, car buyers, or

other people who need capital, this is very important.

Repo and securities lending transactions, although little known

outside the wholesale financial markets, are vital to our capital

markets’ liquidity and efficiency. Repo and securities lending transactions allow market participants to finance and hedge trading positions safely, cheaply, and efficiently. It is utilized by elements of

the Government. The Federal Reserve, in fact, uses this marketplace to implement its monetary policy. Basel II may require banks

to take capital charges inconsistent with the actual level of risks

present in repo and securities lending transactions. Financial institutions should have greater flexibility to employ supervisory-approved internal risk models created to assess counterparty risk in

order to accurately reflect risks present in these transactions.

We agree completely that the current regulatory scheme for bank

capital, Basel I, needs significant revision. The current regulations

are outdated and inflexible, as you have heard before. Updating the

regime can produce significant benefits, including the promotion of

fair global competition, incentives for better internal risk management, and an economically efficient allocation of capital. Getting it

wrong, however, and implementing capital regulations which do

not reflect modern practices or true credit risks on balance sheets

will diminish or eliminate the market efficiencies.

The Basel Committee is on the right track. We need them to improve it even more, and we look forward to working with them in

this process.

Thank you again, Mr. Chairman.

Chairman SHELBY. Professor Altman.

STATEMENT OF EDWARD I. ALTMAN

MAX L. HEINE PROFESSOR OF FINANCE

LEONARD N. STERN SCHOOL OF BUSINESS

NEW YORK UNIVERSITY

Dr. ALTMAN. Thank you very much, Senator Shelby, for inviting

me here today.

I have followed the Basel II’s consultative papers since the first

one was issued in June 1999. A colleague and I have written several commentaries to them, particularly with respect to Pillar 1,

37

the capital adequacy based on specific risk characteristics of bank

counterparties. Our major comments were that capital requirements related to expected and unexpected losses from corporate

and other loans should be based on actual historical experience of

the Loss Given Default from the corporate bond and bank loan

markets. The original 1999 suggestions bore absolutely no resemblance to real-world experience. However, they have made significant modifications since 1999, and I am pleased to say that the

current revision does a much better job of relating the requirements to default experience, although in my opinion still too little

capital is being required for the most risky categories, and probably

too much capital for the least risky categories.

A problem with the suggested regulations, however, is the complexity in determining capital requirements and the somewhat arbitrary choice of modifications to the standardized scale due to such

items as the size of the counterparty and the existence, or not, of

collateral on the loan or the bond. For example, Senator Shelby,

you mentioned before small and medium-sized enterprises as a

very important part of our system.

Chairman SHELBY. Do you agree with that?

Mr. ALTMAN. Absolutely.

Chairman SHELBY. Okay.

Mr. ALTMAN. Absolutely. The Basel Accord under the current recommendations will give lower capital requirements for comparable

risk levels for as much as 25 to 50 percent less capital for SME’s

than larger counterparties. The argument that the correlation of

default rates among these small counterparties is lower than for

larger corporations may be valid, but I have seen little evidence

that the haircut for SME’s for these loans should be as much as

50 percent. In my opinion, this was a concession to those national

banking systems of the world whereby SME’s are the vast majority

of borrowers; hence, lower capital requirements for banks in those

countries. It is also true, however, that SME’s make up the vast

majority of loan assets of smaller banks in the United States and

the same lower capital requirements would hold for U.S. SME’s

and the banks that make these loans, close to all but 100 of our

Nation’s 8,000 banks. But, as I will now discuss, almost all of U.S.

banks will not be required to follow the recommendations of Basel

II. So the reduced capital requirements for SME’s will not be relevant and the old Basel I 8-percent rule will probably still be in

effect for all but the very largest U.S. banks. In other words, SME’s

in other countries will be advantaged vis-a`-vis the United States.

As I indicated above and as you probably all are aware by now,

and you heard the regulators this morning, the central banks of the

world and other bank regulatory bodies set national regulatory policy based on Basel’s recommendations, but they do not have to accept what Basel suggests. Indeed, it came as an enormous surprise

to some observers, including this writer, that only the largest 10

U.S. banks, and perhaps the next 10 to 20 banks in terms of asset

size and other requirements, would be required to conform and the

next 10 to 20 having the option, to opt into Basel II, and for all

other banks, Basel I still remains. In other words, the ‘‘bad wine’’

that Basel I might have been drinking in 1988 is still going to be

38

drunk in the coming years by all but 10, maybe 20, banks in the

United States.

While it is true that as much as two-thirds of all bank assets are

held by the top 30 U.S. banks and more than 95 percent of the foreign exposures of these banks will be covered under Basel II, it is

likely that all the rest of our banks, almost 8,000, will not be asked

to conform and will probably not do so for many of the reasons you

heard this morning: Basel II is too complex and too costly; the U.S.

banking system is presently more than adequately capitalized; the

added Basel II capital required for operating risk is based on highly arbitrary and extremely difficult-to-measure variables; and, finally, the Federal Reserve System’s and other regulatory bodies’

maximum leverage ratios and prompt corrective action have

worked very well. In other words, if it ain’t broke, don’t fix it.

I believe that the choice of only the 10 largest commercial banks

to conform to Basel II and the IRB approaches is unfortunate and

should be reconsidered. Notwithstanding, the recent consolidation

movement of many of our largest and most sophisticated banks, the

possible exemption of number 11 to number 30, including such

large banks as HSBC Bank, Citibank [West], Bank of New York,

Key Bank, which you will hear later from, State Street Bank, number 11 to 15, and the very likely exemption of number 31 to 50, including such seemingly large banks as Charter One, Am South,

Union Bank of California, Mellon Bank, and Northern Trust, to

name just a few, seems arbitrary and belittles the possible sophistication and motivation of these banks which would be substantial institutions in most other countries of the world. For example,

the 50th largest bank in the United States in terms of assets, Compass Bank, $24 billion in assets, or in terms of deposits Mellon

Bank, would be huge institutions in most countries. They do not

have to conform.

The choice of a round number like 10 would seem to be insensitive to world opinion, as well as to the risk management motivation. Speaking from an economic standpoint, rather than a political

one, I would prefer to see either no banks be required or some exemption level whereby the costs/benefits to our banking system

would be more rationally presented and defended, not just the fact

that they are internationally active or not. Certainly, a number like

the top 50 to 100 banks would be much more in line with the number of banks conforming in other countries.

Our largest banks are probably relatively happy to conform to

Basel II even with its complexity and added costs to develop the

systems and models we have been talking about. Some of those

models, by the way, I helped develop a long time ago, and I am

very happy to see that they are getting the play that they are. The

reason is that they expect total capital required for credit assets

will be less than what is required under the current regime. So we

may have a new regulatory regime where everyone, large and

small banks, as well as our bank regulators, are relatively pleased

with the changes recommended. That does not necessarily mean

that it is good legislation.

I have always felt that despite its problems with complexity, too

low capital requirements for risky counterparties, and the difficulty

in managing against operating risks, Basel II had one extremely

39

important by-product, at least one: The motivation for banks to develop or improve upon their existing credit-scoring models and systems to reduce total losses from nonperforming and eventually

charged-off loans. These systems can be used to rate and set capital

for all bank customers rather than using a ‘‘one-size-fits-all,’’ the 8-

percent rule which is now in effect. I have observed the enormous

strides achieved by banks throughout the world—mostly outside

the United States, I might add—including ones of all size and location, as to developing risk management systems and training of

personnel to prepare for Basel II. Indeed, from what I can surmise,

banks in most countries, especially in the European Union, will all

have to adhere to Basel II’s Standardized, Foundation, or Advanced

IRB approaches. Granted that regulators in these countries will

need to sanction far fewer banks than U.S. regulators would have

to do if all banks are mandated to conform, it must have come as

a surprise, perhaps even a resentful shock, that the vast majority

of U.S. banks will not adhere to Basel II. This is especially true

since the United States and its representatives to the BIS were the

early champions of the need to change the way banks allocate capital for credit risk of their clients.

What is disappointing to me is that the Fed’s decision to exempt

all but the largest banks from building and implementing IRB approaches, et cetera, for risk management systems will demotivate

the rest of the banks to do so. Under Basel I, they did not have

to do so. They are not going to have to do so in the future, although

some will opt to do so, as the regulators said. I am very sensitive

to the problems in Basel II and what the regulators are faced with.

But, in conclusion, what I would like to say is that our decision to

exempt smaller banks from Basel II may backfire if many of the

world’s smaller, or even larger, banks in other countries decide also

to opt out of the system because of what we do. This may cause

an international problem in banking, which can affect us due to a

contagion effect.

I have other comments on the procyclicality issue, but in the interest of time, I would like to just conclude and thank you again.

I am certainly happy to answer any questions.

Chairman SHELBY. Thank you.

Ms. Petrou.

STATEMENT OF KAREN SHAW PETROU

MANAGING PARTNER

FEDERAL FINANCIAL ANALYTICS, INC.

Ms. PETROU. Thank you very much, Mr. Chairman, Senator Sarbanes, and the Committee as a whole. I am Karen Shaw Petrou,

Managing Partner of Federal Financial Analytics, which is a firm

that advises on the strategic impact of U.S. legislative, regulatory,

and policy events like the Basel Accord. I also serve as Executive

Director of a group called the Financial Guardian Group, which

represents those U.S. banks most particularly concerned with the

proposed new capital charge for operational risk-based capital.

I thank Senator Sarbanes for mentioning that I have been here

before. Through the 1980’s, as a matter of fact, when this Committee spent a tremendous amount of time and ultimately had to

allocate an awful lot of taxpayer money to rescue the FSLIC and

40

address the savings and loan crisis. My firm then also advised a

national commission on the causes of the S&L crisis chartered by

Congress in 1989, and we concluded that the predicate cause of the

savings and loan debacle was the failure in the early 1980’s by the

thrift regulators to set appropriate regulatory capital. I am a

strong believer in regulatory capital because, at its most simple

level, it means that shareholders put their money first. Their

money is up before the deposit insurance fund, before the lender

of last resort. It is a critical discipline.

I must respectfully disagree with Mr. Ferguson in terms of the

importance of regulatory capital in driving decisionmaking. It is a

profound driver of profit decisions at the most senior level of every

financial services firm, bank and nonbank. And as a result, it can

have major policy impact.

I would point to, for example, the question of Fannie Mae and

Freddie Mac, an issue now before this Committee as a result of recent events. Congress and the markets have allowed Fannie and

Freddie to operate with regulatory capital somewhere between a

half or 20 percent of that which would be required on the same assets if they were held by an insured depository. If you want to look

and ask yourself why have these two GSE’s doubled in size every

5 years to now hold $3.3 trillion in obligations, are they smarter

than everyone else? Maybe. Do they have advantages as GSE’s?

For sure. But, fundamentally, they can run a lot bigger and maintain tremendous profitability on much smaller amounts of regulatory capital. So these issues are very important, and they will

have profound implications for the financial services industry.

As Chairman Powell said, Basel II, for all its hundreds of pages

and formulas, is a major strategic driver of the competitive direction of our financial services industry and its ability to serve a core

customer base in a safe and sound fashion going forward.

I would just like to emphasize four points in the interest of time

this morning.

First, I would suggest that, as Basel II concludes, hopefully

quickly, and the U.S. regulators wrestle with their own implementing rules, we focus on first things first. Five years ago, Basel

was set in motion to deal with the regulatory arbitrage issue, that

is, banks holding high-risk assets when their regulatory capital ratios were too low, and low-risk ones left the banking system because the economic capital, regulatory capital numbers simply did

not match. That is arbitrage, politely, or gamesmanship, not so politely. And it is risky.

There is a lot in Basel II on which all agree. Some of it is in the

more simple standardized models, and, sure, they are not perfect.

But they are a lot better than what we have right now, and that

part of Basel should move forward quickly because existing ongoing

regulatory arbitrage undermines our banking system.

I was surprised to see the regulators post on their website a couple of weeks ago the goals of Basel II, and suddenly they now are

improving internal risk management, promoting market discipline,

and, most mysterious of all, imposing a new operational risk-based

capital charge. Two of those three goals make sense, but the underlying purpose of Basel II regulatory arbitrage termination has disappeared, and I would urge refocusing on that.

41

Second, I do not believe that one-size-fits-all capital works. We

have imposed the leveraged capital requirement. It is the most

primitive of all of those on the table here in the United States because of concern about other sources of risk. But it is a piece of the

puzzle that drives low-risk assets out of the banking system. Again,

our minimum capital requirements are leverage standards. The

way risk-based capital works now is one of the reasons why in recent years the highest-quality, lowest-risk mortgage assets have

left our banks and savings associations for the secondary market

and highest-risk, subprime loans are now being held by banks. We

need a capital system that promotes safety and soundness not

through an arbitrary cushion of capital but, rather, a system that

rewards good risk-taking and imposes higher capital when higher

risks are taken.

The operational risk-based capital proposal, in my opinion, has

a perverse incentive. It will encourage risk-taking not reduce it.

And in the wake of September 11, we have all learned how really

serious operational risk can be. And, most importantly, in those

tragic days we also learned the value of effective operational risk

mitigation, contingency planning, back-up facilities, and in the

days thereafter, insurance.

The crude capital charge proposed in Basel II will promote operational risk-taking because banks will have to hold an arbitrary

amount of capital based on gross income, regardless of the way in

which they invest in operational risk management or mitigation. I

know the United States regulators have decided, rightly, that that

approach is so flawed that we should not impose it here. But maintaining the operational risk capital charge in Basel means that it

will still guide major EU and Japanese banks, and we cannot wall

ourselves off from their operational risk. We need a good regulatory

and supervisory system that rewards appropriate operational risk

management and mitigation that can and should be done under

good supervision.

Finally, I think the challenge of Basel II is just that: Good supervision. We have it here. It does not exist uniformly elsewhere. Pillar 1 in the Basel new paper is about 200-some-odd pages, not

counting footnotes. Pillar 2, which is supposed to improve supervision, is about 20 pages. I would rather see them reversed and put

our efforts into ensuring that here and abroad, when banks threaten their safety and soundness or pose large economic risks, supervisors intervene quickly and meaningfully and, if necessary, shut

the banks down. That does not exist elsewhere, and I think that

is a fundamental challenge still left on the table.

Thank you very much.

Chairman SHELBY. Mr. Ervin.

STATEMENT OF D. WILSON ERVIN

MANAGING DIRECTOR, STRATEGIC RISK MANAGEMENT

CREDIT SUISSE FIRST BOSTON

ON BEHALF OF THE

FINANCIAL SERVICES ROUNDTABLE

Mr. ERVIN. Good afternoon, and thank you for inviting me here

today. My name is Wilson Ervin. I am presenting testimony today

on behalf of Credit Suisse First Boston and on behalf of our trade

42

group, the Financial Services Roundtable. CSFB is a major participant in global capital markets employing approximately 20,000

people, mostly here in the United States. We are regulated as a

U.S. broker-dealer, a U.S. financial holding company, and also as

a Swiss bank. I head CSFB’s risk management function. My job is

to assess the risks of my bank and protect our capital, a goal that

is similar to many of the goals of bank supervisors and at the heart

of the Basel reforms.

We agree with the importance of bringing the current regime upto-date and fully support the objectives of Basel II. The regulators

who have worked on Basel II have addressed a great many challenging issues with stamina and sophistication. I would like to

thank Governor Ferguson, Comptroller Hawke, and FDIC Chairman Powell very much for their openness and willingness to listen

during this process.

Yet, while there is much to admire in the new rules, there are

also many elements that still raise serious concern. On balance, we

believe the advantages of the new rules now outweigh the drawbacks, but this balance remains close. This is a frustrating outcome

for an initiative with so much potential.

Today, I would like to highlight four macro issues that we believe

are particularly important: Number one, the current proposal is

unnecessarily complex and costly and suffers from an excessive reliance on detailed, prescriptive formulae. Number two, procyclicality. The new accord could reduce liquidity in the credit markets during economic downturns and potentially deepen economic

recessions. Number three, the operational risk charge is highly controversial. And, number four, the disclosure requirements require

burdensome additional paperwork, raising costs but adding little

information of value to users.

The first topic I would like to address is the high cost and prescriptive nature of the new accord. Conceptually, the Committee

has attempted to capture current industry best practice and then

boil it down into a fixed formula. These new rules, while well-intentioned, will add burdensome qualification, testing, and reporting

requirements and will be inconsistent with changing market reality

and evolving best practice. The cost of implementing these systems will be very high. We estimate approximately $70 to $100

million in start-up costs for our firm. This increased cost could run

into the billions when added up across the whole banking sector

globally and could tilt the playing field between banks and nonbanks very significantly.

The compliance costs of this accord will also be material and will

be driven by how these rules are enforced. This is particularly true

for international banks, who are regulated by multiple supervisors

and subject to the risk of conflicting interpretations. This raises the

risk of getting caught in a Catch-22 between regulators. While this

problem does exist today to some extent, it will be a lot more important given the number of complex rules under Basel II. The Fed

has recently indicated a constructive approach here which we hope

represents the start of a broader international effort to resolve

this problem.

CSFB and other Roundtable members are also concerned about

the cumulative effect of the numerous conservative choices that are

43

built into the fabric of Basel II. A good example can be found in

the rules for securitizations, which are a common method for financing housing and credit card loans in the United States. The

rules proposed for this area include complex formulae and flowcharts with tough controls over business judgment. The combined

effect of each of these individual items adds up to regulatory capital requirements that can depart significantly from the true economic capital needs that Basel II is aiming to emulate.

The rules seem to be drafted primarily to avoid any possible circumvention, but are likely to deter good financial transactions as

well. We believe the securitization rules will tend to raise capital

requirements in markets where this technology is most advanced,

notably here in the United States.

Our suggested response to the problems of prescriptiveness and

high cost is for the Basel Committee to place a much greater emphasis on a principles-based approach. Whereas Pillar 1 currently

sets out capital calculations in a detailed, prescriptive way, the approach of Pillar 2 is to force the development of better internal

models, based on evolving best practice, and then to scrutinize

those results through the exam process.

The new rules will change the capital requirements for bank

lending which can have consequential effects on the state of the

economy more broadly. Based on a review of the last 20 years of

credit cycles, our calculations indicate that the new rules will require much more bank capital during an economic downturn when

compared to the current system. My personal estimate is that my

bank would have cut back its lending in these circumstances by

perhaps 20 percent if the Basel II rules were in place during the

recent recession. If all banks cut back in lending at the same time,

as they will tend to do under a common regulatory regime, the potential adverse effect on the real economy could lengthen and deepen an economic slump.

The proposed quantification of operational risk, the risk of breakdowns in systems and people, is highly controversial. All of the

Roundtable’s member companies agree that evaluating and controlling this risk is important and should be required. However, many

banks, including CSFB, believe the current approach is deeply

flawed because of the difficulties of measuring and predicting this

type of risk using a quantitative model. Other banks take an opposite view and believe that the operational risk rules will lead to improved risk governance and better transparency and are, therefore,

appropriately placed in the Pillar 1 category.

One of the strengths of the Basel II proposals is that they go beyond capital calculations in Pillar 1. They look to improve market

discipline via greater disclosure. While we appreciate that the Pillar 3 disclosure requirements have been reduced, they continue to

be burdensome and potentially confusing. While we certainly support transparency, as Chairman Greenspan said recently, there is

a large difference between more disclosure and more transparency.

In sum, much hard work has been put into Basel II, but much

also remains ahead. In the pressure to finalize and implement the

accord, we hope enough time will be provided for everyone—banks

and supervisors alike—to consider the implications of this new regime. Streamlining the current proposal will require strong disVerDate 11-MAY-2000 10:04 Jul 07, 2004 Jkt 000000 PO 00000 Frm 00047 Fmt 6633 Sfmt 6633 94514.TXT BANK1 PsN: BANK1
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cipline in the final round of drafting and a return to the original

philosophy underlying the project. I believe very much can be accomplished if we increase the emphasis on best practice principles rather than rigid formula, and if we increase the weight of

Pillar 2.

Pillars 2 and 3 have real people behind them: Regulators and the

market. People can adapt to changes and new markets more easily

than a rulebook can. This also puts the burden back where it

should be—on the shoulders of bank management—to demonstrate

to regulators and the public that they are doing a good job. That

is in the spirit of the Sarbanes–Oxley reforms, and I think it is a

smart and durable way to improve discipline.

Thank you.

Chairman SHELBY. Mr. Blakely.

STATEMENT OF KEVIN M. BLAKELY

EXECUTIVE VICE PRESIDENT AND CHIEF RISK OFFICER

KEYCORP

Mr. BLAKELY. Thank you, Mr. Chairman, Senator Sarbanes, and

other Members of the Committee. I am here today on behalf of

KeyCorp, the 11th largest banking company in the United States

KeyCorp has total assets of approximately $85 billion and spans

the northern half of the United States from Maine to Alaska. While

the vast majority of our business is domestically based, we do have

a modest amount of international business activity.

KeyCorp is not one of the companies included in the definition

of ‘‘the top 10 most internationally active institutions.’’ Accordingly,

under the present regulatory guidance, we will not be required to

comply with Basel II when it becomes effective in 2006. Nonetheless, it is our intent to qualify as an advanced model institution.

We simply believe that it is good banking practice to develop the

risk management tools that are the foundation of Basel II. If that

qualifies us as an advanced model company under the new accord,

so much the better.

KeyCorp believes that Basel I is broken and that a new accord

needs to be implemented. Basel II is a major step forward, and we

applaud its approach. It is not perfect now, nor will it be perfect

when implemented, nor perfect 10 years after implementation. Regardless, it is light years ahead of Basel I, as well as any other proposal we have seen to date.

We acknowledge that it is complex, but banking is a complex

business. A simple solution to complex issues is probably not the

right medicine. As an industry, we should not shy away from the

remedy simply because it is complex. We should work collectively

with the regulators to find the right solution, not the easy one.

We have our doubts as to the high cost figures attributed to

Basel II. Our own experience to date has proved to the contrary.

We believe that many of the Basel II costs are simply expenditures

we should otherwise be making as a matter of sound banking practice. Good risk management costs money, but it is intended to help

avoid even bigger costs that arise from bad risk management.

We do not believe the adoption of Basel II will trap the financial

services industry in a time warp. It will not stifle the creation of

new risk management tools, as some have alleged. Banks will conVerDate 11-MAY-2000 10:04 Jul 07, 2004 Jkt 000000 PO 00000 Frm 00048 Fmt 6633 Sfmt 6633 94514.TXT BANK1 PsN: BANK1
45

tinue to develop better methods of managing risks regardless of

what Basel II requires.

We believe there is substantial merit to including as much as we

can in Pillar 1 versus Pillar 2. One of the greatest benefits that

Basel II promises is that it will utilize the invisible hand of the

market to discipline wayward institutions. In order to do that, investors must have adequate information to compare the risk of one

institution against another on an apples-to-apples comparison

basis. Pillar 1 is the best vehicle for ensuring that banks report on

a consistent basis.

Mr. Chairman, KeyCorp appreciates the opportunity to share our

views on Basel II. We want to make sure our industry operates

within a safe and sound environment. We know that this is the

goal of the Committee, as well as our friends in the regulatory

world. While Basel II is far from perfect, it certainly moves us further down the path.

Chairman SHELBY. Thank you.

I think everyone and I hope everyone recognizes that risk management practices must constantly improve. You are in the business. That said, I am not sure there is complete agreement as to

what actually leads to improved risk management practices. Is it

market forces? Is it the use of detailed and specific capital rules

such as those that have been proposed? What kind of impact can

using these kinds of rules have on the development of risk management practices in the future? Mr. Ervin.

Mr. ERVIN. I think all those things are critically important. It is

not just regulatory capital calculations that drive innovations in

the market and drive innovations in best practice, although I think

they can be helpful.

Our concern here is that the complexity prescriptiveness of what

they are trying to build in Pillar 1 may actually restrict that process, may restrict the evolution of market best practice and may

trap us—I disagree with Mr. Blakely on this—may trap us to some

extent——

Chairman SHELBY. You are trapped in the model, aren’t you?

Mr. ERVIN. To some extent we are trapped in models today. We

are living in an advanced world, and I do not think we can turn

back the clock. The question is: Do we have the right market forces

and the right ways to keep up with how the world is evolving? Or

do we end up having to run two sets of books, one for a potentially

outdated regulatory regime and another one for the world as it has

come to be evolving?

Chairman SHELBY. Ms. Petrou, the proposal, as I understand it,

requires banks to set aside capital for operational risk, assuming

that the potential for these types can be quantified. Is it really possible to measure these risks? And don’t we call some of those risks,

you know, acts of God for a reason? You have heard that all your

life. Do you want to comment?

Ms. PETROU. I do not think it is possible at this point to quantify

operational risk or to measure it in any way on which anybody

agrees. In fact, Basel’s own committee, the Risk Management

Group, recently after reviewing the data that was gathered in an

effort to come up with Basel II, said that the data needed to be

used with caution. And another Basel Committee has said that it

46

does not believe that a quantifiable operational risk capital charge

is in sight.

I believe the proposed ops risk capital charge now is, in essence,

a way to top off the credit risk charge to protect against drops in

credit risk capital. But when low-risk books of credit risk are there,

then I think the capital should drop, and we should not be fudging

the books, as the operational risk charge would do.

Mr. ERVIN. Senator Shelby, if I might expand on that just for a

few moments?

Chairman SHELBY. Yes, you go ahead.

Mr. ERVIN. I am a quantitative person by nature. I came up

through that part of the bank, and I would love to be able to——

Chairman SHELBY. You are still there, too.

[Laughter.]

Mr. ERVIN. But I would love to crack the operational risk management using quantitative people, hire a bunch of my people in

my department and have the problem solved. I am just not convinced we can do that today. And I am concerned that we are

building the system still on models that have not been validated,

still have not been proven.

Chairman SHELBY. This is a work in progress in a sense?

Mr. ERVIN. Absolutely.

Chairman SHELBY. Professor.

Mr. ALTMAN. If I might piggyback on both comments.

Chairman SHELBY. Go ahead.

Mr. ALTMAN. I completely agree with them. I think it was a

major mistake to add operating risk to Basel II. I mean, it almost

was tacked on as an afterthought rather than the main problem,

which was credit risk, which was what Basel II was supposed to

handle. And then everyone plowed around as to how to measure

this, and I agree completely with both Karen Petrou and Mr. Ervin

that this is whistling in the wind. Most of the banks have no idea,

and the regulators have less, about operating risk. I think it is plug

figure, and it is unfortunate because it detracts from all of Basel

II. Nobody likes it. I do not know anybody I have ever met who

likes the operating risk part of Basel II. And yet it is in there. I

think we should have the guts to say it does not belong in there

and get rid of it.

With respect to the first question you asked, it might add, one

of my comments earlier was if we do not require some opting in

by all but the largest banks, we are really going to demotivate risk

management at these other institutions. They are going to throw

up their hands and say it is too complex, I do not need to change

what I have been doing all this time. And just the fact that we

have not had any major bank failures lately—we have short memories. Things back in the 1980’s were not so good. If we have a lot

of stress to the system, I do believe that prompt corrective action

on the part of our regulators, which is not part of Basel II, is a

great thing we have, and Basel II does not have it. And I would

like to see that be put in as well.

Mr. HARTIGAN. Mr. Chairman.

Chairman SHELBY. Sorry, Mr. Hartigan.

47

Mr. HARTIGAN. If I could just respond on operational risk, it is

a nettlesome issue. It will continue to be. It is something which is

not science.

Chairman SHELBY. While you are on that, would you please

touch on the new capital charge for operational risk? That is all involved here.

Mr. HARTIGAN. As the Comptroller of the Currency said, it really

matters not whether it is 1 or 2. I think what we must do, what

the industry must do, is continue to observe and analyze the data

which surrounds operational risk, be more comfortable with it, acknowledge it more, and acknowledge that it does have a role in the

capital charge.

Chairman SHELBY. Do any of you have any concerns about competitive issues associated with the new proposal? We know what

the proposal basically is.

Ms. PETROU. I would just like to say it has some unique U.S.

issues. We have talked about international competitiveness. But it

is also very important to get the rules right here because some big

financial services firms and some little ones that elect to go in will

be in, and some big ones will be out by virtue of their charter

choice. And some of the ones that might think they are in can

change that charter choice and take them out.

In the EU, the proposal is to apply Basel to all financial services

firms, but under U.S. law it can only apply to financial holding

companies.

If the regulatory capital incentives are not better aligned with

the economic ones, some significant advantages to perhaps nonbank institutions will result. And that will push assets out of our

good supervisory framework. So, I think that is a very troublesome

issue that needs careful attention.

Chairman SHELBY. Professor Altman, I want to direct this question to you and also to Mr. Ervin. Could you elaborate on your

statements regarding the procyclical aspects of the proposal? The

proposal could increase booms and busts during the economic cycle,

some people believe.

Mr. ALTMAN. Yes. I skipped over it in the interest of time. Thank

you for giving me the opportunity.

Procyclicality is considered by some as a very serious issue.

Other people, including most of the regulators in the United States,

seem to think that it is not that serious of an issue. I personally

think that the New Basel II has all the ingredients to increase

procyclicality, perhaps dramatically. It exists already. Banks cut

back in difficult times, either through credit rationing or——

Chairman SHELBY. What could that do to the economy?

Mr. ALTMAN. That is what I am getting to.

Chairman SHELBY. Okay.

Mr. ALTMAN. In times of stress, if the banks are motivated

through Basel II higher capital requirements on losses and downgrades, then they will lend even less. That is exactly the time that

we need it. One of the reasons we have had so many bankruptcies

and defaults in the last couple of years is that banks were much

too liberal in 1993 through 1998, and that is procyclicality. They

were fat and happy. That is good. But they made too many bad

loans as a result of being that. So that is the procyclicality.

48

I recommend that we consider a smoothing of the capital requirements, that more capital be required in good times and less capital

in bad times. You have got to prompt corrective action anyway to

move into the banks if they have got too little capital. So exercise

that, but reduce that procyclicality by much more proactive action

on the part of the regulators.

Chairman SHELBY. The bottom line is capital is important. Let’s

face it.

Mr. ALTMAN. Absolutely.

Chairman SHELBY. Mr. Ervin, do you have a comment?

Mr. ERVIN. I would support what Professor Altman said. I do believe this could be potentially quite important. When we have

looked at our own bank and looked at our own behavior, we think

this could significantly affect the number of loans we choose to

make. And if you pull liquidity out of the market in the tough

times, that will have an effect in the economy. I am not smart

enough to know exactly what effect that will have, but we do believe that could be a potentially substantial impact, and it is something that the U.S. regulators in particular need to be aware of and

have contingency plans to make sure we do not fall into that trap.

Chairman SHELBY. Mr. Blakely.

Mr. BLAKELY. Mr. Chairman, if I may, we disagree on the issue

of procyclicality because the whole concept of procyclicality depends

on the banks’ operating at the absolute bare minimum level of capital. I do not think any bank worth its salt is going to be doing

that. Most banks will maintain a buffer zone of capital above the

bare minimum that should——

Chairman SHELBY. Well, banks get nervous during stress time.

Mr. BLAKELY. Banks do get nervous, but banks will not stop

lending during a recessionary environment. Lending is the business

that most banks are in. It is our lifeline of revenue.

Chairman SHELBY. Excuse me a minute. They might not quit

lending, but they curtail some lending or tighten up on credit. We

know that. And that can exacerbate an economic downturn, a cyclical thing, as Dr. Altman references. Is that correct?

Mr. ALTMAN. That is correct.

Mr. BLAKELY. I will not deny that banks do curtail in some areas

of lending. But, again, banks do need to continue lending in order

to keep their revenue stream going. Also during a recessionary environment, you are afforded the opportunity to get better underwriting standards and to get better pricing. There is an old saying

that says that the best of loans are made in the worst of times and

the worst of loans are made in the best of times. And that is true

right now.

We do not stop lending. We may become a little bit more cautious, and as long as we have that buffer zone of capital, we will

continue to lend when opportunities present themselves.

Chairman SHELBY. Thank you very much, Senator Sarbanes, for

your indulgence.

Senator SARBANES. I will be very brief because it is getting late,

and this panel has been with us quite a while.

I am a little concerned or perhaps even confused by some of what

I have been hearing from this panel. First of all, is there anyone

on the panel who disagrees with the statements made by the preVerDate 11-MAY-2000 10:04 Jul 07, 2004 Jkt 000000 PO 00000 Frm 00052 Fmt 6633 Sfmt 6633 94514.TXT BANK1 PsN: BANK1
49

vious panel that Basel I is deficient and does not constitute a

framework within which we should continue to function? That is

what I understood the previous panel to say. If you disagree with

that, you should correct me. But is there anyone at the table who

disagrees with that.

Mr. HARTIGAN. No.

Mr. GREEN. No.

Mr. ALTMAN. No.

Ms. PETROU. No.

Mr. ERVIN. No.

Mr. BLAKELY. No.

Senator SARBANES. I think the reporter should indicate that——

[Laughter.]

All right. Now, my next question is: Is there anyone at the table

who thinks the Basel II process should be terminated?

Mr. HARTIGAN. No.

Mr. GREEN. No

Mr. ALTMAN. No.

Ms. PETROU. No.

Mr. ERVIN. No.

Mr. BLAKELY. No.

Senator SARBANES. The question then is: How do we carry forward in the Basel II process to take into account some, if not all,

of the concerns, to review the concerns that have been enunciated,

and to try to weigh them and see what can be done? Would that

be a fair statement?

Mr. HARTIGAN. Could I start? I think that many of these issues

that we have discussed today really have to continue to be broken

down in a hierarchy of needs, and that some of the issues in the

implementation are scalable. I think that the whole system of capital based on risk, and appropriate capital, is where the industry

is moving and, indeed, where we are being encouraged to move,

where the industry has been encouraged to move by the regulators.

I think that the way to do it, Senator Sarbanes, is to continue

to test the observations and to make recommendations based on

valid tests. It may be that we do not meet the timetable that is in

place now. Timetables can be moved. But at the end of the day, the

system will be better off for a capital system based on risk.

Mr. GREEN. Senator Sarbanes, I would say that this Committee

deserves a good deal of credit for holding this hearing in a timely

way before the comment period on the Consultative Paper 3 is complete. The fact is, what you heard here is unanimity in favor of the

Basel process and support for what the regulators are trying to get

done generally. And yet we all have issues that we would like to

raise consistent with our support. By holding the hearing, you have

advanced the dialogue of those constructive points of criticism.

We came here today to put on your radar screen and to reiterate

on the radar screens of the Basel Committee the effects on the

securitization market and the repurchase agreement and securities

lending market, and yet not be critical of the Basel process. It is

not even a fine line. We can be wholly supportive of the Basel process and point out things that still need to be dealt with before it

is finalized and fully implemented. So we thank you for what you

have done.

50

Senator SARBANES. Does anyone else want to add anything on

that point?

Mr. BLAKELY. I would just like to say that since the initial draft

of Basel II came out, there has been tremendous progress that has

been made on it, and that has come about through work between

the banking institutions themselves, as well as the regulators trying to come together on common ground.

As I look back retrospectively and look at the progress that has

been made, it is nothing short of phenomenal, and I think by the

time Basel II eventually arrives, it will be better, much better than

it is now. We do all agree that Basel II is the right direction to go.

We just do not necessarily agree on certain aspects of it. But we

will eventually get there.

Senator SARBANES. Well, Mr. Chairman, I—sorry, yes.

Mr. ERVIN. If I may just expand on that, I would agree that it

has improved a lot, and I do agree that it is also through hearings

like this one that the public airing and the public dialogue can be

improved, and that has had a major impact on the quality of the

work recently released in CP–3.

I do think there is significantly more work to do in balancing between not sticking with an outmoded regime or going to Basel II

as it exists today. I think as Professor Altman says, we need to

have the guts to take out the parts that do not seem to be working,

do not seem to be getting consensus, and focus on the parts that

work, get that implemented, and take a more evolutionary approach. I think that will be a smart way to move forward here.

Senator SARBANES. Well, it is an interesting process, and I just

wanted to clarify that. I once was the Executive Director of the

Charter Revision Commission in Baltimore, and we had to take our

proposed charter to the City Council. The director of finance, who

was a very influential figure in the city government, came to testify. He was in support of what we were trying to do. But then he

got in front of the City Council, and he had a number of pinpointed

criticisms to make of our work. And by the end of his first session

with the City Council, they were convinced he was against the

charter changes. We had to go back, and he had to make very clear

that he was basically in favor of the charter changes, and he was

just trying to improve it here and there. And I wanted to be clear

on that.

This Economist article I quoted earlier, illustrates the difficult

problem of this international relationship, said, ‘‘For the past 5

years, the world’s financial regulators have been working on a new

set of rules for bank capital called Basel II. Getting this far has

taken a lot of sweat and horse trading. American bankers and regulators have been at the forefront. American financial institutions

have debated the rule changes as keenly as anybody. Imagine,

therefore, the consternation of other committee members on learning how America plans to treat the new rulebook,’’ and then they

went on.

You know, we have gone far enough down this path that we

have, in a sense, that problem on our hands. On the other hand,

I do not think that should lead us not to insist on shaping this

thing in a way that people can look at it and say it did not make

sense. And I do think the regulators need, one, to work to get

51

themselves in alignment and, two, to continue to interact with the

private sector to address some of these concerns so we develop a

broader and deeper consensus about what we are seeking to do.

And in that respect, I think, Mr. Chairman, that it was a very constructive contribution for you to schedule this hearing.

Chairman SHELBY. Thank you.

A couple of quick observations. Mr. Green, has there been any

work done on the effects of Basel II on securitization that considers

the downstream effects on consumer financing?

Mr. GREEN. Yes, that is our principal level of concern. As they

have currently defined regulatory requirements, we believe that

they are significantly too severe. And we think it could have an effect on the ability of financial institutions who are very active participants in that securitization market, not just of originators of

loans and——

Chairman SHELBY. And have an effect on our economy, right?

Mr. GREEN. Absolutely, Mr. Chairman. All this high finance and

complexity really does boil down to how does it affect real people.

And the securitization market is one of those examples as to how

real people would be affected, whether you are buying a home, refinancing a home, buying a car, have credit card debt, or just simply

need capital. That $2.7 trillion, $151 billion, and $51 billion in the

United States, Europe, and Asia of a market——

Chairman SHELBY. That has to be addressed, doesn’t it?

Mr. GREEN. Absolutely.

Chairman SHELBY. If the Fed does not pull operational risk,

should we address it here in Congress, Dr. Altman? Should we address operational risk here?

Mr. ALTMAN. I am not sure of the proper forum for that. I am

not sure also that capital will—more capital will obviate the possibility of massive losses due to fraud or some other types of activity

which is under operational risk. You put another 0.6 percent of

capital for operating risk, but then you have got a rogue trader or

some fraud action, and you have got an institution being brought

down, regardless of that other 0.6 percent.

Chairman SHELBY. It has happened.

Mr. ALTMAN. Yes, exactly, and it is going to happen again. It has

to happen again because that is the nature of fraud. I do not know

when it is going to happen, and I do not think this extra 0.6 percent capital is going to do anything with respect to operating risk.

Chairman SHELBY. Ms. Petrou, you know a lot about capital.

What do you think? Do you agree with him or disagree?

Ms. PETROU. Yes, I do.

Chairman SHELBY. You agree?

Ms. PETROU. Yes, I think it is a meaningless charge, and to your

question of where Congress should go, I think what you and on the

House side as well, these hearings are focusing attention back on

the policy issues that Basel raises. When you have rules that are

hundreds of pages long with the kinds of formulas as Mr. Ervin

has said, all of us at this table and everywhere, we get into these

‘‘how do we do it’’ debates, and the ‘‘should we do it’’ issues get lost.

And I think you are helping everyone focus back on the ‘‘should it

be done’’ issue, which is of paramount importance.

52

Chairman SHELBY. Well, Senator Sarbanes and other Members

of the Committee have thought this is a very important hearing.

I know it is very technical in nature and probably boring to a lot

of people, but it will have a tremendous effect on our economy

down the road in our banking system.

I want to thank all of you for being here and being patient, waiting through the first panel, but when we have these types of panels, yours and the other one before you, it is hard to leave.

Thank you very much.

The hearing is adjourned.

[Whereupon, at 12:59 p.m., the hearing was adjourned.]

[Prepared statements supplied for the record follow:]

53

PREPARED STATEMENT OF SENATOR WAYNE ALLARD

I would like to thank Chairman Shelby for holding this important hearing today

to discuss the changing supervisory needs of some of the world’s largest and most

complex internationally active banks. The nature and activities of these banking institutions have evolved since the inception of the Basel I Capital Accords in 1988.

It is necessary that the standards and requirements of internationally active U.S.

banking organizations are subject to the appropriate standards and requirements to

ensure that they remain competitive, healthy, and well-capitalized.

The varying capital requirements for internationally active banks made the 1988

Basel I Accord necessary to address the problem of competitive inequality by establishing uniform capital requirements. In the last decade or so, securitization and the

use of derivatives have prompted the Basel Committee to reconsider the relevance

of the 1988 Accord standards. Since 1999, the Committee has been working to develop a more risk sensitive capital adequacy framework to replace Basel I.

For most banks in the United States, Basel I is more than adequate in establishing a capital framework. For a few large, complex, and internationally active

banks, the framework needs adjustment in order to maintain the health of banking

organizations in the United States. I would like to thank the regulators for their

ongoing work and attention to this critical issue. I also thank all of our witnesses

for appearing before the Committee today. I look forward to your testimony.

—————

PREPARED STATEMENT OF ROGER W. FERGUSON, JR.

VICE CHAIRMAN

BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM

JUNE 18, 2003

Chairman Shelby, Senator Sarbanes, Members of the Committee, it is a pleasure

to appear before you this morning on behalf of the Board of Governors to discuss

Basel II, the evolving New Capital Accord for internationally active banking organizations. After 5 years of discussion, the proposal is entering its final stage of public

comment and review, although there still remains additional steps to the process.

Why Is a New Capital Standard Necessary?

The banking supervisors in this country believe that Basel I, the current capital

regime adopted in 1988, must be replaced for the largest, most complex banks for

three major reasons: (1) Basel I has serious shortcomings as it applies to these large

entities, (2) the art of risk management has evolved at the largest banks, and (3)

the banking system has become increasingly concentrated.

Shortcomings in Basel I

Basel I was a major step forward in capital regulation. For most banks in this

country Basel I, as we in the United States have augmented it, is now—and for the

foreseeable future will be—more than adequate as a capital framework. However,

for the small number of large, complex, internationally active banking organizations, Basel I has serious shortcomings which are becoming more evident with time.

Developing a replacement to apply to these banking organizations is imperative.

Basel I is too simplistic to address the activities of our most complex banking institutions. The framework has only four risk categories, and most loans receive the

same regulatory capital charge even though loans made by banks encompass the

whole spectrum of credit quality. The limited differentiation among the degrees of

risk means that the calculated capital ratios are too often uninformative and might

well provide misleading information for banks with risky or problem credits or, for

that matter, with portfolios dominated by very safe loans.

Moreover, the limited number of risk categories creates incentives for banks to

game the system through capital arbitrage. Capital arbitrage is the avoidance of certain minimum capital charges through the sale or securitization of bank assets for

which the capital requirement that the market would impose is less than the current regulatory capital charge. For example, credit card loans and residential mortgages are securitized in volume, rather than held on banks’ balance sheets, because

the market requires less capital, in the form of bank credit enhancements, than

Basel I requires in capital charges. This behavior by banks is perfectly understandable, even desirable in terms of economic efficiency. But it means that banks that

engage in such arbitrage retain the higher-risk assets for which the regulatory capital charge—calibrated to assets of average quality—is on average too low.

54

To be sure, through the examination process supervisors are still able to evaluate

the true risk position of the bank, but the regulatory minimum capital ratios of the

larger banks are becoming less and less meaningful, a trend that will only accelerate. Not only are creditors, counterparties, and investors less able to evaluate the

capital strength of individual banks from what are supposed to be risk-based capital

ratios, but also regulations and statutory requirements tied to capital ratios have

less meaning as well. Basel I capital ratios neither adequately reflect risk nor measure bank strength at the larger banks.

The Evolving State of the Art

Risk measurement and management have improved significantly beyond the state

of the art of 15 years ago, when Basel I was developed. Banks themselves have created some of the new techniques to improve their risk management and internal

economic capital measures in order to be more effective competitors and to control

and manage their credit losses. But clearly banks can go considerably further. One

objective of Basel II is to speed adoption of these new techniques and to promote

the further evolution of risk measurement and management by harnessing them to

the regulatory process.

Increased Heterogeneity and Concentration in Banking

Market pressures have led to consolidation in banking around the world. Our own

banking system has not been immune; it, too, has become increasingly concentrated

with a small number of very large banks operating across a wide range of product

and geographic markets. The operations of these large banks are tremendously complex and sophisticated, and they have markedly different product mixes. At the

same time, significant weakness in one of these entities has the potential for severely adverse macroeconomic consequences. Although their insured liabilities have

been declining over time as a share of their total funding, these organizations, with

their scale and role in payment and settlement systems and in derivatives markets,

have presented the authorities with an increasing moral hazard. It is imperative

that the regulatory framework should encourage these banks to adopt the best possible risk-measurement and management techniques while allowing for the considerable differences in their business strategies. Basel II presents an opportunity for

supervisors to encourage these and other large banks to push their management

frontier forward.

Basel II

The proposed substitute for the current capital accord, Basel II, is more complex

than its predecessor for very good reasons. First, the assessment of risk in an environment of a growing number of instruments and strategies with subtle differences

in risk-reward characteristics is inevitably complicated

Second, the Basel II reform has several objectives: U.S. supervisors are trying to

improve risk measurement and management both domestically and internationally;

to link to the extent that we can the amount of required capital to the amount of

risk taken; to further focus the supervisor-bank dialog on the measurement and

management of risk and the risk-capital nexus; and to make all of this transparent

to the counterparties that ultimately fund—and hence share—these risk positions.

To achieve all these objectives, the framework for Basel II contains three elements, called Pillars 1, 2, and 3. The most important pillar, Pillar 1, consists of minimum capital requirements—that is, the rules by which a bank calculates its capital

ratio and by which its supervisor assesses whether it is in compliance with the

minimum capital threshold. As under Basel I, a bank’s risk-based capital ratio

under Basel II would have a numerator representing the capital available to the

bank and a denominator that would be a measure of the risks faced by the bank,

referred to as ‘‘risk-weighted assets.’’ The definition of regulatory capital in the form

of equity, reserves, and subordinated debt and the minimum required ratio, 8 percent, are not changing. What would be different is the definition of risk-weighted

assets, that is, the methods used to measure the ‘‘riskiness’’ of the loans and investments held by the bank. It is this modified definition of risk-weighted assets, its

greater risk-sensitivity, that is the hallmark of Basel II. The modified definition of

risk-weighted assets would also include an explicit, rather than implicit, treatment

of ‘‘operational risk.’’

Pillar 2 addresses supervisory oversight; it encompasses the concept that wellmanaged banks should seek to go beyond simple compliance with minimum capital

requirements and perform for themselves a comprehensive assessment of whether

they have sufficient capital to support their risks. In addition, on the basis of their

knowledge of industry practices at a range of institutions, supervisors should provide constructive feedback to bank management on these internal assessments.

55

Finally, Pillar 3 seeks to complement these activities with stronger market discipline by requiring banks publicly to disclose key measures related to their risk and

capital positions. The concept of these three mutually reinforcing pillars has been

central to the Basel II effort.

Scope of Application in the United States

The U.S. supervisory agencies will propose that most banking organizations in

this country remain under the existing Basel I-type capital rules and would continue to have no explicit capital charge for operational risk. Earlier I emphasized

that Basel I had outlived its usefulness for the larger banking organizations. How

then did we conclude that most of our banks should remain under rules based on

the old accord?

Banks Remaining Under Current Capital Rules

To begin with, most of our banks have relatively straightforward balance sheets

and do not yet need the full panoply of sophisticated risk-management techniques

required under the advanced versions of Basel II. In addition, for various reasons,

most of our banks now hold considerable capital in excess of regulatory minimums:

More than 93 percent have risk-weighted capital ratios in excess of 10 percent—an

attained ratio that is 25 percent above the current regulatory minimum. No additional capital would likely have to be held if these institutions were required to

adopt Basel II.

Moreover, U.S. banks have long been subject to comprehensive and thorough supervision that is much less common in most other countries planning to implement

Basel II. Indeed, U.S. supervisors will continue to be interested in reviewing and

understanding the risk-measurement and management processes of all banks. Our

banks also disclose considerable information through regulatory reports and under

accounting rules and requirements of the Securities and Exchange Commission;

they already provide significant disclosure—consistent with Pillar 3 of Basel II.

Thus, when we balanced the costs of imposing a new capital regime on thousands

of our banks against the benefits—slightly more risk sensitivity of capital requirements under, say, the standardized version of Basel II for credit risk, and somewhat

more disclosure—it did not seem worthwhile to require most of our banks to take

that step. Countries with an institutional structure different from ours might clearly

find universal application of Basel II to benefit their banking system, but we do not

think that imposing Basel II on most of our banks is either necessary or practical.

Banks Moving to Basel II

We have an entirely different view for our largest and most complicated banking organizations, especially those with significant operations abroad. Among the

most important objectives of both Basel I and the proposed Basel II is to promote

competitive consistency of capital requirements for banks that compete directly in

global markets.

Another important objective has been to encourage the largest banking organizations of the world to continue to incorporate into their operations the most sophisticated techniques for the measurement and management of risk. As I have noted,

these entities use financial instruments and procedures that are not adequately captured by the Basel I paradigm. They have already begun to use—or have the capability to adopt—the techniques of modern finance to measure and manage their

exposures; and because substantial difficulty at one of the largest banking organizations could have significant effects on global financial markets, all of the largest

banks should be using these procedures. In our view, prudential supervisors and

central bankers would be remiss if we did not address the evolving complexity of

our largest banks and ensure that modern techniques were being used to manage

their risks. The U.S. supervisors have concluded that the advanced versions of Basel

II—the Advanced Internal Ratings-Based (A–IRB) approach for measuring credit

risk and the Advanced Measurement Approaches (AMA) for measuring operational

risk—are best suited to achieve this last objective.

Under the A–IRB approach, a banking organization would have to estimate, for

each credit exposure, the probability that the borrower will default, the likely size

of the loss that will be incurred in the event of default: And—where the lender has

an undrawn line of credit or loan commitment to the borrower—an estimate of what

the amount borrowed is likely to be at the time a default occurs. These three key

inputs—probability of default (PD), loss given default (LGD), and exposure at default (EAD)—are inputs that would be used in formulas provided by supervisors to

determine the minimum required capital for a given portfolio of exposure. While the

organization would estimate these key inputs, the estimates would have to be rigorously based on empirical information, using procedures and controls validated by its

supervisor, and the results would have to accurately measure risk.

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Those banks that are required, or choose, to adopt the A–IRB approach to measuring credit risk, would also be required to hold capital for operational risk, using

a procedure known as the Advanced Management Approach (AMA) to establish the

size of that charge. Under the AMA, banks themselves would bear the primary responsibility for developing their own methodology for assessing their own operational risk capital requirement. To be sure, supervisors would require that the

procedures used are comprehensive, systematic, and consistent with certain broad

outlines, and must review and validate each bank’s process. In this way, a bank’s

‘‘op risk’’ capital charge would reflect its own environment and controls. Importantly, the size of the charge could be reduced by actions that the bank takes to

mitigate operational risk. This provides an important incentive for the bank to take

actions to limit their potential losses from operational problems.

Determining Basel II Banks

To promote a more level global playing field, the banking agencies in the United

States will be proposing in the forthcoming Advance Notice of Proposed Rulemaking

(ANPR) that those U.S. banking organizations with foreign exposure above a specified amount would be in the core set of banks that would be required to adopt the

advanced versions of Basel II. To improve risk management at those organizations

whose disruption would have the largest effect on the global economy, we would also

require the same of banks whose scale exceeds a specified amount. That is, banks

meeting either the foreign exposure criterion or the asset size criterion would be required to adopt the advanced versions of Basel II, although most banks meeting one

criterion also meet the other.

Ten U.S. banks meet the proposed criteria to be core banks and thus would be

required, under our proposal, to adopt A–IRB and AMA to measure their credit and

operational risks, respectively. As they grow, other banks could very well meet the

criteria and thus shift into the core group in the years ahead. We would also permit

any bank that meets the infrastructure requirements of A–IRB and AMA—the ability to quantify and develop the necessary risk parameters on credit exposures and

develop measurement systems for operational risk exposures—to choose Basel II.

Banks that choose to use A–IRB and AMA would need to consider several factors,

including the benefits of Basel II relative to its costs, the nature of their operations,

the capital impact, and the message they want to send their counterparties about

their risk-management techniques. We anticipate that after conducting such a review, about 10 or so large banks now outside the core group would choose to adopt

Basel II in the near-term. Thus we expect about 20 banks to adopt the advanced

version of Basel II before or shortly after the initial implementation date.

Over time, other large banks, perhaps responding to market pressure and facing

declining costs and wider understanding of the technology, may also choose this capital regime, but we do not think that the cost-benefit assessment would induce

smaller banks to do so for a very long time. Our discussions with the rating agencies

confirm they do not expect that regional banks would find adoption of Basel II to

be cost effective in the initial implementation period. Preliminary surveys of the

views of bank equity security analysts indicate that they are more focused on the

disclosure aspects of Basel II rather than on the scope of application. To be clear,

supervisors have no intention of pressuring any of the banks outside the core group

to adopt Basel II.

The 10 core banks that would be required to adopt Basel II, together with the

approximately 10 self-selecting banks that we anticipate would adopt it before or

shortly after the initial implementation date, today account for 99 percent of the foreign assets and two-thirds of all the assets of domestic U.S. banking organizations,

a rate of coverage demonstrating the importance of these entities to the United

States and global banking and financial markets. These data also underscore our

commitment to international competitive equity and the adoption of best-practice

policies at the organizations critical to our financial stability while minimizing cost

and disruption at our purely domestic, less-complicated organizations.

Issues

Bankers have identified three key areas of concern: Cost, competitive equity, and

Pillar 1 treatment of operational risk.

Cost

Implementing A–IRB and AMA in this country is going to be expensive for the

small number of banks for which it will be required, for other banks choosing it,

and for the supervisors. For the banks, the greatest expense would be establishing

the mechanisms necessary for a bank to evaluate and control its risk exposures

more formally. The A–IRB approach would not eliminate losses: Banks are in the

business of taking risk, and where there are risks, there will be losses. But we beVerDate 11-MAY-2000 10:04 Jul 07, 2004 Jkt 000000 PO 00000 Frm 00060 Fmt 6621 Sfmt 6621 94514.TXT BANK1 PsN: BANK1
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lieve that the better risk-management that is required for the A–IRB and AMA

would better align risk and return and thereby provide benefits to bank stakeholders and the economy. And, more risk-sensitive capital requirements would assist in ensuring that banks would have sufficient capital to absorb losses when they

do occur. The cost-benefit ratio looks right to the supervisors.

This ratio is further enhanced because attributing to Basel II all the costs associated with the adoption of modern, formal risk-management systems is a logical fallacy. The large banks that would be required, or that would choose, to adopt A–IRB

and AMA must compete for funding in a global marketplace and thus already have

adopted many of these processes and would continue to develop them even without

Basel II. The new accord may well appropriately speed up the adoption process, but

overall, the costs of adopting these processes are being forced on these banks not

by Basel II but by the requirements of doing business in an increasingly complex

financial environment. In any event, the ANPR will include questions designed to

quantify the cost of implementing Basel II.

Competitive Equity

A second key concern is competitive equity. Some are concerned that the U.S. supervisors would be more stringent in their application of Basel II rules than other

countries and would thereby place U.S. banks at a competitive disadvantage. To address this concern, the Basel Agreement establishes an Accord Implementation

Group (AIG), made up of senior supervisors from each Basel member country, which

has already begun to meet. It is the AIG’s task to work out common standards and

procedures and act as a forum in which conflicts can be addressed. No doubt some

differences in application would be unavoidable across banking systems with different institutional and supervisory structures, but all of the supervisors, and certainly the Federal Reserve, would remain alert to this issue and work to minimize

it. I also emphasize that, as is the case today, U.S. bank subsidiaries of foreign

banks would be operating under U.S. rules, just as foreign bank subsidiaries of U.S.

banks would be operating under host-country rules.

Another issue relates to the concern among U.S. Basel II banks of the potential

competitive edge that might be given to any bank that would have its capital requirements lowered by more than that of another Basel II bank. The essence of

Basel II is that it is designed to link the capital requirement to the risk of the exposures of each individual bank. A bank that holds mainly lower-risk assets, such as

high-quality residential mortgages, would have no advantage over a rival that held

mainly lower-quality, and therefore riskier, commercial loans just because the

former had lower required capital charges. The capital requirements should be a

function of risk taken, and, under Basel II, if the two banks had very similar loans,

they both should have a very similar required capital charge. For this reason, competitive equity among Basel II banks in this country should not be a genuine issue

because capital should reflect risk taken. Under the current capital regime, banks

with different risk profiles have the same capital requirements, creating now a competitive inequity for the banks that have chosen lower-risk profiles.

The most frequently voiced concern about possible competitive imbalance reflects

the ‘‘bifurcated’’ rules implicit in the U.S. supervisors’ proposed scope of application:

That is, requiring Basel II through A–IRB and AMA for a small number of large

banks while requiring the current capital rules for all other U.S. banks. The stated

concern of some observers is that the banks that remained under the current capital

rules, with capital charges that are not as risk sensitive, would be at a competitive

disadvantage compared to Basel II banks that would get lower capital charges on

less-risky assets. The same credit exposure might have a lower regulatory minimum

capital charge at a Basel II bank than at a Basel I bank. Of course, Basel II banks

would have higher capital charges on higher-risk assets and the cost of adopting a

new infrastructure, neither of which Basel I banks would have. And any bank that

might feel threatened could adopt Basel II if they would make the investment required to reach the qualifying criteria.

But a concern remains about competitive equity in our proposed scope of application, one that could present some difficult trade-offs if the competitive issue is real

and significant. On the one hand is the pressing need to reform the capital system

for the largest banks and the practical arguments for retaining the present system

for most U.S. banks. Against that is the concern that there might be an unintended

consequence of disadvantaging those banks that would remain on the current capital regime.

We take the latter concern seriously and will be exploring it through the ANPR.

But, without prejudging the issue, there are reasons to believe that little if any competitive disadvantage would be brought to those banks remaining under the current

capital regime.

58

The basic question is the role of minimum regulatory capital requirements in the

determination of the price and availability of credit. Economic analysis suggests

that regulatory capital should be considerably less important than the capital allocations that banks make internally within their organization, so-called economic capital. Our understanding of bank pricing is that it starts with economic capital and

the explicit recognition of the riskiness of the credit and is then adjusted on the

basis of market conditions and local competition from bank and nonbank sources.

In some markets, some banks will be relatively passive price takers. In either case,

regulatory capital is mostly irrelevant in the pricing decision, and therefore unlikely

to cause competitive disparities.

Moreover, most banks, and especially the smaller ones, hold capital far in excess

of regulatory minimums for various reasons. Thus, changes in their own or their rivals’ minimum regulatory capital generally would not have much effect on the level

of capital they choose to hold and would therefore not necessarily affect internal

capital allocations for pricing purposes.

In addition, the banks that most frequently express a fear of being disadvantaged

by a bifurcated regulatory regime have for years faced capital arbitrage from larger

rivals who were able to reduce their capital charges by securitizing loans for which

the regulatory charge was too high relative to the market or economic capital

charge. The more risk-sensitive A–IRB in fact would reduce the regulatory capital

charge in just those areas where capital requirements are too high under the current regime. In those areas, capital arbitrage has already reduced the regulatory

capital charge. The A–IRB would provide, in effect, risk-sensitive capital charges for

lower-risk assets that are similar to what the larger banks have for years already

obtained through capital arbitrage. In short, competitive realities between banks

might not change in many markets in which minimum regulatory capital charges

would become more explicitly risk sensitive.

Concerns have also been raised about the effect of Basel II capital requirements

on the competitive relationships between depository institutions and their nondepository rivals. Of course, the argument that economic capital is the driving force

in pricing applies in this case, too. Its role is only reinforced by the fact that the

cost of capital and funding is less at insured depositories than at their nondepository rivals because of the safety net. Insured deposits and access to the Federal

Reserve discount window (and Federal Home Loan Bank advances) let insured depositories operate with far less capital or collateralization than the market would

otherwise require of them and far less than it does require of nondepository rivals.

Again, Basel II would not change those market realities.

Let me repeat that I do not mean to dismiss competitive equity concerns. Indeed,

I hope that the comments on the ANPR bring forth insights and analyses that respond directly to the issues, particularly the observations I have just made. But, I

must say, we need to see reasoned analysis and not assertions.

Operational Risk

The third key area of concern is the proposed Pillar 1 treatment of operational

risk. Operational risk refers to losses from failures of systems, controls, or people

and will, for the first time, be explicitly subject to capital charges under the Basel

II proposal. Neither operational risk nor capital to offset it are new concepts. Supervisors have been expecting banks to manage operational risk for some time, and

banks have been holding capital against it. Under Basel I both operational and credit risks have been implicitly covered in one measure of risk and one capital charge.

But Basel II, by designing a risk-based system for credit and operational risk, separates the two risks and would require capital to be held for each separately.

Operational disruptions have caused banks to suffer huge losses and, in some

cases, failure here and abroad. At times they have dominated the business news and

even the front pages. Appendix 1 to this statement lists the 10 largest such events

of recent years. In an increasingly technology-driven banking system, operational

risks have become an even larger share of total risk; at some banks they are the

dominant risk. To avoid addressing them would be imprudent and would leave a

considerable gap in our regulatory system.

A capital charge to cover operational risk would no more eliminate operational

risk than a capital charge for credit risk eliminates credit risk. For both risks, capital is a measure of a bank’s ability to absorb losses and survive without endangering the banking and financial system. The AMA for determining capital charges

on operational risk is a principles-based approach that would obligate banks to

evaluate their own operational risks in a structured but flexible way. Importantly,

a bank could reduce its operational-risk charge by adopting procedures, systems,

and controls that reduce its risk or by shifting the risk to others through measures

such as insurance. This approach parallels that for credit risk, in which capital

59

1Papers from that conference are available at http://www.newyorkfed.org/pihome/news/

speeches/2003/con052903.html.

charges can be reduced by shifting to less-risky exposures or by making use of riskmitigation techniques such as collateral or guarantees.

Some banks for which operational risk is the dominant risk oppose an explicit

capital charge on operational risk. Some of these organizations tend to have little

credit exposure and hence very small required capital under the current regime, but

would have significant required capital charges should operational risk be explicitly

treated under Pillar 1 of Basel II. Such banks, and also some whose principal risks

are credit-related, would prefer that operational risk be handled case by case

through the supervisory review of buffer capital under Pillar 2 of the Basel proposal

rather than be subject to an explicit regulatory capital charge under Pillar 1. The

Federal Reserve believes that would be a mistake because it would greatly reduce

the transparency of risk and capital that is such an important part of Basel II and

would make it very difficult to treat risks comparably across banks because Pillar

2 is judgmentally based.

Most of the banks to which Basel II would apply in the United States are well

along in developing their AMA-based capital charge and believe that the process has

already induced them to adopt risk-reducing innovations. Presentations at a conference held late last month illustrated the significant advances in operational-risk

quantification being made by most internationally active banks. The presentations

were made by representatives from most of the major banks in Europe, Asia, and

North America, and many presenters enthusiastically supported the use of AMAtype techniques to incorporate operational risk in their formal modeling of economic

capital. Many banks also acknowledged the important role played by the Basel process in encouraging them to develop improved operational risk management.1

Overall Capital and An Evolving Basel II

Before I move on to other issues, I would like to address the concern that the combination of credit and operational risk capital charges for those United States banks

that are under Basel II would decline too much for prudent supervisory purposes.

Speaking for the Federal Reserve Board, let me underline that we could not support

a final Basel II that we felt caused capital to decline to unsafe and unsound levels

at the largest banks. That is why we anticipate that the United States authorities

would conduct a Quantitative Impact Study (QIS) in 2004 to supplement the one

conducted late last year; I anticipate at least one or two more before final implementation. It is also why CP–3 calls for 1 year of parallel (Basel I and II) capital calculation and a 2-year phase-in with capital floors set at 90 and 80 percent, respectively,

of the Basel I levels before full Basel II implementation. At any of those stages, if

the evidence suggested that capital were declining too much the Federal Reserve

Board would insist that Basel II be adjusted or recalibrated, regardless of the difficulties with bankers here and abroad or with supervisors in other countries. This

is the stated position of the Board and our supervisors and has not changed during

the process.

Of course, capital ratios are not the sole consideration. The improved risk measurement and management, and its integration into the supervisory system, under

Basel II, are also critical to ensuring the safety and soundness of the banking system. When coupled with the special U.S. features, such as prompt corrective action,

minimum leverage ratios, statutory provisions that make capital a prerequisite to

exercising additional powers, and market demands for buffer capital, some modest

reduction in the minimum regulatory capital for sound, well-managed banks could

be tolerable. I note that banks with lower risk profiles, as a matter of sound public

policy, should have lower capital than banks with higher-risk profiles. Greater dispersion in required capital ratios, if reflective of underlying risk, is an objective, not

a problem to be overcome.

I should also underline that Basel II is designed to adapt to changing technology

and procedures. I fully expect that in the years ahead banks and supervisors will

develop better ways of estimating risk parameters as well as better functions that

convert those parameters to capital requirements. When they do, these changes

could be substituted directly into the Basel II framework, portfolio by portfolio if

necessary. Basel II would not lock risk management into any particular structure;

rather Basel II could evolve as best practice evolves and, as it were, be evergreen.

The Schedule and Transparency

I would like to say a few words about the schedule. In a few weeks, the agencies

will be publishing their joint ANPR for a 90-day comment period, and will also issue

early drafts of related supervisory guidance so that banks can have a fuller underVerDate 11-MAY-2000 10:04 Jul 07, 2004 Jkt 000000 PO 00000 Frm 00063 Fmt 6621 Sfmt 6621 94514.TXT BANK1 PsN: BANK1
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2The documents used in these presentations are available at the Board’s web site, http://

www.Federalreserve.gov/banknreg.htm (Documents Relating to U.S. Implementation of Basel

II).

standing of supervisory expectations and more carefully begin their planning process. The comments on the domestic rulemaking as well as on CP–3 will be critical

in developing the negotiating position of the U.S. agencies, and highlighting the

need for any potential modifications in the proposal. The U.S. agencies are committed to careful and considered review of the comments received.

When the comments on CP–3 and the ANPR have been received, the agencies will

review them and meet to discuss whether changes are required in the Basel II proposal. In November, we are scheduled to meet in Basel to negotiate our remaining

differences. I fear this part of the schedule may be too tight because it may not provide U.S. negotiators with sufficient time to digest the comments on the ANPR and

develop a national position to present to our negotiating partners. There may well

be some slippage from the November target, but this slippage in the schedule is unlikely to be very great.

In any event, implementation in this country of the final agreement on Basel II

would require a Notice of Proposed Rulemaking (NPR) in 2004 and a review of comments followed by a final rule before the end of 2004. On a parallel track, core

banks and potential opt in banks in the United States will be having preliminary

discussions with their relevant supervisors in 2003 and 2004 to develop a work plan

and schedule. As I noted, we intend to conduct more Quantitative Impact Studies,

starting in 2004, so we can be more certain of the impact of the proposed changes

on individual banks and the banking system. As it stands now, core and opt in

banks will be asked by the fall of 2004 to develop an action plan leading up to final

implementation. Implementation by the end of 2006 would be desirable, but each

bank’s plan will be based on a joint assessment by the individual bank and its relevant supervisors of a realistic schedule; for some banks the adoption date may be

beyond the end of 2006 because of the complexity of the required changes in systems. It is our preference to have an institution ‘‘do it right’’ rather than ‘‘do it

quickly’’. We do not plan to force any bank into a regime for which it is not ready,

but supervisors do expect a formal plan and a reasonable implementation date. At

any time during that period, we can slow down the schedule or revise the rules if

there is a good reason to do so.

The development of Basel II has been highly transparent from the beginning and

will remain so. All of the consultative papers over the past 5 years have been supported by a large number of public papers and documents to provide background

on the concepts, framework, and options. After each previous consultative paper, extensive public comment has been followed by significant refinement and improvement of the proposal.

During the past 5 years, a number of meetings with bankers have been held in

Basel and in other nations, including the United States. Over the past 18 months,

I have chaired a series of meetings with bankers, often jointly with Comptroller

Hawke. More than 20 U.S. banks late last year joined 365 others around the world

in the third Quantitative Impact Survey (QIS–3), which was intended to estimate

the effects of Basel II on their operations. The banking agencies last month held

three regional meetings with the bankers that would not be required to adopt Basel

II but might have an interest in choosing to adopt the A–IRB approach and the

AMA. Our purpose was to ensure that these banks understand the proposal and the

options it provides them.2 As I noted, in about 1 month the banking agencies in this

country hope to release an ANPR that will outline and seek comment on specific

proposals for the application of Basel II in this country. In the past week or so we

have also released two White Papers to help commenters frame their views on commercial real estate and the capital implications of recognizing certain guarantees.

These, too, are available at our web site.

This dialog with bankers has had a substantive impact on the Basel II proposal.

I have attached to my statement a comparison of some of the major provisions of

Basel II as proposed in each of the three consultative documents published by the

Basel Committee on Bank Supervision (Appendix 2). As you can see, commenters

have significantly influenced the shape and detail of the proposal. For example,

comments about the earlier proposed crude formulas for addressing operational risk

led to a change in the way capital for operational risk may be calculated; banks may

now use their own methods for assessing this form of risk, as long as these methods

are sufficiently comprehensive and systematic and meet a set of principles-based

qualifying criteria. That is the AMA. The mechanism for establishing capital for

credit risk has also evolved significantly since the first Consultative Paper on the

basis of industry comments and suggestions; as a result, a large number of exposure

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types are now treated separately. Similarly, disclosure rules have been simplified

and streamlined in response to industry concerns.

At this stage of the proposal, comments that are based on evidence and analysis

are most likely to be effective. Perhaps an example of the importance of supporting

evidence in causing a change in positions might be useful. As some Members of this

Committee may know, the Federal Reserve had concluded earlier, on the basis of

both supervisory judgment and the available evidence, that the risk associated with

commercial real estate loans on certain existing or completed property required a

capital charge higher than the capital charge on other commercial real estate and

on commercial and industrial loans. In recent weeks, however, our analysis of additional data suggested that the evidence was contradictory. With such inconsistent

empirical evidence, we concluded that, despite our supervisory judgment on the potential risk of these exposures, we could not support requiring a higher minimum

capital charge on commercial real estate loans on any existing or completed property, and we will not do so.

In the same vein, we also remain open minded about proposals that simplify the

proposal but attain its objective. Both the modifications of the proposals in CP–3

and the changes in U.S. supervisory views, as evidenced by the commercial real estate proposal, testify to the willingness of the agencies, even at this late stage of

the process, to entertain new ideas and to change previous views when warranted.

Summary

The existing capital regime must be replaced for the large, internationally active

banks whose operations have outgrown the simple paradigm of Basel I and whose

scale requires improved risk-management and supervisory techniques to minimize

the risk of disruptions to world financial markets. Fortunately, the state of the art

of risk measurement and risk management has improved dramatically since the

first capital accord was adopted, and the new techniques are the basis for the proposed new accord. In my judgment, we have no alternative but to adopt, as soon

as practical, these approaches for the supervision of our larger banks.

The Basel II framework is the product of extensive multiyear dialogs with the

banking industry regarding evolving best practice risk-management techniques in

every significant area of banking activity. Accordingly, by aligning supervision and

regulation with these techniques, it provides a great step forward in protecting our

financial system and that of other nations to the benefit of our citizens. Basel II

will provide strong incentives for banks to continue improving their internal riskmanagement capabilities as well as the tools for supervisors to focus on emerging

problems and issues more rapidly than ever before.

I am pleased to appear before you today to report on this effort as it nears completion. Open discussion of complex issues has been at the heart of the Basel II development process from the outset and will continue to characterize it as Basel II

evolves further.

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PREPARED STATEMENT OF JOHN D. HAWKE, JR.

COMPTROLLER OF THE CURRENCY

U.S. DEPARTMENT OF THE TREASURY

JUNE 18, 2003

Introduction

Chairman Shelby, Senator Sarbanes, and Members of the Committee, thank you

for inviting the Office of the Comptroller of the Currency (OCC) to participate in

this hearing on proposed revisions to the 1988 Capital Accord developed by the

Basel Committee on Banking Supervision (Basel Committee). I welcome the efforts

of the Committee to focus attention on these critical issues. The health of the U.S.

commercial banking system is a critical element to a strong economy. Thus, it is

essential that any regulatory changes that might affect the condition and competitiveness of our banking system be fully understood and carefully evaluated by the

banking industry, the U.S. Congress and the American public.

The 1988 Accord, referred to as Basel I, established the framework for the riskbased capital adequacy standards applicable to internationally active commercial

banks in all of the G–10 countries, and it has been adopted by most other banking

authorities around the world. U.S. banking and thrift agencies have applied the

1988 framework to all U.S. insured depository institutions.

By the late 1990’s, it became evident that Basel I had become outdated. The increased scope and complexity of the banking activities of our largest banking institutions over the last decade and the unintended consequences of various provisions

of the regulations, severely undercut the utility of the Capital Accord. Basel I simply

does not provide a meaningful measure of the risks faced by large, internationally

active banks or the capital they should hold against those risks.

Consequently, over the past several years, the Basel Committee has been developing a more detailed and risk sensitive capital adequacy framework to replace

Basel I. The Committee’s first draft document, Consultative Paper No. 1 (CP–1),

was issued in June 1999. It laid the groundwork for the new capital adequacy

framework (Basel II), but provided few details. The Committee provided additional

details on the specifics of Basel II in its January 2001 issuance of Consultative

Paper No. 2 (CP–2). Although more detailed, CP–2 still left a number of key issues

unaddressed and unresolved. The Committee’s most recent paper, Consultative

Paper No. 3 (CP–3), which I will discuss today, was issued on April 29 of this year.

As work on these consultative papers has progressed, the Basel Committee also

has attempted to gauge the impact of its proposals on the required capital levels

of banking institutions through a series of quantitative impact studies. In May, the

Committee published the results of the most recent assessment, the third quantitative impact study (QIS–3). While the Committee concluded that the results were

generally in line with the objectives of Basel II, the QIS–3 data still do not provide

a sufficiently reliable estimate of the likely regulatory capital requirements for

banks subject to Basel II. More work in this area is clearly warranted and I will

discuss this later in my testimony.

The Basel Committee has outlined an aggressive timeline for the remaining actions leading to the adoption of Basel II. As a consequence, the U.S. banking agencies, the agencies responsible for the maintenance of capital adequacy standards for

U.S. financial institutions, are faced with a daunting task. While we will work earnestly in this effort, the timeline should be seen as a means to an end, not an end

in itself. As will be highlighted in my testimony, basic principles of safety and

soundness demand that the banking agencies have a more complete understanding

of the consequences of this proposal on the overall capital levels of affected institutions, the competitive effects on our financial system, and associated compliance

costs and burdens before moving forward to finalize this proposal.

Our current primary focus in this effort is the development of U.S. implementing

regulations and policies. As I will discuss later, the OCC and the other U.S. banking

agencies will soon issue for comment proposed revisions to U.S. risk-based capital

regulations to reflect the primary components of Basel II. Let me be absolutely clear

about the integrity of this rulemaking process—the OCC, which has the sole statutory responsibility for promulgating capital regulations for national banks, will not

begin implementing a final Basel II framework until we have conducted whatever

cost-benefit and impact analyses that are required, and fully considered all comments received during our notice and comment process—as we would with any

domestic rulemaking. If we determine through this process that changes to the proposal are necessary, we will not implement proposed revisions until appropriate

changes are made. We made this point quite clearly to our Basel Committee colleagues before we agreed to go forward with CP–3. Indeed, many of them will also

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have to go through their own internal domestic processes before they can adopt the

Basel II framework.

Current Basel Proposal

The Basel Committee deserves considerable credit for its articulation of Basel II

in CP–3. The proposal is still exceedingly complex, but CP–3 is a clearer presentation of inherently difficult material than its predecessors. This is an important

step, since regardless of the complexity of the proposal, it is important the industry

and other interested parties have a clear understanding of the proposed Accord.

The attachment to this written statement provides a summary of the substantive

provisions contained in CP–3. As before, this iteration of the proposed new Accord

has three mutually reinforcing ‘‘pillars’’ that comprise the framework for assessing

bank capital adequacy. The first pillar of the new Accord is the minimum regulatory

capital requirement. The Pillar 1 capital requirement includes a credit risk charge,

measured by either a standardized approach or one of the new internal ratingsbased (IRB) approaches (foundation or advanced), an operational risk charge, and

a market risk charge. Again, the attached document provides a more detailed description of the various components of the Pillar 1 charge.

Pillar 2 addresses supervisory review. It is, ‘‘intended to ensure not only that

banks have adequate capital to support all the risks in their business, but also to

encourage banks to develop and use better risk management techniques in monitoring and managing these risks.’’ This pillar encourages supervisors to assess

banks’ internal approaches to capital allocation and internal assessments of capital

adequacy, and, subject to national discretion, provides an opportunity for the supervisor to indicate where such approaches do not appear sufficient. Pillar 2 should

also be seen as a way to focus supervisors on other means of addressing risks in

a bank’s portfolio, such as improving overall risk management techniques and internal controls.

The third pillar recognizes that market discipline has the potential to reinforce

capital regulation and other supervisory efforts to ensure the safety and soundness

of the banking system. Thus, the Committee is proposing a wide range of disclosure

initiatives, which are designed to make the risk and capital positions of a bank more

transparent. As a bank begins to use the more advanced methodologies, such as the

Advanced IRB approach, the new Accord will require a significant increase in the

level of disclosure. In essence, the tradeoff for greater reliance on a bank’s own assessment of the building blocks of capital adequacy is greater transparency.

U.S. Implementation Actions

It is important to recognize that the Basel Accord is not self-executing in the U.S.

Even when adopted by the Basel Committee, Basel II will not apply to U.S. institutions unless and until the U.S. banking agencies adopt regulations to implement it.

In accordance with the Administrative Procedure Act, 5 U.S.C. 551, et seq., the U.S.

banking agencies must publish notice and seek comment from all interested persons

on any such proposal, and must fully consider those comments, before adopting a

new capital regulation in final form. Obviously, the OCC and the other Federal

banking agencies intend to comply fully with these requirements. The importance

of this rulemaking makes this comment process particularly critical to our success.

Thus, we welcome this process as a means for positive contribution to this deliberative effort. We believe that the solicitation and assessment of comments is a critical

step in determining the feasibility, effectiveness, and expected consequences of Basel

II and related domestic capital regulations.

Next month, the U.S. banking agencies expect to jointly issue an Advance Notice

of Proposed Rulemaking (ANPR) soliciting comment on proposed revisions to the existing domestic capital adequacy regulations that would implement Basel II. The

ANPR will be largely based on CP–3, and will provide a description of proposed

revisions to current capital regulations, while seeking comment on outstanding or

contentious issues associated with the proposal. The ANPR will also request information on the cost of implementing the proposal, and will seek comment on the

competitive implications in both domestic and international markets for banks of all

sizes. In conjunction with the ANPR, the banking agencies will also issue for comment draft supervisory guidance articulating general supervisory expectations for

banks seeking to implement Basel II-compliant methodologies for the Advanced

Measurement Approach (AMA) to operational risk and Advanced IRB for corporate

credits. Recognizing that CP–3 is a complex document, we understand the importance of providing U.S. banks an opportunity to review and comment on U.S. implementing documents as soon as practicable. By describing these concepts within the

context of our existing regulatory and supervisory regime, the ANPR and draft guidance will provide a meaningful forum for a full discussion of Basel II.

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After assessing comments generated during the ANPR process, the U.S. banking

agencies will consider a complete cost analysis in accordance with applicable rulemaking requirements, including the standards of Executive Order 12866, discussed

below, and will develop specific regulatory language for a joint Notice of Proposed

Rulemaking (NPR). Again, the banking industry and other interested parties will

have an opportunity to comment on this fully articulated proposal before any revisions to our capital regulations are finalized.

Let me now focus on two important, unique features of the U.S. regulatory capital

regime that will be highlighted in the ANPR and NPR—the scope of application of

Basel II and the content and structure of the proposed revisions to the capital adequacy regulations. First, the United States expects to set forth in the ANPR proposed criteria for identifying which banks in the United States will be subject to

the new Accord. Despite language in the 1988 Capital Accord that permitted a more

limited application, U.S. banking and thrift agencies applied the Basel framework

to all U.S. insured depository institutions. As we will highlight in the forthcoming

ANPR, the U.S. agencies have determined to apply Basel II concepts more narrowly.

Specifically, consistent with the focus of the Basel Capital Accord on banks that

compete in the global marketplace, we will propose applying Basel II concepts on

a mandatory basis only to large, internationally active institutions that compete on

a significant global basis with other financial service providers. Other institutions

will have the opportunity to voluntarily opt into the Basel framework upon application to, and approval by, their primary Federal supervisor.

Preliminary analysis by the U.S. agencies suggests that under the narrow approach we are proposing, there are currently fewer than a dozen U.S. banks that

would be mandatorily subject to Basel II-based regulatory capital requirements. Of

course, the approach of requiring only a small population of banks to comply with

Basel II will be subject to notice and comment in the ANPR and will be definitively

resolved only after the U.S. rulemaking process has been completed.

Second, in developing revisions to existing capital adequacy regulations, U.S.

banking agencies recognize that the revised regulation, and interagency implementation policies, need not follow the literal structure and language of Basel II. While

consistent with the objectives, general principles and core elements of the revised

Basel Accord, the language, structure, and degree of detail of U.S. implementing

documents may be very different from Basel II. These implementation differences

are reflective of the particular statutory, regulatory and accounting structures and

practices in place in the United States. It is important to note that U.S. implementation actions do not contemplate changes to many fundamental aspects of our regulatory/supervisory process, including a focus on regular on-site supervision, our

prompt corrective action rules, and our minimum leverage ratio for capital adequacy. As described more fully in the attachment, the U.S. agencies will propose for

notice and comment a Basel II-based regime incorporating only the Advanced IRB

approach for credit risk, the AMA for operational risk, and the internal models approach for market risk.

We are also very cognizant that in connection with this, or any rulemaking, existing requirements may compel preparation of detailed analysis of the costs, benefits,

and other effects of our regulations, depending on threshold determinations of

whether the rulemaking in question triggers the substantive requirements of particular statutes or Executive Orders. Relevant requirements are set forth in the

Regulatory Flexibility Act (RFA), the Unfunded Mandates Reform Act of 1995

(UMRA) and Executive Order 12866 (E.O. 12866). Issuance of the ANPR will help

us identify and determine costs, benefits, and other effects of the proposed rulemaking, for purposes of complying with these requirements.

Timing

As I noted early on in my testimony, the Basel Committee timeline presents a

daunting task to both the U.S. banking agencies and the banking industry. While

it is clearly necessary to move forward in addressing the acknowledged deficiencies

in the current Basel Capital Accord, the banking agencies must better understand

the full range and scale of likely consequences before finalizing any proposal. The

list provided below identifies the milestones the OCC must meet under the current

Basel II timeline. Each step is critical in a prudential consideration of Basel II in

the United States:

• Consideration of comments received by the Basel Committee on CP–3. The comment period on this document concludes on July 31.

• Finalization, issuance, and consideration of comments on the U.S. ANPR. Based

on the current estimates, the notice and comment period will run from July to

October.

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• Finalization, issuance, and consideration of comments on supervisory guidance on

Corporate IRB and AMA methodologies. Based on current estimates, the notice

and comment period will run from July to October.

• Development, issuance, and consideration of comments on supervisory guidance on

other substantive aspects of Basel II-based regulations, especially including retail

IRB. Based on current estimates, the agencies hope to commence solicitation of

comment on this guidance by year-end 2003.

• Participation in the Basel Committee’s consideration of Basel II. Under the current

timeline, the Committee is to consider approval of Basel II in December of this

year.

• Development, issuance, and analysis of results of additional agency efforts to

evaluate the prospective effects of Basel II implementation. E.O. 12866 may compel

the OCC and OTS to undertake such analysis prior to the issuance of an NPR.

Even without regard to this requirement, however, it is essential that we have

a reliable estimate of the impact of Basel II on the capital and competitive position of U.S. banks.

• Development, issuance, and consideration of comments on the U.S. NPR. This document would only be issued after the Basel Committee finalizes its consideration

of Basel II. If the existing timeline is maintained, solicitation of comment on the

NPR would commence no earlier than the first quarter of 2004.

• Development and issuance of a U.S. final rule and supervisory guidance. Again,

assuming the present timeline is maintained, our best estimate for the issue date

of a final rule implementing Basel II is the third or fourth quarter of 2004.

• Completion of all necessary supervision-related steps to implement Basel II-based

regulations in advance of the presently proposed December 2006 effective date.

Most significantly, the agencies need to determine whether each bank subject to

Basel II-based regulations has appropriate systems and procedures in place to

qualify for using the A–IRB and AMA.

Status of Basel Proposal—Outstanding Issues

In commencing an objective assessment of the status of Basel II, it is important

to reiterate and reaffirm the commendable work of the Basel Committee, and in particular, the strong and intelligent leadership of its former Chairman, William

McDonough. The OCC firmly supports the objectives of Basel II. These objectives

constitute a sound conceptual basis for the development of a new regulatory capital

regime and should continue to serve as a useful benchmark to gauge our progress

in this effort. Nonetheless, much of that conceptual basis has not been tested in

practice in any manner approaching the magnitude of Basel II. We continue to be

concerned about the potential for unintended or unanticipated consequences of the

Basel II proposals.

Implementation Challenges

At its foundation, the Basel II proposals permit qualifying institutions to calculate

their minimum risk-based capital requirements by reference to their own internal

systems and methodologies. While it is the hallmark of Basel II, a greater alignment

of internal risk assessment with minimum regulatory capital derived through internal models represents a radical departure from our existing regulatory capital

framework. As we will highlight in the ANPR and accompanying guidance, this reliance on internal risk assessment systems mandates changes in the way we structure our capital regulations and, in certain important respects, how we conduct our

supervisory activities. The fundamental question for the banking agencies in assessing Basel II is the issue the OCC has previously identified—whether the regime will

work in practice, as well as theory, as the basis for a regulatory capital regime.

For bank supervisors and other external stakeholders to be in a position to rely

on a bank’s internal process in the establishment of regulatory capital requirements,

there must be a high degree of confidence that regulators can establish and enforce

appropriate risk measurement and management standards consistently across the

banks subject to a Basel II-based regime. The challenge for supervisors is to create

a verifiably accurate system that appropriately balances the need for flexibility, to

promote continued improvement in risk management practices, with the need for objective standards, to ensure consistency in application across institutions and supervisors, both foreign and domestic.

The capital rule we implement must respect the evolutionary nature of risk management. As regulators, we must acknowledge that we are still in the relatively

early days of model-based credit and operational risk measurement and management. We must recognize the inevitability of further innovation and improvements

in this area. This respect for the evolutionary nature of this discipline must then

be reconciled with the need for objective standards to ensure consistency in applicaVerDate 11-MAY-2000 10:04 Jul 07, 2004 Jkt 000000 PO 00000 Frm 00078 Fmt 6621 Sfmt 6621 94514.TXT BANK1 PsN: BANK1
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1See, Daniel E. Nolle, ‘‘Bank Supervision in the United States and the G–10: Implications for

Basel II,’’ RMA Journal, June 2003.

tion. Much of the detail and complexity within Basel II derives from the need to

establish more objective expectations for bank rating systems, control mechanisms,

audit processes, data systems, and other internal determinations of risk by individual banks. In many cases, this has led to the establishment of supervisory standards in areas previously left to management discretion or supervisory judgment.

Not surprisingly, the regulatory community has struggled with the establishment

of these standards. Failing to achieve the proper balance for these often conflicting

objectives while moving forward with the radically different Basel II-based regime

can have dramatic consequences. If our regulation and supervisory process is overly

flexible, bank internal calculations of capital adequacy may prove insufficient, noncomparable, or both. If we err on the other extreme, we establish an excessively

prescriptive supervisory regime that stifles innovation, imposes undue regulatory

burden, and inappropriately narrows the role of judgment.

This need to carefully balance dramatically opposed objectives, together with the

significant uncertainties that still exist about the practical feasibility of these proposed changes to the Capital Accord, raise doubts about the achievability of the

timeframe established by the Basel Committee.

Competitive Equality

A stated goal of the Basel Committee in developing Basel II was that, ‘‘the Accord

should continue to enhance competitive equality.’’ Realistically, we are not yet in a

position to assess definitively the full range of consequences from the implementation of Basel II, including its effect on competitive equality in the global financial

marketplace. There are risks that Basel II may create or exacerbate relative advantages between domestic banks and foreign banks; between banks and nonbanks; and

between large domestic banks and mid-size/small domestic banks. It is imperative

that the U.S. banking agencies remain sensitive to these concerns and assess, to the

extent possible, any unintended consequences resulting from the implementation of

Basel II.

One of the primary objectives of the Basel Committee itself is the reduction of

gaps and differences in international supervisory coverage by national supervisory

agencies, especially as it relates to large internationally active banks that compete

on a significant global basis with other financial service providers. This principle of

competitive equality and a level playing field for international banks is an admirable one, and an appropriate goal of the Committee’s efforts. Yet, the very complexity of the rules themselves calls this objective into question. Bank supervision

varies significantly from one country to another in approach, intrusiveness, and

quality. Is it realistic to think that an enormously complex set of rules will be applied in an evenhanded way across such a broad spectrum of supervisory regimes?

For example, the OCC has as many as 30 to 40 full-time resident examiners in our

largest banks. They are intimately involved as supervisors in assessing the banks’

operations and judging the banks’ compliance with a myriad of laws, rules, and

guidelines. Some other countries may send examiners in once a year to a comparably sized institution, or may examine such an institution thoroughly only every

5 years, or may put heavy reliance on the oversight of outside auditors.1

It is fair to ask, I think, in which type of supervisory regime detailed, prescriptive

capital rules are more likely to be robustly and reliably enforced. The Basel Committee has not undertaken to set standards of supervision for member countries. Yet

the attainment of competitive equity among internationally active banks is a bedrock principle of Basel II. Can we really achieve competitive equality without addressing disparities in supervision, particularly when we are operating on the

assumption that the complex new rules we are writing will be applied in an evenhanded way throughout the world?

Another principle source of competition for many banks is not other insured depository institutions, but nonbanks. This situation is especially pronounced in businesses such as asset management and payments processing. As you are aware,

however, regulations implementing Basel II-based concepts in the United States will

apply only to insured depository institutions and their holding companies. While differences in regulatory requirements for banks and nonbanks exist today, many institutions have voiced concern that implementation of Basel II may unduly exacerbate

the current differences. These concerns have been mainly focused on the effects on

competition from the application of the operational risk proposal and the enhanced

disclosures required under Pillar 3.

Finally, there is concern about the potential effect of Basel II on the competitive

balance between large and small banks. As implemented in the United States, Basel

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2See Advance Notice of Proposed Rulemaking, Simplified Capital Framework for Non-Complex Institutions, 65 FR 66193 (November 3, 2000).

II would result in a bifurcated regulatory capital regime, with large banks subject

to Basel II-based requirements and small and mid-sized banks subject to the current

capital regime. This structure is premised on the belief that, to the extent possible,

regulations should reflect the size, structure, complexity, and risk profile of banking

institutions. The Basel II framework was developed to address the unique risks of

large internationally active institutions. Mandatory application of such a framework

to small banks, with its associated costs, was deemed inappropriate. In fact, the

banking agencies sought comment from the banking industry, especially smaller

institutions, on the development of a simplified capital framework specifically for

noncomplex institutions.2 Industry comments were overwhelming negative on the

proposal—most institutions felt that the cost of adopting a new regulatory capital

regime outweighed any potential benefits. Accordingly, the banking agencies tabled

the proposal.

With that said, the banking agencies need to continue to assess the competitive

effects of a bifurcated regulatory capital regime, and it is one of the areas on which

we will seek guidance in our ANPR. There are several concerns in this regard. First,

banks using a Basel II-based regime may have a lower minimum capital requirement, allowing those banks to grow and compete more aggressively with smaller

banks for both assets and liabilities. To be sure, banks subject to the New Basel

II requirements will incur very significant systems and compliance costs in preparing for the new regime. These concerns are discussed in more detail in the ‘‘Calibration’’ section below. Moreover, banks using a Basel II-based regime may have

significantly higher or lower marginal regulatory capital charges than non-Basel

banks for some types of loan products, resulting in potential pricing differentials.

While Basel II might enable larger banks to compete more effectively for high quality credits, it could also result in larger concentrations of lower quality credits in

smaller institutions. Finally, the potential implications on industry consolidation are

simply not known. The banking agencies must continue to assess this situation and,

if warranted, take steps to mitigate adverse effects on the competitive balance between large and small banks. We would be seriously concerned if, as an unintended

consequence of the implementation of Basel II, we significantly alter the structure

of banking in the United States.

Calibration

The first objective of the Basel Committee in embarking on the Basel II effort was

to calibrate minimum capital requirements to bring about a level of capital in the

industry that, on average, is approximately equal to the global requirements of the

present Basel Accord. That calibration was to be designed to provide an incentive

to banks to develop and maintain sophisticated and risk-sensitive internal ratingsbased systems.

In order to gauge its success in meeting that objective, the Basel Committee attempted to measure the impact of its proposals on the required capital levels of

banking institutions through several quantitative impact studies. On May 5, 2003,

the Committee published an overview of the results of its most recent assessment,

the third quantitative impact study (QIS–3). On the basis of QIS–3 results, the

Committee concluded that the aggregate results were generally in line with the objectives established for Basel II.

Unfortunately, the QIS–3 data do not provide a reliable estimate of the likely regulatory capital requirements for banks subject to Basel II. And banks encountered

several practical impediments to providing accurate estimates of the effect of the

proposals on their measured ratios; thus, the estimated risk-based capital ratios

were subject to a substantial margin of error. For example, in many cases, existing

bank systems were not able to produce the data requirements necessary for inputs

required by the new Accord. In some areas, the QIS–3 instructions were not sufficiently clear or were misinterpreted, and in other cases, the proposals were still in

flux as banks were completing the survey. Most important, QIS–3 was completed

without the rigorous supervisory validation and oversight that would occur when

the proposal actually takes effect.

A key concern is that focusing on the overall results of the QIS–3 exercise masks

the wide dispersion of results for individual institutions. In the U.S., measured

against current risk-weighted assets, the use of advanced approaches yielded results

that ranged from a decrease in regulatory capital requirements of 36 percent to an

increase of 43 percent. Similarly broad dispersions are found in a great many of the

underlying components that make up the total capital requirement. While some dispersion of results in a truly more risk-sensitive framework would be expected, we

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are not convinced that the wide ranges indicated by QIS–3 can be explained by relative differences in risk among institutions; it appears that comparability of QIS–

3 results among different institutions may be severely lacking.

Finally, the quantitative studies that have been done to date have been based on

unilateral inputs from the participating banks. We and other supervisors have had

only very limited ability to review the veracity of the results. I want to be clear that

we have no reason to believe that U.S. banks did not make every effort to provide

results as accurate as possible given the constraints they were operating under.

Nonetheless, it is certainly conceivable—I would say highly likely—that the results

might change significantly, and not necessarily in any particular direction, when

all the intricacies of real-world implementation come into play. It seems fair to assume that banks will have fewer incentives to take conservative stances and greater

incentives to exploit any loopholes or gray areas in the final rules; the extent to

which these effects might be offset, or exceeded by, greater supervisory oversight

is unknown.

Notwithstanding the significant uncertainties noted above, it presently appears

that the required capital levels of some U.S. institutions could drop significantly,

even taking into account the temporary minimum floor capital requirements, discussed in the attachment. The OCC does not believe that some reduction in minimum regulatory capital requirements for certain institutions is, in and of itself, an

adverse feature of Basel II. Such a result is only acceptable, however, if the reduction is based on a regulatory capital regime that appropriately reflects the degree

of risk in that bank’s positions and activities. Given the fact that relevant bank systems and procedures are still in development, the OCC is not yet in a position to

make that determination as it relates to Basel II. As such, the OCC is not yet comfortable allowing national banks to materially lower their current capital levels simply on the basis of the output of the currently proposed Basel II framework.

The OCC expects that an additional quantitative study will be necessary after the

Basel Committee’s work on Basel II is completed. Ideally, this should take the form

of another global study by the Basel Committee itself—that is, a QIS–4. However,

even if the Basel Committee does not undertake such a study, I believe that it is

absolutely essential that the U.S. agencies do so prior to the adoption of final implementing regulations. I strongly believe that we cannot responsibly adopt final rules

implementing Basel II until we have not only determined with a high degree of reliability what the impact will be on the capital of our banks, but we have also made

the judgment that the impact is acceptable and conducive to the maintenance of a

safe and sound banking system in the United States.

Conclusion

As I have indicated, the OCC firmly supports the objectives of Basel II—a more

risk-sensitive and accurate capital regime. However, in light of the issues that have

been identified with the current iteration of Basel II, the U.S. banking agencies

must now determine how best to proceed on this critically important issue. I believe

the following are essential elements in the agencies’ consideration of Basel II implementation within the United States.

First, the agencies need to move forward with the solicitation of comments on a

Basel II-related ANPR and associated guidance. That is the most effective mechanism to have full and complete consideration of the proposal from all interested

parties. The solicitation of comments on a proposed regulatory and supervisory

structure for Basel II implementation will also permit supervisors to tangibly assess

the feasibility of the proposal.

Second, the agencies need to undertake additional steps to evaluate the costs, benefits, and other effects of the proposal before moving forward with any final regulatory action. Frankly, we simply need additional information to reasonably address

the numerous issues, concerns, and uncertainties associated with Basel II implementation. We must better understand the likely consequences of this proposal on

overall capital levels of affected institutions, the competitive effects on our financial

system, and associated compliance costs and burdens. In determining the appropriate additional steps, the agencies should consider the obligations imposed under

E.O. 12866, the other statutory requirements for consideration of costs and impact,

lessons learned from QIS–3, and perhaps, a U.S. version of QIS–4.

Third, as I have consistently reiterated, if we determine through this process that

changes to the Basel II proposal are necessary, the U.S. agencies must pursue those

changes, both domestically and in the Basel Committee. In this regard, the U.S.

agencies should not foreclose consideration of alternative proposals that address the

acknowledged deficiencies of the 1988 Accord but that do not constitute such a radical departure from our existing regulatory capital framework.

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Fourth, the overarching consideration for supervisors in moving forward on Basel

II is the need to act in accordance with our primary mission—to ensure the continued maintenance of a robust and safe and sound banking system. We need to incent

banks to continue to better measure and manage the full panoply of risks they face

and to make use of new and evolving risk management practices. We must also

ensure that prudential consideration of safety and soundness principles remain

paramount.

As I said in the beginning of my statement, the OCC, the agency to which Congress has committed the authority to define capital requirements for national banks,

will not sign off on implementation of a final Basel II framework until we have fully

considered all comments received during our notice and comment process. Given the

importance of this proposal, the significant issues that remain unresolved, and the

prospect that whatever emerges from this process is likely to govern the financial

landscape for years to come, we need to take whatever time is necessary to develop

and implement a revised risk-based capital regime that achieves the stated objectives of the Basel Committee in both theory as well as practice.

I am pleased to have had this opportunity to provide our views on this important

initiative, and I would be happy to answer any questions you may have.

***

ATTACHMENT

Summary of Basel II: The Proposed New Accord Office of the Comptroller

of the Currency

The Basel Committee (the Committee) has been developing the new Accord over

the past 5 years. During that time, three full-scale consultative papers (June 1999,

January 2001, and April 2003) and numerous working papers supporting various

elements of the new Accord have been released to the industry for comment. This

summary is intended to convey a general idea of the structure and substance of the

proposed new Accord, and does not attempt to provide a complete analysis. It is

based on the most recent publications from the Basel Committee, notably the New

Basel Capital Accord (Consultative Document) which is out for comment until July

31; the document can be found on the Committee’s website at http://www.bis.org/

bcbs/index.htm.

The new Accord will include menus of approaches for measuring the capital required for credit risk, market risk, and operational risk. For credit risk and operational risk, each of the proposed approaches is described briefly below; capital

charges for market risk are unchanged in the new Accord and are not discussed

here. Some of the approaches described are unlikely to be implemented in the

United States and have been noted as such. Moreover, based on preliminary analysis by the U.S. agencies, currently there are less than a dozen U.S. banks that

would be mandatorily subject to Basel-based regulatory capital requirements. While

other banks would be permitted to opt in to the Basel rules (subject to meeting prudential qualification requirements), the U.S. capital rules will remain in place for

the vast majority of U.S. banks that either are not required to or do not opt to apply

the Basel II framework. Of course, any issues regarding U.S. implementation of the

new Accord will be definitively resolved only after the U.S. rulemaking process has

been completed.

The current structure of the Accord has been influenced by the results of several

quantitative impact studies (QIS), the most recent of which was completed in December 2002. Approximately 20 U.S. banks participated in the QIS exercise in

December and the results have been factored into the most recent version of the Accord. Changes were made in several areas including the treatment of retail credits,

specialized lending, securitization, and operational risk.

General Structure of the Proposed New Accord

The new Accord has three mutually reinforcing ‘‘pillars’’ that make up the framework for assessing capital adequacy in a bank. The first pillar of the new Accord

is the minimum regulatory capital charge. In order to calculate the capital charge

under Pillar 1, banks will have to determine the individual charges for credit, market, and operational risk. The new Accord offers a series of options for calculating

credit and operational risk. Market risk will remain unchanged from a 1996 amendment to the Accord. The new options for credit and operational risk were designed

to be available to a wide range of banks, from relatively simple to very complex.

For credit risk, the Pillar 1 capital requirement includes both the standardized approach, updated since the 1988 Accord, and the new Internal Ratings-Based (IRB)

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approaches (foundation and advanced). Pillar 1 has been the focal point of much of

the discussion and comment from the industry on the new Accord.

Pillar 2 covers supervisory review and banks’ obligation to hold sufficient capital

vis-a`-vis their risk profile. The pillar is, ‘‘intended to ensure not only that banks

have adequate capital to support all the risks in their business, but also to encourage banks to develop and use better risk management techniques in monitoring and

managing these risks.’’ This pillar encourages supervisors to assess banks’ internal

approaches to capital allocation and internal assessments of capital adequacy. It

provides an opportunity for the supervisor to indicate where such approaches do not

appear sufficient. Pillar 2 is also a way to focus supervisors on other means of addressing risks in bank’s portfolio, such as improving risk management techniques

and internal controls.

The third pillar recognizes that market discipline has the potential to reinforce

capital regulation and other supervisory efforts to ensure the safety and soundness

of the banking system. Thus, the new Accord proposes a wide range of disclosure

initiatives, which are designed to make the risk and capital positions of a bank more

transparent. As a bank begins to use the more advanced methodologies for market

and operational risk, the new Accord will require a significant increase in the level

of disclosure. In essence, the tradeoff for greater reliance on a bank’s own assessment of capital adequacy is greater transparency. This pillar has been subject to

numerous changes as the Committee has worked to balance the need for robust

disclosure with a recognition of the proprietary and confidential nature of some of

the information.

Capital for Credit Risk

Under Basel II, banks must select one of three approaches to determine their capital for credit risk. The three approaches, from simplest to most complex are: The

standardized approach, the foundation IRB, and the advanced IRB.

Standardized Approach

The 1988 Accord introduced the standardized risk-bucketing approach for setting

the minimum regulatory capital requirement, which is still used in the United

States today. The approach has been subject to criticism that it lacks sufficient risk

sensitivity. The revised standardized approach under Basel II enhances the 1988

Accord by providing greater, though still limited, risk sensitivity.

Key changes to create a more risk-sensitive framework include the refinement and

addition of risk buckets, the introduction of external credit ratings, and a wider recognition of credit risk mitigation techniques. Risk weights are still determined by

category of the borrower—sovereign, bank, or corporate—but within each of these

categories changes have been made to make the capital more reflective of the riskiness of the asset category. For example, the risk weight on mortgage loans has decreased from 50 percent to 35 percent and the risk weight on certain retail credits

has moved from 100 percent to 75 percent. Risk weights for externally rated corporate credits, currently 100 percent, will range from 20 percent to 150 percent.

Sovereign risk weights are no longer dependent upon whether a country is a member of the Organization for Economic Cooperation and Development (OECD), but

rather on the external rating identified for the country.

The standardized approach is not likely to be implemented in the United States.

U.S. supervisors believe that credit risk measured under the standardized approach

of Basel II would generally not be appreciably different than that measured under

current rules for most U.S. banks, and the marginal changes in capital requirements would not justify the cost of implementation.

Internal Ratings-Based Approach (Foundation and Advanced)

The IRB approach represents a fundamental shift in the Committee’s thinking on

regulatory capital. It builds on internal credit risk rating practices used by some institutions to estimate the amount of capital they believe necessary to support their

economic risks. In recent years, as a result of technological and financial innovations and the growth of the securities markets, leading banking institutions

throughout the world have improved their measurement and management of credit

risks. These developments have encouraged the supervisory authorities to devote

greater attention to introducing more risk-sensitive regulatory capital requirements,

particularly for large, complex banking organizations.

Banks must meet an extensive set of eligibility standards or ‘‘qualifying criteria’’

in order to use the IRB approach. Because the requirements include both qualitative

and quantitative measures, national supervisors will need to evaluate compliance

with them to determine which banks may apply the new framework. The requirements vary by both the type of exposure and whether the bank intends to use the

simpler foundation IRB framework or the more advanced IRB framework. The reVerDate 11-MAY-2000 10:04 Jul 07, 2004 Jkt 000000 PO 00000 Frm 00083 Fmt 6621 Sfmt 6621 94514.TXT BANK1 PsN: BANK1
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quirements are extensive and cover a number of different areas, including rating

system design, risk rating system operations, corporate governance, and validation

of internal estimates. A brief sample of actual criteria include:

• The board of directors and senior management have a responsibility to oversee

all material aspects of the IRB framework, including rating and probability of default (PD) estimation processes, frequency and content of risk rating management

reports, documentation of risk rating determinations, and evaluation of control

functions.

• A 1-year PD estimate for each grade must be provided as a minimum input.

• Banks must collect and store historical data on borrower defaults, rating decisions, rating histories, rating migration, information used to assign ratings, PD

estimate histories, key borrower characteristics, and facility information.

As mentioned above, the requirements that a bank must meet are partially dependent upon which of the two IRB approaches a bank will use. The first methodology, called the foundation approach, requires fewer direct inputs by banks and

provides several supervisory parameters that, in many cases, carry over from those

proposed for the standardized approach. For a variety of reasons, the United States

does not plan to introduce the foundation approach in its regulations. The second

approach, the advanced IRB approach, allows banks much greater use of their internal assessments in calculating the regulatory capital requirements. This flexibility

is subject to the constraints of prudential regulation, current banking practices and

capabilities, and the need for sufficiently compatible standards among countries to

maintain competitive equality among banks worldwide.

There are four key inputs that are needed under IRB, for both the foundation and

advanced approaches. The first element is the PD of a borrower; the bank is required to provide the PD in both the foundation and the advanced approaches. The

second input is the estimate of loss severity, known as the loss given default (LGD).

The final two elements are the amount at risk in the event of default or exposure

at default (EAD) and the facility’s remaining maturity (M). LGD, EAD, and M are

provided by supervisors in the foundation approach, but must be provided by banks

operating under the advanced approach (subject to supervisory review and validation). For each exposure, the risk weight is a function of PD, LGD, and EAD.

The IRB approach envisions internal rating systems that are two-dimensional.

One dimension focuses on the borrower’s financial capacity and PD estimates that

quantify the likelihood of default by the borrower, independent of the structure of

the facility. The other dimension takes into account transaction-specific factors such

as terms, structure, and collateral. These characteristics would determine the second dimension, that is, the LGD. Implicit in this treatment is the assumption that

when a borrower defaults on one obligation, it will generally default on all its obligations. (This assumption is relaxed with the IRB treatment of retail portfolios.)

Calculating the capital charge under the IRB approach involves several steps. The

first of these steps is the breakdown of the bank’s portfolio into five categories: Corporate (including commercial real estate), retail, bank, sovereign, and equity. The

IRB rules differ to varying degrees across these portfolios. As a result, the IRB capital charge is calculated by category, with the PD, LGD, and EAD inputs potentially

differing across these categories. Supervisory approval is needed before banks can

use the IRB approach for any of the five categories. The minimum requirements described above were written to apply across these five types of exposures.

Another important step is the determination by the bank of the PD’s for its loan

grading categories. The PD of an exposure is the 1-year PD associated with the borrower grade, subject to a floor of 0.03 percent (excluding sovereigns). The determination of PD’s for borrowers supported by guarantees or credit derivatives is more

complex. Banks under the advanced approach would use their internal assessments

of the degree of risk transfer within supervisory defined parameters, while those

under the foundation approach would use the framework set forth in the new credit

risk mitigation provisions. Overall, the PD must be, ‘‘grounded in historical experience and empirical evidence,’’ while being ‘‘forward looking’’ and ‘‘conservative.’’ A

reference definition of default has been developed for use in PD estimation and internal data collection of realized defaults.

Once the PD has been established, banks must then establish the dimensions of

LGD based on collateral and M. Under the foundation approach, M is assumed to

be 2.5 years. There are several options that may be selected for the advanced approach, but in general, M is defined as the greater of 1 year or the remaining effective maturity in years.

After the bank determines the PD’s and LGD’s for all applicable exposures, these

combinations can be mapped into regulatory risk weights. The risk weights, which

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pressed as a continuous function. The minimum capital charge is then determined

by multiplying the risk weight by the amount expected to be outstanding at the

time of default (EAD), and by 8 percent.

A final step in this process involves the ongoing review by the supervisors of the

systems used to develop the IRB capital charge. Periodically, supervisors will need

to validate these systems and review the internal controls that provide the foundation for the IRB approach. In addition, supervisors will also have to consider, under

Pillar 2, whether the amount of capital generated by the IRB approach is commensurate with the bank’s risk profile.

Implementation of the IRB Approach

In addition to the requirement that a bank meet the qualifying or eligibility criteria, the new Accord requires that banks using the IRB approach run parallel

systems for 1 year before implementation. This means that a bank planning to implement the IRB approach in December 2006, will actually have to begin calculating

results as of December 2005, while continuing to run its current systems.

Adjustments to the Capital Charge for Credit Risk

There are additional considerations that banks may have to factor in when determining the capital charge for credit risk. These additional considerations will further adjust required capital, outside of the requirements of the different approaches

to credit risk. The two primary adjustments that might be made to the credit risk

charge are for credit risk mitigation and asset securitization.

Credit Risk Mitigation

The new Accord provides a measure of capital relief for certain qualifying riskmitigating techniques used by banks. However, it is important to note that most of

the credit risk mitigation proposals in the new Accord are only directly relevant to

the standardized or foundation IRB approaches, which are not likely to be used in

the United States. In the advanced IRB approach, credit risk mitigation must meet

certain qualitative requirements, such as legal certainty. In addition, specific proposals related to maturity mismatches and backtesting requirements of certain

model results are applicable to the Advanced IRB approach. Otherwise, it is assumed that any credit risk mitigation efforts will be factored into the PD’s and

LGD’s assigned by the bank.

With that caveat in mind, the section on credit risk mitigation in the new Accord

attempts to provide some rough approximations of the risk reduction attributable

to various forms of collateralized credit exposures, guarantees, credit derivatives, and on-balance sheet netting arrangements. The Committee has proposed a

conceptual approach to these risk mitigation techniques that, while recognizing

their risk reduction benefits, attempts to capture the additional risks posed by such

transactions.

The credit risk mitigation proposal provides both a simple and a comprehensive

approach to dealing with collateral. The proposal expands the range of eligible collateral from that recognized in Basel I. It also discusses the appropriate treatment

for maturity mismatches between the credit risk mitigant and the underlying credit

exposure. The proposal introduces ‘‘haircuts,’’ which the bank may estimate, to cover

the market price and foreign exchange volatility that may be inherent in collateral.

The proposal allows banks to greatly reduce the capital requirements for exposures

with large amounts of high quality collateral. There are strict quantitative and qualitative factors that must be met in order for a bank to be permitted to use its own

haircut estimates. The proposal encourages the use of credit risk mitigation by expanding the type of collateral, guarantors, and transaction structures that are recognized for capital reduction. Different types of credit risk mitigation techniques pose

different levels of additional risk; the proposal incorporates flexibility that recognizes these differences and adjusts the capital treatment accordingly.

Asset Securitization

Asset securitization is clearly an important issue in the United States, as the

securitization market is significantly greater than the securitization market of any

other Basel-member country. The Committee believes that it is important to construct a more comprehensive framework to better reflect the risks inherent in the

many forms of asset securitizations, including traditional and synthetic forms.

The securitization framework in the New Basel Accord applies generally when

there is a transaction that involves the stratification or tranching of credit risk. The

Committee has developed securitization approaches for both standardized and IRB

banks. The level of complexity is significantly higher for IRB banks. The framework

tries to focus on the economic substance of the transaction, rather than on its

legal form.

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Under the proposal for the treatment of securitizations by standardized banks, the

capital charge is generally determined by multiplying the amount of the securitization exposure by the risk weight mapped to the long- and short-term rating categories. Off-balance sheet exposures are subject to a conversion factor before the

appropriate risk weight is applied. The proposal does allow for some recognition of

credit risk mitigants provided on securitization exposures, but that recognition is

permitted only when the bank meets a series of stringent criteria.

Banks that adopt the IRB approach for credit risk are generally required to use

one of two methods for determining capital requirements for securitization exposures. One method is the Supervisory Formula Approach (SFA), under which capital

is calculated through the use of five bank-supplied inputs: The IRB capital charge

on the underlying securitized exposures (as if held directly on the bank’s balance

sheet); the tranche’s credit enhancement level and thickness; the pool’s effective

number of loans; and the pool’s exposure weighted average loss given default (LGD).

The second method is known as the Ratings-Based Approach (RBA). Under this approach, capital is determined by multiplying the amount of the exposure by the appropriate asset-backed security risk weights, which depend on external rating

grades, short- or long-term. Granularity of the pool and the level of seniority of the

position are also considered.

The securitization proposal is one of the newest pieces of the Accord and its potential impact on the industry is still being assessed. In the December 2002 QIS exercise, banks were asked for the first time to provide data on the relative impact of

the proposals. The QIS results did not provide entirely reliable results. However, the

Committee has responded to some of the concerns raised during the QIS process by

making changes to the securitization framework. One key change was the introduction of a simpler approach for liquidity facilities.

Operational Risk

One of the most significant changes in the new Accord is the proposal for an operational risk charge. It is expected to represent, on average, 10–15 percent of the

total minimum regulatory capital charge. The framework is based upon the following operational risk definition: The risk of loss resulting from inadequate or

failed internal processes, people, and systems or from external events. This includes

legal risk, but excludes strategic and reputational risks.

The Committee has proposed three approaches to calculate the operational risk

charge, which represent a continuum of increasing sophistication and risk sensitivity. The Basic Indicator Approach (BIA) is the simplest of the three approaches;

the capital charge is determined by taking an alpha factor decided by the Committee and multiplying it by an indicator, gross income. The next approach is known

as the Standardized Approach and is similar to the BIA, but breaks out gross income into business lines. The Committee has introduced an Alternative Standardized Approach to address some of the concerns raised by the results of the December

2002 QIS exercise; this is not a separate approach, but rather a modification to the

Standardized Approach. Because there is no compelling link between these measures and the level of operational risk, the United States does not plan to utilize the

BIA or the Standardized Approach (including the Alternative Standardized Approach) to determine the capital charge for operational risk.

The Committee has made the most significant changes to the advanced approach

since it was originally introduced in January 2001. At that time, the Committee envisaged a single, very prescriptive advanced approach for operational risk, similar

to credit risk. However, after numerous comments from the industry, the Committee

made substantive changes in the proposal to reflect the evolutionary nature of the

operational risk framework. The Committee recognized that, unlike credit risk,

there are very little data and no internal systems specifically designed to target

operational risk; instead, banks and supervisors rely primarily on internal controls

to deal with a myriad of banking risks that cannot be as readily quantified as credit

and market risks.

The Committee considered the comments and analyzed the state of the art of

operational risk and developed what is known as the Advanced Measurement Approaches (AMA). Rather than prescribing one methodology, the AMA will allow

banks the option of designing the operational risk measurement framework that

best suits their institution, subject to some broad criteria. The criteria will be the

key to achieving a certain level of consistency and comparability among institutions,

as well as providing a margin of comfort to supervisors who must assess these differing systems. The criteria currently identified in the new Accord include the need

for internal and external data, scenario analysis, and consideration of business environment and internal control factors. Banks may also, under the AMA, consider the

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impact of risk mitigation (such as insurance), again subject to certain criteria set

to ensure that the risk mitigants act as an effective capital-replacement tool.

Temporary Capital Floors

Two floors that have been established for the Basel II framework. In the first year

of implementation, an institution’s required minimum level of regulatory risk-based

capital cannot be less than 90 percent of the minimum level of capital that would

be required under the Agencies’ general risk-based capital rules. In the following

year, an institution’s minimum level of regulatory risk-based capital cannot be less

than 80 percent of the minimum amount required under the Agencies’ general riskbased capital rules.

—————

PREPARED STATEMENT OF DONALD E. POWELL

CHAIRMAN, FEDERAL DEPOSIT INSURANCE CORPORATION

JUNE 18, 2003

Thank you, Mr. Chairman and Members of the Committee. I welcome the opportunity to testify on behalf of the Federal Deposit Insurance Corporation on the New

Basel Capital Accord (Basel II). The proposals contained in the Third Consultative

Paper (CP–3) recently published by the Basel Committee on Banking Supervision,

if adopted in the United States, would easily rank among the most important pieces

of banking regulation in our Nation’s history.

Introduction

Basel II would change bank capital regulation in the United States in at least

three important ways. First, rather than emphasizing simple preset minimum numerical capital ratios, Basel II would allow qualifying banks to use their own internal risk estimates as inputs to regulator-supplied formulas with the supervisors

providing oversight and evaluation of the banks’ ability to measure risk. Second, the

new framework would formally adopt a ‘‘bifurcated’’ capital system in the United

States: One set of rules for the large, complex, and internationally active institutions, and another set for the balance of banks in the country. A third key change

is that the total minimum regulatory capital charge under the new framework will

include an explicit charge for operational risk. For those large institutions that qualify, the new framework may lead to reduced credit risk capital requirements for

certain asset classes with additional capital held based on a flexible operational

risk charge.

The FDIC supports the overall goal of Basel II, which is to create regulatory capital standards that are more sensitive to the economic substance of risks taken by

these large banks, to limit their opportunities for regulatory capital arbitrage and

to encourage sound risk management.

Over the years that Basel II has been under development, the Basel Committee

and the U.S. Federal supervisors have reached out to the industry and the public

for comment on how to more closely align the proposed new framework with the

ways that large banks measure risk. There have been quantitative impact studies

to assess the potential impact on capital levels. We have been engaged in

roundtables and discussions. Over this time, various aspects of the new framework

have been refined and changed. Today, these refinements are reflected in CP–3,

which the Basel Committee recently released for additional comment.

The work in this country continues. The agencies intend to issue an Advance Notice of Proposed Rulemaking (ANPR) that will suggest how CP–3 will be proposed

for adoption in the United States and will seek additional comments on all facets

of Basel II. As in the past, it can be anticipated that further changes to the framework may be required. The FDIC is committed to an interagency process to achieve

the overall goals of Basel II and to fully understand its possible impact on bank capital levels and competitiveness.

The goal of more closely tying regulatory capital to banks’ own internal assessment of risk is a good one. This goal is reached in part by using regulatory capital

formulas that are based on ways of measuring credit risk and allocating internal

capital that, to some degree, are already in place in large banks. The term ‘‘economic capital’’ is often used to refer to the amount of capital that should be allocated to an activity according to the results of a numerical loss analysis. Banks use

models based on historical data and economic analysis to estimate future losses and

the amount of income, reserves, and capital needed to ensure their portfolios conform to management’s target level of risk.

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These calculations produce different results for different bank activities. For example, the measured risk on residential mortgages might be much less than the

measured risk on construction loans. The bank might use the economic capital

measures to compute its risk-adjusted returns on the two activities and to assist its

pricing decisions. This is a disciplined approach to risk management, and Basel II

establishes firm expectations for banks to be rigorous in this respect. Basel II expands these risk management expectations beyond the area of credit risk and into

the realm of operational risk.

Tying capital requirements closer to risk and increasing the incentives for disciplined risk management have the potential to improve the safety and soundness

of the U.S. financial system. The FDIC supports enhancing the incentives for the

largest banks in the United States to strengthen risk management processes. Tying

regulatory capital closer to risk would reduce the incentives for banks to make uneconomic decisions designed to reduce regulatory capital.

At the same time, the domestic impact of Basel II has not been determined. Given

current analysis, it seems likely Basel II will confer some degree of regulatory capital benefits on the limited number of banks that qualify, in exchange for their

substantial investments in systems and infrastructure intended to improve risk

management. The critical issue for the safety and soundness of our financial system

is whether the improvements in risk management systems, and the resulting bank

risk profiles, would justify the level of capital reductions that banks might ultimately realize.

It is virtually impossible to quantify at this time the potential changes in capital

under Basel II. Basel II proposes floors by which risk-based capital would be allowed to decline by at most 10 percent the first year of implementation, and at most

20 percent the second year. After the second year, Basel II does not impose a floor

on the minimum risk-based capital requirement. A quantitative study conducted in

the fall of 2002 showed a wide range of changes in capital requirements for 19 large

U.S. banks under the Advanced Internal Ratings-Based (A–IRB) approach, with an

average reduction in capital requirements for credit risk of 17 percent. In this study,

the reduction in capital was offset by the operational risk capital charge, which was

substantial. However, the amount of this operational risk charge was by necessity

estimated using an approach that will not be used in the United States.

The agencies understand that the results to date of the impact studies do not provide a full picture of the possible impact of Basel II. There are many moving parts

to the proposal and the banks’ participation in the study was on a best efforts basis.

Moreover, in the United States, leverage ratio floors and the demands of the marketplace would act as a constraint on the potential reduction in actual capital.

Still, these initial estimated results show that the Basel II formulas are potent

instruments for affecting risk-based capital requirements in the United States. This

is a matter of great interest to the FDIC and we are committed to working with

the other banking agencies as we move forward to more accurately assess the impact of the proposed new standards.

A significant business challenge for the banking and thrift agencies would be how

to achieve interagency consistency in the application of these complex rules. Required capital charges will depend heavily on the ongoing judgments of banks and

regulators about a variety of specific risks.

In addition to understanding the impact of Basel II on capital levels, we must also

understand the significance of mandating two tiers of regulatory capital standards—

a bifurcated framework that will offer competitors different regulatory capital

charges for similar assets. The critical issues in terms of the competitive playing

field are whether the direct competitors of a core group of about 10 large banks

would feel forced to opt in to the new framework for competitive reasons, and

whether banks in the tier below those able to opt in would be at substantial competitive risk.

To resolve these fundamental issues satisfactorily, much hard work remains.

Given the magnitude of the issues, we must proceed carefully.

Capital Adequacy

The U.S. banking system has weathered the last 10 years better than the banking

systems of some other countries for a number of reasons. One significant reason

is strong capital levels. Bank capital is subject to Federal legislation and regulation

because of its critical importance to the health and well-being of the U.S. financial

system. An adequate capital cushion enhances banks’ financial flexibility and their

ability to withstand periods of adversity. As insurer, the FDIC has a vital stake in

the adequacy of bank capital—as do our fellow regulators and all U.S. taxpayers.

Congress recognized this important principle when it established the Prompt Corrective Action (PCA) requirements in the Federal Deposit Insurance Corporation ImVerDate 11-MAY-2000 10:04 Jul 07, 2004 Jkt 000000 PO 00000 Frm 00088 Fmt 6621 Sfmt 6621 94514.TXT BANK1 PsN: BANK1
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provement Act. A critical aspect of the existing PCA regulations is the minimum

leverage capital requirement. To be considered well-capitalized, a bank must have

a ratio of Tier 1 capital-to-total assets (the leverage ratio) of at least 5 percent.

Banks with leverage ratios under 4 percent are considered undercapitalized. The

agencies agree that maintaining the minimum regulatory capital standards as

reflected in the current PCA legislation and existing implementing regulations is

very important.

Capital is not the only thing needed for safety-and-soundness. The strong risk

management that Basel II promotes is also essential. There is no denying that

banks with good risk management and a lower-risk profile should be able to operate

with somewhat less capital than more risky banks. But there is also no denying that

when the unexpected happens, the hard-earned benefits of risk management can

evaporate overnight without adequate capital.

The sophistication of the measurement of economic capital can make it easy to

lose sight of the fact that, in reality, no one knows the range of potential future

losses for a given activity, or the associated probabilities. Certain risk management

practitioners express great faith in the calculation of economic capital, and believe

that the regulatory capital standard should in all instances be less than the economic capital amount. The idea behind this philosophy is that banks tend to be

forced out of low-risk activities where regulatory capital requirements exceed economic capital requirements. It is this belief that gives us concern about a clash of

expectations about Basel II between a number of prominent risk management practitioners on the one hand, and the FDIC and our fellow bank regulatory agencies

on the other.

As the regulators move forward to finalize our views on Basel II, we need to proceed cautiously. Where a proposal seems to run counter to established U.S. supervisory practice, we need to ask whether the established practice should be reexamined in light of the proposed new rules, or whether the new rules need to be reexamined for U.S. purposes.

Basel II is the object of intense scrutiny and comment. Changes have been and

will be suggested by banks in many areas, including the treatment of commercial

real estate, credit cards (and the related issue of future margin income), mortgages,

securitizations, and capital recognition of certain risk-mitigating activities. The potential for many moving parts could make it difficult to evaluate the capital impact

or the competitive impact of Basel II. Yet, we believe that we must achieve a better

understanding of these issues before the bank regulatory agencies commit the

United States to the new framework.

Interagency Consistency

Basel II would provide banks and supervisors some flexibility to determine what

capital would be held on an ongoing basis. The degree of conservatism to apply to

a particular situation would often be a judgment call. Is the loss given default on

a secured commercial loan likely to be 20 percent or 40 percent? Capital for that

loan would double, or be cut in half, depending on the answer—and the answer

could well depend on a mix of historical data, the specific underwriting methods

used by individual banks and the specific analytical techniques banks use to make

their case. Supervisors would need to validate—uniformly and consistently across

banks—the answers to such questions. In this new framework, regulators must be

prepared to challenge the modeled outputs of sophisticated risk measurement systems of the largest U.S. financial institutions, a difficult and demanding task. It will

require courage and discipline to respond to this new challenge.

Much progress has been made by the regulators and the industry in deciding how

this validation might be done. Interagency guidelines are being drafted and implementation approaches are being discussed. The FDIC has an active interest in the

development of a sound approach to ensure the consistent and uniform review of

bank risk measurement systems under Basel II.

A Level Playing Field

Capitalism, with its inevitable winners and losers, is about competition. It is the

job of the regulators to make certain that the competition is fair. In our capitalist

system, one of the key functions of regulation is to ensure the rules do not display

favoritism and that the competitive struggle is carried out on equal terms. We need

to evaluate Basel II against this standard before committing to implement it in the

United States.

The proposed agreement raises several very important questions. The fundamental question is what are the economic benefits of the regulatory capital relief

some banks might realize under Basel II? Conversely, what are the costs of additional capital they might be required to hold for certain activities? Would small or

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mid-sized regional banks, unable to qualify for the new framework, become acquisition targets of Basel II banks whose reduced capital has boosted their returns on

equity? Would a large credit card bank that must hold capital for unused credit card

lines be at a disadvantage to a non-Basel bank that faces no such requirements?

Would a securitizing regional bank that is forced to deduct most of its retained interests from capital be at a disadvantage to a Basel bank whose deductions from

capital would now be capped? What would be the ramifications of significantly reduced capital requirements for Basel banks on specific assets held by banks of all

sizes, such as mortgage-backed securities issued by the Federal Government sponsored enterprises?

The Basel II formulas are designed to work for large diversified portfolios, and

the capital requirements they produce might be too low for most small banks. The

Basel framework also requires significant systems investments at a level likely beyond the reach of—and not essential for—small institutions. Therefore, it is not

practical to think that any competitive concerns that may exist could be resolved

simply by allowing all banks access to the Basel framework.

To a large extent, the banking system in the United States is already a two-tier

system, with large financial institutions possessing the vast majority of U.S. bank

assets. Still, we must evaluate thoroughly whether Basel II will unnecessarily disturb this current, albeit divided, field of competition. Even though the industry may

already be divided between the large and complex and the small and less complex,

banking supervisors must understand fully whether Basel II adds significant additional competitive pressures or would trigger additional industry consolidation. The

ANPR will seek input from all interested parties, including banks that believe they

will be competitively harmed if they cannot embrace the Basel II framework.

Conclusion

An Advance Notice of Proposed Rulemaking will be issued this summer and will

reflect the United States banking and thrift agencies’ views on how Basel II would

be adopted in the United States. More importantly, it will present issues and concerns, and raise questions to the industry and the public. The comments will provide invaluable insight to many of the key concerns being raised by the agencies

and by Congress.

Given the importance of these issues, it is vital that we treat the implementation

of Basel II in the United States as we would any other proposed regulation—with

a dose of skepticism, a willingness to entertain the discussion of options, and a commitment to fully explore potential costs and benefits before reaching a final decision.

We need to listen carefully to comments that will be received in the rulemaking

process to ensure we address these threshold issues.

It also is important that the financial services industry, the Congress, and the

banking agencies have a full opportunity to review the response to the ANPR and

achieve a better understanding of the impact of this proposed agreement before we

commit the United States to the Basel II approach. The FDIC has no interest in

delaying the agreement and its implementation beyond what is necessary to address

the issues we have raised and to understand the impact of this new system of capital regulation.

I have full confidence that this interagency process will work and will arrive at

an appropriate outcome. The FDIC will continue to remain fully involved in this

process and will work to ensure that the goals of Basel II and of Congress are being

met as the process moves forward.

Thank you for the opportunity to present the views of the FDIC.

—————

PREPARED STATEMENT OF JAMES E. GILLERAN

DIRECTOR, OFFICE OF THRIFT SUPERVISION

JUNE 18, 2003

Introduction

Good morning, Chairman Shelby, Senator Sarbanes, and Members of the Committee. Thank you for the opportunity to discuss the proposed revisions to the 1988

Capital Accord (Basel I) developed by the Basel Committee on Banking Supervision

(BSC). Although the Office of Thrift Supervision (OTS) has been involved in the

Basel process for some time, we have only recently attempted to engage ourselves

in the process internationally. While we are very supportive of the Basel process,

there are numerous policy implications involved in the recently proposed international capital standards for banking organizations in the United States. These inVerDate 11-MAY-2000 10:04 Jul 07, 2004 Jkt 000000 PO 00000 Frm 00090 Fmt 6621 Sfmt 6621 94514.TXT BANK1 PsN: BANK1
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clude issues that we all must strive to understand and address. I welcome your

efforts to highlight these pending and important changes.

The proposed change in capital standards currently under consideration arises

from a third consultative paper, CP–3, recently issued for public comment by

the BSC. CP–3 is expected to result in the New Basel Capital Accord, or Basel II.

Basel II will directly affect the largest and most internationally active banking

organizations around the world, including approximately 10 banking organizations

in the United States. Basel II may also significantly impact, albeit indirectly, all

other banking organizations around the world, including roughly 9,500 institutions in the United States. These institutions include large, medium, and small

banks and thrifts that operate nationally, regionally, and at the community level,

many of which compete domestically with our largest internationally active banking

organizations.

Development of Basel II

Basel I, signed in 1988, addressed only the largest, internationally active banks

in G–10 countries and encouraged countries outside the G–10 to adopt the framework for their banks that were operating internationally. The underlying principles

of Basel I, however, were intended to apply to all banking organizations of any size

and activity. Thus, while OTS did not sign Basel I, we applied it along with the

other Federal banking agencies. Since Basel I, the four banking agencies have developed risk-based capital standards consistent with its underlying principles, but with

modifications intended to enhance risk sensitivity.

In connection with our involvement and experience with Basel I, OTS has been

monitoring for many years the work leading up to Basel II. Because of the potential

impact of Basel II on the institutions we regulate, we stepped up our involvement

in the Basel process. In anticipation of the domestic application of Basel II, OTS

is participating fully in preparation of an interagency Advanced Notice of Proposed

Rulemaking (ANPR), with accompanying supervisory guidance, to be published in

the Federal Register in the near future. The initiative will trigger the official kickoff of the national debate on the subject of new international capital standards, but,

as you are aware, many of the issues raised by Basel II have already attracted significant attention. While OTS has not been directly involved in the international deliberations to date, our role on the domestic front—particularly in the mortgage

markets—provides us a unique and useful perspective for this discussion.

In Basel I, the BSC identified two fundamental objectives at the heart of its work

on regulatory convergence. As the Committee stated, first, ‘‘the new framework

should serve to strengthen the soundness and stability of the international banking

system; and [second,] the framework should be fair and have a high degree of consistency in its application to banks in different countries with a view to diminishing

an existing source of competitive inequality among international banks.’’ Although

the BSC developed a far more detailed and risk-sensitive capital adequacy framework in Basel II than in the original Accord, it does not stray from the objectives

set 15 years earlier. In fact, the BSC expanded upon these objectives as a guide to

its efforts in producing the current proposal. In particular, the Committee observed

that Basel II should:

• Continue to promote safety and soundness and at least maintain the current overall level of capital in the system. • Continue to enhance competitive equality. • Establish a more comprehensive approach to address risk. • Contain approaches to capital adequacy that are appropriately sensitive to risk. • Focus on internationally active banks, although its underlying principles should

be suitable for application to all banking organizations.

While the objectives for Basel II set forth by the BSC are important to ensure

consistency and competitiveness among internationally active banking organizations, the impact of the proposed changes may affect many other banking entities

domestically. It is important to encourage a thorough discussion among the regulators, Congress, and the thousands of banking organizations in the United States

that may be affected, directly or indirectly, by Basel II. Hearings such as this and

the upcoming ANPR will help stimulate this debate.

Overview of Basel II

Basel II contains three ‘‘pillars’’ that are intended to be mutually reinforcing. Pillar 1 is a minimum regulatory capital requirement; Pillar 2 addresses supervisory

review; and Pillar 3 is intended to promote risk and capital transparency. Briefly,

a description of these is as follows:

• Pillar 1 includes a credit risk component that is measured by either a standardized approach or one of two internal ratings-based approaches. The two ratingsVerDate 11-MAY-2000 10:04 Jul 07, 2004 Jkt 000000 PO 00000 Frm 00091 Fmt 6621 Sfmt 6621 94514.TXT BANK1 PsN: BANK1
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1Statement of Paul G. Merski, Chief Economist and Director of Federal Tax Policy, Independent Community Bankers of America, before the House Small Business Committee, March

1, 2002.

based approaches or models are the Advanced Internal Ratings-Based (A–IRB)

approach and the ‘‘Foundation’’ approach. Pillar 1 also includes an operational

risk component that has several optional approaches. The centerpiece of the operational risk component of Pillar 1 also permits use of an internal model, the Advanced Measurement Approach (AMA).

• Pillar 2 is viewed by the BSC as a way for the banking supervisors to attain better overall risk management and internal controls at the banking organizations

we regulate.

• Pillar 3 includes a wide range of disclosure initiatives designed to make the risk

and capital positions of banking organizations more transparent.

Issues for Consideration

As I noted at the outset, OTS has only recently sought to be involved internationally in the Basel process. While we are supportive of this process and encouraged

by the work completed so far, both domestically and internationally, there are a

number of issues that we have considered regarding the application of Basel II in

the United States. In the following discussion, I highlight some of these issues.

Competitive Equality

Regardless of how we strive to explain Basel II, the extraordinary technical detail

at its core is substantial. Our banking organizations will need to master the complexity of Basel II to provide effective feedback during the upcoming ANPR comment process on the balance of its burdens and benefits. As we proceed, we need

their input to weigh changes to our existing capital rules, and to assure ourselves

that our actions do not significantly alter the competitive landscape for all U.S.

banking entities. We want to assure that U.S. banking organizations remain

healthy, competitive, and well-capitalized.

The key principle underlying Basel II, and the basis for the advancement from

Basel I, is greater risk sensitivity. This principle has as much meaning for a small

community banking organization as it does for a large internationally active institution. The challenge lies in how to address this issue simultaneously for both types

of banking organizations, especially considering that under the proposed scope of application in the United States, all but the few largest banking organizations will not

be ‘‘Basel II banks.’’ A significant issue in this debate is whether we maintain consistent capital standards for all banking organizations for lending activities that

have the same risk characteristics.

From our standpoint, maintaining competitive equality for community banks is

important, particularly as our economy is showing encouraging signs of improvement. Community banking organizations play a significant role in small business

lending, which feeds new job creation. ‘‘Community banks are one of the key sources

of credit and other financial services to small businesses—the most prolific job creating sector of our economy. Small businesses employ 60 percent of the Nation’s

workforce and have created two-thirds of all the net new jobs since 1970.’’ 1

Another aspect of this issue that we must consider is the extent to which we alter

our existing capital rules, applicable to all banks, to accommodate changes proposed

by Basel II. For example, under Basel I, the blunt-edged risk-based capital requirement for 1–4 family residential mortgages (a 50 percent risk-weight, or 4 percent

capital requirement) is not commensurate with the historical risk associated with

residential mortgage lending in the United States. For residential mortgage loans

with relatively low loan-to-value ratios, a substantially lower risk—weight is more

reflective of loss experience. By contrast, the Federal banking agencies have concluded that for some concentrations of subprime loans, a significantly higher risk

weight than 100 percent—and therefore, a capital requirement higher than 8 percent might be more appropriate. While Basel II is intended to enhance the risk sensitivity of our capital rules, it is important that the proposed changes are truly

reflective of actual risk, as measured over an appropriate historical timeframe.

Supervisory Effectiveness

Another important issue is the potential impact of Basel II on our supervisory effectiveness. The U.S. bank regulatory system is considered to be among the most

comprehensive and admired in the world. Capital requirements are only part of our

multifaceted supervisory response to ensure safety and soundness. Our supervisory

system is grounded in a regular program of on-site examinations complemented by

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comprehensive and frequent reporting and off-site monitoring—a level of supervisory review that may be unparalleled.

As we move forward with a relatively dramatic approach that places a tremendous emphasis on capital, we must be careful not to minimize or diminish the other

supervisory tools and regulatory judgment that is integral to our supervisory system. In particular, we should focus on how Basel II fits within and improves our

system, and how to strike the right balance between capital rules and effective supervisory oversight. In the end, sound regulatory judgment is the key to our supervisory effectiveness and cannot be compromised.

Accountability in a Ratings-Based Capital Model

A corollary to this issue is the role of examiners and our examination process in

evaluating ratings-based models dictated in a Basel II supervisory world. The application of Basel II in the United States will include complex mathematical formulas

and models used to measure regulatory capital levels for our largest financial institutions. While prior regulatory approval is required to use the models, once obtained, an institution would effectively set its own capital requirements. This would

be based largely on inputs derived from credit assessments from the institution’s

own credit risk and operational risk models.

The accuracy and consistency of ratings is extremely important in any ratingsbased system. Numerous subjective decisions are made daily by bank personnel regarding model inputs. These inputs involve judgments made on items such as rating

a loan’s probability of default, an estimate of loss given default, and the probability

of a major loss arising from an institution’s operational risk. It is important to keep

in mind that these are human inputs, and are not infallible. Of particular concern

is how to account for the subjectivity of the ‘‘human factor’’ as we implement and

apply Basel II.

Equally important is that we take the steps necessary to support and train our

examiners who will be expected to review the many subjective decisions made

under, and evaluate the mathematical models of, Basel II. We must also consider

how the Basel II models and mathematical formulas reconcile with our existing

rules, such as with our asset risk classification and prompt corrective action rules.

This includes whether any of our existing rules, in addition to risk-based capital,

would have to be changed to accommodate Basel II.

Operational Risk

Another important issue is the operational risk capital charge in Basel II. The

concerns include the difficulty of trying to measure something that cannot be readily

modeled. Currently, the ability to measure and quantify operational risk is less advanced than the measurement and quantification of credit risk. In addition, the

boundaries between credit risk and operational risk are not always clear. Another

question is whether operational risk should receive a more qualitative Pillar 2 supervisory review as opposed to the quantitative Pillar 1 approach proposed in Basel

II. This question is significant because assessment of operational risk inherently involves human judgment, which lies more squarely within Pillar 2.

There are also questions about the availability of good data to measure operational risk. Under the AMA model of Pillar 1, the most sophisticated institutions

would use available external data to measure risk and compute their own capital

charge. While data may be readily available for ordinary risk events that can be

budgeted, truly high-risk loss events occur infrequently. We must consider how to

proceed where there is a lack of readily available data for precisely the type of

risk for which capital may be most relevant to a particular institution or group of

institutions.

We will also want to consider the positive effect that an institution’s internal systems and controls have on operational risk exposure. In computing their operational

risk capital charge, it is important to understand whether and how different institutions would allocate capital appropriately for weaknesses in their internal systems

and controls, as well as the disincentives in doing so. This is important to ensure

both consistency and accuracy in the operational risk capital charge.

Conclusion

Thank you, Chairman Shelby, Senator Sarbanes, and Members of the Committee

for the opportunity to testify on Basel II. As you are aware, Basel II raises very

significant issues not only for our very largest banking organizations, but potentially

for all our insured institutions. I urge all of the Members of the Committee to remain involved in this process going forward.

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1 Headquartered in Philadelphia, RMA has 3,000 institutional members that include banks of

all sizes as well as nonbank institutions. They are represented in the Association by 16,000 commercial loan, credit, and risk management professionals in the 50 States, Puerto Rico, Canada,

and numerous foreign cities, including Hong Kong, Singapore, and London. RMA was founded

in 1914 and formerly known as Robert Morris Associates. 2 All of RMA’s research and our formal responses to the Consultatives Papers issued by the

Basel Committee are available on our Web site at www.rmahq.org. RMA’s Securities Lending

Committee has also responded to the proposed treatment of securities lending activities, and the

work of that Committee is available to the public on our Web site as well. Institutions participating in the research are listed on the Web site and may hold views different from those expressed in this testimony.

PREPARED STATEMENT OF MAURICE H. HARTIGAN, II

PRESIDENT AND CEO

RMA—THE RISK MANAGEMENT ASSOCIATION

JUNE 18, 2003

Good morning, Mr. Chairman and Members of the Committee. Thank you for inviting me to appear before the Committee to discuss the important work under way

to reform the 1988 Capital Accord, sometimes known as the Basel Accord. My name

is Maurice Hartigan and I am the President and CEO of RMA—the Risk Management Association. RMA is a member-driven professional association whose sole purpose is to advance the use of sound risk principles in the financial services industry.

RMA promotes an enterprise-wide approach to risk management that focuses on

credit risk, market risk, and operational risk.1

RMA has been actively involved in the reform of the 1988 Accord. In 1999, we

formed the RMA Capital Working Group, consisting of the chief economic capital officers of major banking institutions in North America. Our group conducted research

to demonstrate how banks use their internal risk rating systems to assign economic

capital. The RMA Capital Working Group has produced a substantial body of research, and has commented extensively on different drafts of the new Accord. It is

currently formulating comments to the most recent Basel Committee Draft, the

third consultative paper. This group also plans to comment on the forthcoming

interagency advanced notice of proposed rulemaking that will deal with the U.S. implementation of the new Accord.

The main point I want to make to you today is that the New Basel Accord will

be a step forward for the U.S. and world banking industries, provided it is modified

as it is being finalized and provided it is implemented flexibly. It will be a step forward because it is directionally correct in improving the risk sensitivity of regulatory minimum capital adequacy standards. But it must be modified to ensure that

it is not too conservative—that these are truly minimum and not maximum capital

standards—and to ensure that it is not too prescriptive.

The purpose of the New Basel Accord is to make capital regulation truly risk sensitive. The 1988 Accord was called the Risk-Based Capital Accord, but it was that

in name only. The new accord is designed to be much more risk sensitive. It will

require additional capital for activities that are more risky and less capital for those

that are not. The 1988 Accord relied solely on a regulatory minimum capital standard. In contrast, the new accord will be grounded on three principles or ‘‘pillars’’ as

they are called: (1) Capital requirements, (2) enhanced supervision, and (3) greater

disclosure. This alone represents a significant improvement.

Nonetheless, we have specific concerns in this area. Pillar 1, which deals with the

capital standard itself, must contain assurances that Basel will evolve toward a full

models-based approach for credit risk, and it must avoid arbitrary specificity. Pillar

2, which deals with the implementation of the standard through the process of supervision, must allow regulators enough discretion to accommodate the diversity of

best practices in risk management today. Pillar 3, which requires increased disclosure in order to provide greater market discipline, must ensure that comparability

is meaningful across the varying international accounting regimes.

Our research to date suggests that the new accord, as proposed in the third consultative paper, will require more overall capital than many banks’ internal risk rating systems require today, even though for some banks and some portfolios, the new

overall requirement will be somewhat less than under the old accord.2 This will

often be inappropriate.

The new accord should represent a true minimum capital requirement. For well

run banks in normal times this implies that regulatory capital levels should be set

below a bank’s economic capital based on best-practice internal risk measurement

procedures.

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RMA and many others within the industry have long argued that regulatory capital requirements should be more closely aligned with an institution’s own internal

risk rating systems. Best-practice institutions today assign internal capital to their

portfolios and measure performance on a risk-adjusted basis. Doing so enables them

to better price for risk and maximize shareholder value. Thus, good business practices are consistent with the economic capital principles underlying the proposed

new accord.

The old Capital Accord requires best-practice institutions to maintain two completely separate capital regimes: An internal system that mirrors their true risk

profile, and a regulatory capital system that is a simple, flat capital charge. Advanced-practice institutions do not manage risk based on the current regulatory capital requirements. It would not be in their shareholders’ or their customers’ best

interests to do so. This fact has certainly not gone unnoticed by the regulators. Indeed, that is why reform of the 1988 Accord is under way.

For best-practice institutions, the possibility to align internal capital estimation

processes and regulatory capital procedures represents a significant and meaningful

improvement over the current system. Turning this promising possibility into reality

is not an easy task, however. And that is why we are here before you today for a

review of the New Basel Accord.

The process to reform the 1988 Capital Accord has had a positive impact on the

development of risk measurement and management procedures in the financial

services industry. Moreover, the dialog between the industry and its regulators surrounding Basel reform, while not without frustration on both sides, has been useful

and productive. While outstanding issues clearly remain, some quite significant,

continued discussion with the industry is ongoing, and I would expect that to be the

case throughout the reform process and into the implementation stage as well. Indeed, it may not be possible to resolve a number of specific issues without an active

two-way dialog between regulators and the industry as the implementation process

takes place.

Further discussion can only help promote innovation and investment in best practices throughout the industry. It is for this reason that the reform process must

continue. However, it must be framed as a work in progress. There cannot be a prescribed ‘‘end state’’ for sound risk management practices. Otherwise, the ink on the

new accord would not be dry before it became obsolete. This is much like the 1988

Capital Accord.

The quantitative analytics supporting sound credit risk measurement and management are still evolving. Many of these emerging practices were born out of the

last economic downturn. The resilience of the financial services industry over the

past 3 years should not go without comment. Many have credited the industry’s success to the better risk management practices established over the past decade. I

would have to agree.

One way to look at the new accord is that it is aimed at bringing capital adequacy

standards for credit and operational risk closer to those for market risk. For some

time, market risk has had a well-established language among practitioners, strong

analytics, and a robust disclosure framework to support it. It is for this reason that

amendments to the 1988 Capital Accord were adopted in 1995 to acknowledge the

industry’s advancement in the field.

Credit and operational risk management are still evolving to catch up with market risk management. The practice of credit risk measurement and management

will no doubt benefit greatly over the next 2 years as new data become available

to populate quantitative credit risk modeling systems. Operational risk measurement is a younger field, and it is making strides on the back of our achievements

in credit and market risk.

Given the newness of the fields of study surrounding credit and operational risk

management, it is natural that regulators should be prone to conservatism. But too

much capital is just as bad as too little capital. Too much capital will drive down

the risk-adjusted rates of return on a particular business line and cause bankers

to lend less than they otherwise would and should. This is not a good thing for the

shareholders of the bank, the loan customers of the bank, or the general economy.

Furthermore, in our own review of Basel II, we find that some of the new requirements are written in a very prescriptive fashion that does not lend itself to allowing

individual banks to employ a diversity of best practices. Without such diversity we

cannot have continued evolution of best practices, and without evolution we could

not have had the improvements in risk measurement that have occurred over the

past decade.

I would now like to touch on two areas, which are somewhat more technical in

nature, about which we have great concern at present. Foremost is the adoption by

Basel of the same credit risk model as used by advanced banks. A key parameter

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of these models—the degree to which loan losses are correlated—is set by Basel, not

by the empirical research of best-practice banks. In some cases, such as certain retail loan products, this critical parameter has been set too high by Basel, causing

the regulatory capital minimums to be too high. This is why RMA has consistently

stated in all our papers to the Basel Committee that, ‘‘we believe strongly that the

Internal Ratings-Based (IRB) approach must be followed with a full internal models

approach to capital.’’

Second, RMA also has repeatedly argued that the Basel definition of capital

should be changed to conform to the definition used by the industry. Indeed, Basel

II will run into problems to the extent that the Basel view of capital differs substantially from the view of economic capital held by the industry. In the industry view,

economic capital is required only for unexpected loss (known as UL). The Basel

Committee has proposed that both UL and expected loss (known as EL) be included

in bank capital. RMA disagrees. For purposes of estimating economic capital and

capital adequacy, EL is covered by earnings (spread and fees, net of expenses), and

we believe that it is double counting to include expected losses in capital. Indeed,

if EL is included in bank regulatory capital, it will clearly disadvantage banks with

their nonbank competitors.

RMA has additional technical concerns specific to the Third Consultative Paper

that we will address in our formal response.

To conclude, I would like to reiterate RMA’s belief that the reform process has

helped advance the practice of sound risk measurement and management within the

industry. RMA is hopeful that the New Capital Accord can be structured to encourage and enhance continued industry innovation and that it will recognize the benefit

that diversity of practice within the industry provides.

Much good work has been done in conjunction with the new accord. It has helped

foster valuable research that has contributed to industry innovation. It has also focused the industry and its regulators on the need for additional research. Data limitations remain in a number of key areas, and this is likely to be the case for some

time. Again, this only reinforces the fact that development of the new accord must

be an ongoing process.

Regulatory capital standards must evolve over time as practices within the industry evolve. Otherwise, the industry and its regulators will continue to face the same

limitations embedded in the current accord.

The only way for this goal to be achieved is to allow for the development, over

time, of a full Internal Models-Based approach to bank capital. The proposals contained within the third consultative paper, subject to the specific concerns we will

be addressing shortly, can represent a necessary start to this process. Thank you,

and I would be happy to answer any questions that you might have.

—————

PREPARED STATEMENT OF MICAH S. GREEN

PRESIDENT, THE BOND MARKET ASSOCIATION

JUNE 18, 2003

On the Basel II Capital Accord

The Bond Market Association is grateful for the opportunity to testify on the

Basel Committee on Banking Supervision’s proposed New Capital Accords, or Basel

II. The Bond Market Association represents securities firms and banks that underwrite, distribute and trade debt securities domestically and internationally. Association member firms account for in excess of 95 percent of all primary issuance and

secondary market activity in the U.S. debt capital markets. Through our affiliate

American and European Securitization Forums, we represent a majority of the participants in the growing securitization markets in the United States and Europe.

The following comments focus on only those issues related to Basel II that are most

important to our membership.

TBMA Supports the Goals of Basel II

The Association supports the Basel Committee’s overall goal of rationalizing the

current risk-based capital regime, and aligning regulatory capital requirements

more closely with actual credit risk. This goal is critically important to the global

financial market, in which capital flows are increasingly mobile and interdependent.

Also, we are grateful to the Federal Reserve Board and other U.S. bank regulatory

agencies for working with us to address the issues presented by the proposed capital

accord revisions that affect the domestic bond market. While some of our concerns

expressed previously were addressed in the Basel Committee’s third consultative

paper (CP–3) on Basel II, critical issues still remain.

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The Basel Committee has an important role in promoting a prudential but efficient allocation of capital throughout the banking system. An updated regulatory

capital regime can produce significant benefits, including the promotion of fair global competition, the creation of incentives for better internal risk management, and

an economically efficient allocation of capital to its most productive uses.

Although we support the direction and goals embodied in Basel II, the revised Accord should not be viewed as the last word on regulatory capital. In attempting to

promulgate a universal rules-based system that applies the same basic capital requirements to all regulated financial institutions, Basel II—like its predecessor—is

overly rigid and prescriptive in certain critical respects. However, no such ‘‘one-sizefits-all’’ regulatory capital regime can fully accommodate the unique needs of these

diverse institutions, or flexibly respond to rapid changes in the financial markets

in which they operate, without suffering from this basic limitation. To overcome this

deficiency, the global financial community will need to move toward a broader reliance on internal risk models, with supervisory review and approval, to determine

appropriate regulatory capital levels, and we encourage financial market regulators

to continue moving in this direction.

In the meantime, our comments focus on aspects of the proposed Accord that we

believe will, at least in the short-term, facilitate the goal of aligning regulatory capital requirements more closely with actual credit risk.

The Association has principally focused on two areas of the proposed Basel Accord

that significantly affect the bond markets—securitizations and collateralized transactions, including securities repurchase (repo) and securities lending arrangements.

By creating more risk-sensitive capital standards in these areas, Basel II can ensure

these transactions continue to serve as useful funding, liquidity, and risk management tools.

Securitizations allow banks and other entities to obtain efficient funding and to

remove certain risks from their balance sheet so they can be borne by other parties

who desire such an exposure. Repo and securities lending transactions also aid institutions in managing risk by allowing them to readily obtain securities in order to

meet delivery obligations and to hedge exposures arising from separate transactions.

Setting regulatory capital charges too high for these increasingly important and

widely used arrangements threatens to distort economic decisionmaking on the part

of a financial institution. This has the potential of eroding the significant benefits

that consumers and businesses alike realize from securitization and collateralized

transactions.

Background on the Securitization and the Repo and Securities Lending

Markets

MARKET SIZE

The past several years have seen phenomenal global growth of the securitization

market. Since 1995, the United States, European, and Asian markets combined

have grown from $497 billion to $2.9 trillion. The U.S. market by itself has accounted for about 95 percent of that volume.

The repo market has also shown steady growth over the same period. Approximately $1.7 trillion in repo and securities lending transactions were outstanding on

average in 1996 and today an average $3.7 trillion are outstanding. Hundreds of billions of dollars in repo transactions are conducted daily to fund the positions of bond

market participants and allow the Federal Reserve Board to conduct open market

operations.

BENEFITS OF SECURITIZATION AND SECURITIES LENDING AND REPO AGREEMENTS

Securitization offers numerous benefits to consumers, investors, regulators, corporations, and financial institutions.

Securitization has developed as a large market that provides an efficient funding

mechanism for originators of receivables, loans, bonds, mortgages, and other financial assets. Securitization performs a crucial role for the entire U.S. economy by providing liquidity to nearly all major sectors including the residential and commercial

real estate industry, the automobile industry, the consumer credit industry, the

leasing industry, and the bank commercial lending and corporate credit markets. In

addition, securitization has provided a means for banks to effectively disperse the

risk of various positions they hold throughout the broader financial market.

Securitization provides low-cost financing for banks and other companies, lowers

borrowing costs for consumers and homebuyers, adds liquidity to banks’ balance

sheets, provides for efficient bank balance sheet and capital management, and

draws nontraditional sources of capital to the consumer and corporate lending markets. The efficiencies introduced by securitization are passed on to consumers and

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businesses in the form of more widely available credit, lower interest rates, and

lower prices.

Securities Lending and Repurchase Transactions

Securities lending and repo transactions are integral to maintaining liquidity in

the capital markets. They are a secure and flexible method of obtaining funding and

securities for market participants. For example, a market participant may purchase

securities which are then sold in a repo transaction, with an agreement to repurchase such securities sometime in the future. The repo seller can use the proceeds

of this transaction to fund their initial purchase. The repo buyer is able to invest

funds for short periods in a safe and liquid product. By providing a ready source

of funding, repos and securities lending transactions are critical to maintaining liquidity in the bond markets. In the Treasury markets in particular, this liquidity

ensures that the Treasury’s borrowing costs are kept low. In short, America’s capital

markets operate as efficiently as they do because wholesale market participants can

use repos and securities lending transaction to finance and hedge positions. The liquidity and efficiency provided by the repo market lowers financing costs for the

Federal Government, homebuyers, corporations, and consumers.

Basel II’s Impact on Securitization and the Repo and Securities Lending

Market

The Association applauds the goal of the Basel Accord to allow financial institutions the ability to more closely tailor risk-based capital requirements to the actual

amount of risk present in financial transactions. The proposed Accord, however,

does not currently meet this goal because under the proposal, institutions would be

required to maintain a higher level of capital than is warranted by the practical risk

of their positions. We have summarized below some of our principal concerns in connection with the proposed capital treatment of securitization exposures and repo

and securities lending transactions. The Association is continuing to develop additional quantitative and analytical arguments to support these points, which will be

submitted prior to the July 31 comment deadline in response to the CP–3. The Association will share our comments with Committee Members at that time.

SECURITIZATION

The Association is troubled by the treatment in Basel II of certain securitization

products and positions. We are especially concerned that if Basel II is not amended,

the onerous capital charges imposed on banks will discourage them from engaging

in securitization transactions. As a result, the benefits conveyed by a robust and efficient securitization market would be diminished or lost.

Securitization Risk Weights Are Too High

The floor capital charge is too high for many types of securitization positions,

given their actual risk profile. Subinvestment grade positions in particular attract

too high a capital charge under the proposals, given the actual credit risk they

present. Many of the key assumptions underlying securitization formulas and risk

weights are too conservative, and lack a proper theoretical or empirical foundation.

By setting the floor requirements at a higher level than the actual risk of a position, Basel II reduces incentives for banks to participate in securitizations. This

would lower incentives to conduct transactions that actually lessen a bank’s risk exposure and that allow banks effectively to disseminate the risk of a particular transaction throughout the marketplace.

Conservative Rules Result in Inordinately High Charges

In establishing rules governing the manner in which regulatory capital computations are to be made, Basel II defaults to the conservative alternative so often

that—cumulatively—these rules result in an inappropriately high capital charge for

securitizations. For example, given the general ability under Basel II to rely upon

qualified external ratings to determine regulatory capital requirements, we believe

that originators of securitized assets should be able to use such ratings to determine

risk weights, even if this produces a lower capital charge than if the assets had not

been securitized. Originators do not have this ability under the proposal as drafted.

There are numerous other examples of excessively conservative rules that—in the

aggregate—produce unduly high capital charges for securitizations.

Synthetic Securitizations Should Not Be Discriminated Against

Higher capital charges should not be levied against synthetic securitizations, in

comparison to traditional asset securitizations. (Synthetic securitizations involve the

bundling and securitization of credit exposures, rather than the underlying financial

assets.) Synthetic securitizations are increasingly used by financial institutions to

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manage their balance sheets, and provide additional options and flexibility for risk

management. Since the risk profile of a synthetic asset is the same as for a cash

asset, the risk-based capital treatment should be equivalent. However, this would

not be the outcome under the proposals as currently drafted and, in several respects, synthetic securitization positions attract inordinately high capital charges.

Limited Credit Risk Inherent in Liquidity Facilities Should be Recognized

In a number of important respects the Basel II proposals would require financial

institutions to hold disproportionately high levels of capital against liquidity facilities they provide in connection with securitizations. Such liquidity facilities are

extended by financial institutions to a variety of securitization issuance vehicles, including but not limited to asset-backed commercial paper conduits. Through the

securitization market, these conduits provide competitive short-term financing for a

wide range of asset originators. The performance history of liquidity facilities in this

context demonstrates that the likelihood of draws are extremely low, and the incidence of credit losses negligible.

We believe that internal modeling is the most appropriate method for determining

regulatory capital for liquidity facilities. The key operational requirement for liquidity facilities is that there be an asset quality test that adjusts dynamically to preclude funding of defaulted assets. Such a dynamic test is one that is built into liquidity facilities that have been in the market for many years. This has led to historical performance data showing the relatively low risk of draws and of losses on

such draws.

Under Basel II, if a liquidity position is not rated, we believe that a bank should

be able to look through to the risk weight assigned to the underlying transaction

that the liquidity supports if that underlying transaction has been externally rated.

Given that the underlying transaction reflects the ultimate risk of a liquidity position, we see no reason not to permit the reliance on the rating of that transaction

if a liquidity position itself is not rated.

SECURITIES LENDING AND REPURCHASE TRANSACTIONS

The Association is concerned that Basel II, as proposed, falls short with regard

to recognizing modern risk-management techniques as they relate to secured transactions such as securities lending and repurchase transactions. By failing to account

for methods widely used to mitigate risk exposure, capital charges for banks would

not reflect true balance sheet risk. The undue capital charges would ultimately result in less efficient and more costly markets.

Encourage the Use of Cross-Product Netting as a Risk Management Technique

The Association believes that the manner in which risk-based capital requirements for repo and securities lending transactions are calculated should be revisited

along with the treatment of similar collateralized transactions. The Association

strongly believes that transactions which present similar risks—and mitigate

against similar risks—as repo and securities lending transactions should be treated

in the same way for risk-based capital purposes. Many financial institutions currently manage risks for all collateralized transactions in a uniform manner.

After conforming the manner in which risk is calculated for repo and securities

lending transactions and other collateralized transactions, the Basel Accord should

take the next logical step and allow for recognition of the netting of exposures across

such transactions. Currently, the Basel Accord contemplates netting only between

repo and securities lending transactions. It is widely recognized that netting exposures across different transactions helps financial institutions reduce their exposure

to the risks such transactions present. Providing incentives in the Basel Accord

through broader recognition of cross-product netting will provide added incentives

for financial institutions to implement this risk-reducing practice.

Encourage the Use of Internal Risk Models

It is the Association’s view that allowing financial institutions to utilize internal

risk models—as Basel II would—to determine counterparty risk for collateralized

transactions is a step in the right direction. Basel II should not, however, dictate

rigid rules as to what models financial institutions must utilize in determining risk.

The Accord should allow financial institutions to utilize their own risk models subject to the review and approval of national supervisors under Pillar 2 of the Basel

Accord. Otherwise, financial institutions would likely devote resources to creating a

model that may not accurately capture the risks present in collateralized transactions. In addition, the Association believes the Accord should not set out a rigid

backtesting regime for such models. (In this case, backtesting refers to evaluating

the performance of a model based on historical data.) In any event, the backtesting

regime currently set out in the Basel Accord risks dissuading financial institutions

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from improving upon their existing risk management practices through the use of

internal risk models by risking the imposition of significantly increased capital

charges. As currently contemplated, should the results of the backtesting regime

generate a number of mismatches or ‘‘exceptions’’ between estimated and actual

data, an institution’s risk-based capital charge would be significantly increased.

Such backtesting regime—and its potentially punitive results—do not have any commercially reasonable basis in relation to the repo and securities lending markets.

Conclusion

The Association supports the overall goal of the Basel Committee to align capital

requirements for financial institutions more closely to actual credit risk. While the

revised Accord has the potential to move regulatory capital requirements in the

right direction, the Association continues to have fundamental concerns with the

proposal that must be addressed to uphold the Basel Committee’s stated goals

without causing economic distortions in the securitization, repo, and securities lending markets.

The Association looks forward to continuing its dialog with the Federal Reserve

Board and other U.S. regulators on the issues we have addressed above. We plan

to offer formal comments on the third consultative paper this summer, and when

the Board issues its advanced notice of proposed rulemaking describing the U.S. implementation of Basel II, the Association will provide further input.

—————

PREPARED STATEMENT OF EDWARD I. ALTMAN, PH.D.

MAX L. HEINE PROFESSOR OF FINANCE

LEONARD N. STERN SCHOOL OF BUSINESS

NEW YORK UNIVERSITY

JUNE 18, 2003

Thank you for inviting me to the Senate hearings on the B.I.S. recommended regulations on Capital Allocations for Bank Credit and Other Assets—the so-called

‘‘Basel II’’ Accord. I have followed Basel II’s consultative papers since the first one

was issued in June 1999. We have submitted two formal commentaries to the Basel

Commission on Bank Supervision, primarily related to the first of the so-called

pillars of the new recommendations—capital adequacy based on the specific risk

characteristics of bank counterparties. Our major comments were that the capital

requirements related to expected and unexpected losses from corporate and other

loans should be based on the actual historical experience of Loss Given Default

(LGD) from the corporate bond and bank loan markets. The original 1999 suggestions bore little resemblance to actual performance and we pointed this out fairly

precisely. I am pleased to note that the latest version of Basel II’s capital requirements based on the riskiness of bank portfolios does a much better job of relating

the requirements to default experience, although too little capital is still being required for the most risky categories.

A problem with the suggested regulations, however, is the complexity in determining capital requirements and the somewhat arbitrary choice of modifications to

the standardized scale due to such items as the size of the counterparty and the

existence, or not, of collateral on the loan/bond. For example, small and mediumsized enterprises (SME’s) are given lower capital requirements for comparable risk

levels of as much as 25–50 percent less capital. The argument that the correlation

of default rates amongst these small counterparties is lower than for larger corporations may be valid, but I have seen little evidence that the ‘‘haircut’’ for these loans

should be as much as 50 percent. In my opinion, this was a concession to those national banking systems of the world whereby SME’s are the vast majority of borrowers—hence lower capital requirements for banks in those countries. It is also

true that SME’s make up the vast majority of loan assets of the smaller banks in

the United States and the same lower capital requirements would hold for U.S.

SME’s and the banks that make these loans—close to all but 100 of our Nation’s

8,000 banks. But, as I will now discuss, almost all of U.S. banks will not be required

to follow the recommendations of Basel II, so the reduced capital requirements on

SME’s will not be relevant and the old Basel I’s 8 percent rate will probably still

be in effect for all except the very largest U.S. banks.

United States vs. Rest of the World and Basel II

As I indicated above, and as you are probably all aware of, Basel II’s recommendations on credit risk and operating risk dimensions of bank activity are just

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that—recommendations. The Central Banks of the world, and other bank regulatory

bodies, who set national bank regulatory policy, may or may not choose to conform

to all or any parts of Basel II’s recommendations. Indeed, it came as an enormous

surprise to some observers, including this writer, that only the largest 10 U.S.

banks, and perhaps the next 10–20 banks in terms of asset size, would be required

(top 10) or will have the option (next 10–20) to follow the advanced Internal RateBased (IRB) version of Basel II’s Accord with respect to specifying the LGD dimensions of their portfolios and hence, set capital requirements based on portfolios risk

characteristics. While it is true that as much as two-thirds of all bank assets are

held by the top 30 U.S. banks and more than 95 percent of foreign bank assets operating in the United States will be covered by Basel II’s most sophisticated guidelines, it is likely that all the rest of our banks (almost 8,000 smaller banks) will

not be asked to conform and will probably not do so for the following reasons:

(1) Basel II is too complex and costly to introduce and conform with.

(2) The U.S. banking system is presently more than adequately capitalized and

the recent decade’s experience of very low numbers of bank failures makes change

unnecessary.

(3) The added Basel II capital required for operating risk is based on highly arbitrary and extremely difficult to measure variables.

(4) The Federal Reserve System’s, and other bank regulatory agencies, policy of

‘‘prompt corrective action,’’ and maximum leveraged ratios, when bank capital falls

below a certain specified level has worked very well in the United States and is not

specified as part of Basel II—even in Pillar 2’s regulatory oversight.

In other words, ‘‘if it ain’t broke, don’t fix it!’’

I believe that the choice of only the largest 10 commercial banks to conform to

Basel II, and the IRB approaches, is unfortunate and should be reconsidered. Not

withstanding the recent consolidation movement of many of our largest and most

sophisticated banks, the possible exemption of #11 to #30 (including HSBC Bank

USA, Citibank [West], Bank of New York, Key Bank, and State Street, #11–15) and

the very likely exemption of #31 to #50 up to 8,000 (including such seemingly large

banks as Charter One, Am South, Union Bank of California, Mellon Bank, and

Northern Trust, to name just a few, seems arbitrary and belittles the possible sophistication and motivation of these banks which would be substantial institutions

in most other countries of the world. For example, the 50th largest bank in the U.S.

in terms of assets (Compass Bank with $24.3 billion) or in terms of deposits (Mellon

Bank with $15.2 billion) would be huge institutions in most countries.

The choice of a round number, like ten, would seem to be insensitive to world

opinion as well as to risk management motivation. Speaking from an economic

standpoint, rather than a political one, I would prefer to see either no banks be required to conform or some exemption level whereby the costs/benefits to our banking system would be more rationally presented and defended. Certainly, a number

like the top 50–100 banks would be much more in line with the number of banks

conforming in other countries. This would help ensure a ‘‘level playing field’’

amongst banks.

Our largest banks are probably relatively happy to conform to Basel II even with

its complexity and added costs to develop information and credit scoring systems to

conform to the requirements of the advanced Internal Rating-Based (IRB) systems

mandated under Basel II. The reason is that they expect that the total capital required for credit assets will be less than what is required under the current regime

(which will continue until 2007). So, we may have a new regulatory regime where

everyone—large and small banks, as well as out bank regulators—are relatively

pleased with the changes recommended under Basel II.

A Related Disappointing Result of U.S. Policy

I have always felt that despite its problems with: (1) complexity, (2) too low capital requirements on the more risky counterparty assets and (3) the difficulty of

managing against operations risks, Basel II had one extremely important by-product—the motivation for banks to develop or improve upon their existing credit scoring models and systems to reduce total losses from nonperforming and eventually

charged-off loans. These systems can be used to rate and set capital for all bank

customers rather than setting a ‘‘one-size-fits-all’’ (8 percent) requirement on them.

I have observed the enormous strides achieved by banks throughout the world, including ones of all size and location, as to developing risk management systems and

training of personnel to prepare for Basel II. Indeed, from what I can surmise,

banks in most countries, especially in the European Union, will all adhere to Basel

II’s Standardized, Foundation or Advance IRB approaches. Granted that regulators

in these countries will need to sanction far fewer banks than U.S. regulators would

have to do if all banks are mandated to conform, it must have come as a surprise,

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perhaps even a resentful shock, that the vast majority of U.S. banks will not adhere

to Basel II. This is especially true since the United States and its representatives

to the B.I.S. were early champions of the need to change the way banks allocate

capital for credit risk of their clients.

What is disappointing to me is that the Fed’s decision to exempt all but the largest banks from building and implementing an IRB approach of some level of increased sophistication will reduce the motivation for most banks to move to a more

risk sensitive lending policy. I recommend that our Federal regulators require some

level of added due diligence on the part of banks with respect to economic capital

decisionmaking and the use of credit scoring or rating systems even if they are not

absolutely required under the old (and continuing) Basel Accords. One way to accomplish this on a cost effective basis is for smaller banks to combine resources

(data and money) to accomplish these goals. Our decision to exempt smaller banks

from Basel II may backfire if many of the world’s smaller, or even larger, banks

from developing and developed countries, also opt out of the process, leading to

greater instability in these banking systems and perhaps to ours through contagion.

A Note on Procyclicality

One of the likely by-products of Basel II and its reliance on systems that require

a careful assessment of credit ratings and loss given default reserves is the possible

procyclical impact. That is, any system which requires more capital when defaults

increase and banks’ portfolios become more risky, such as what is likely to occur

during periods of economic stress, will motivate banks to provide even less credit,

for example, ration credit or a credit-crunch, thereby exacerbating economic

downturns. The opposite will likely occur during periods of above average economic

growth, thereby causing too much easy credit and subsequent higher levels of defaults and charge offs than would have been the case under the old system. Now

I am aware that this problem called procyclicality already exists due to banks and

other lending and capital providers having ‘‘short memories’’ of the last period of

economic stress. Indeed, the procyclical problem resulting from the benign credit

cycle of the mid-1990’s (1993–1998) helped to cause the enormous level of defaults

in 2000–2002. And, our research shows that when bond and loan defaults increase,

we can expect a coincident reduction in recovery rates. Hence, the LGD result will

be even greater due to the negative correlation between probabilities of default and

recoveries given default. I would be surprised if bank regulators, and the banks

themselves, have considered this double negative effect in times of economic stress.

Fortunately, our banking system was very well capitalized prior to these problems

and seems to have weathered the avalanche of large firm bankruptcies (77 in 2001/

2002 with liabilities greater than $1 billion) without too much stress.

Despite out seeming capital adequate condition and the fact that a great deal of

procyclical behavior (for example, herding, over compensation for short-term loan

losses) can be expected from current bank regulatory guidelines, I suggest that the

Fed consider a more smoothed capital allocation system to even out the normal fluctuations in bank reserves, capital allocations, and lending behavior. This would require more capital set aside in good times and less during periods of stress.

Conclusion

Thank you for inviting me to attend today’s hearings and express my views. On

balance, Basel II has many positive recommendations but still may prove to be inadequate to overcome strong systemic problems that normally could be mitigated by

a well-capitalized and prudent regulatory oversight policy. I look forward to observing the results of Basel II on a worldwide level as well as special concern for the

U.S. banking system. For your information, I have provided my bio-sketch as an attachment to this document.

—————

PREPARED STATEMENT OF KAREN SHAW PETROU

MANAGING PARTNER

FEDERAL FINANCIAL ANALYTICS, INC.

JUNE 18, 2003

It is an honor to appear today before this Committee to discuss the potential

ramifications of the international risk-based capital rules under consideration in

Basel for U.S. financial institutions and—even more important—for the economy

that depends upon them. I am the Managing Partner of Federal Financial Analytics,

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a consulting firm that advises on U.S. legislative, regulatory, and policy issues affecting strategic planning. In this capacity, we advise a variety of companies on the

implications of specific sections of the Basel proposal. We also advise the Financial

Guardian Group, which represents those U.S. banks most concerned with the proposed operational risk-based capital charge.

In my testimony I will focus on the most recent version of the Basel rules—the

third consultative paper or CP–3, as well as on the advance notice of proposed rulemaking (ANPR) on which the U.S. regulators are now working. Although the

effective date for the new version of the international capital rules—Basel II—is December 31, 2006, its actual impact will be felt far more quickly. Indeed some markets have already begun to change in anticipation of the Basel standards. As the

final shape of the rules becomes more clear, financial markets—and the larger economy—will change more noticeably. Congress’ review of the rules thus comes in a

timely fashion that ensures any policy concerns posed by the rules can be addressed

well in advance.

Much in CP–3 is very worthwhile. Overall, Basel II is a worthy and overdue effort

to fix the problems in Basel I that have created all too many opportunities for banks

to ‘‘arbitrage’’ the capital rules. When regulatory capital diverges from the ‘‘economic’’ capital dictated by the markets, banks change their portfolio, pricing, and

risk decisions. This has profound impact on overall franchise value and on key lines

of business, as well as affecting the cost and availability of credit to consumers and

companies across the country and around the world.

When regulatory capital is too low, banks can take undue risk—a problem observed since Basel I went into effect that needs a quick remedy. When regulatory

capital is too high, banks cannot compete against nonbanks, and assets flee the

banking system with possible adverse consequences for overall market stability.

However, Basel II now has gone far from its initial clear goal of ending regulatory

arbitrage. In fact, the most recent statement of the purposes of Basel II—posed 2

weeks ago by U.S. regulators—no longer even mentions this. Now, the goals of Basel

II are said to be: Improvements to internal risk management and capital allocation,

enhanced market discipline and—of all things—a new capital charge for operational

risk. I shall have more to say about the operational risk capital charge later, but

suffice it to say that this proposal worsens the relationship between regulatory capital and risk—absolutely the reverse of where Basel II initially intended to go. If

Basel II cannot be brought back to its initial and important purpose, then the U.S.

capital rules alone should change to do so.

Based on our review of the third consultative paper and recent statements from

U.S. regulators about our own implementing rules:

• There is a ‘‘first-things-first’’ solution that fixes the Basel II’s complexity problem.

Much in the proposal can be quickly implemented at reasonable cost for all banks

and savings associations here and abroad. U.S. regulators should act now on those

sections of Basel II on which they can agree unanimously, and defer other sections

until they can do so.

• A ‘‘one-size-fits-all’’ approach won’t work in the United States Capital should go

up or down with risk, not be squeezed into the current requirements that were

originally set with scant regard for actual credit losses. Unique factors in the U.S.

market make it especially important that bank capital appropriately reflect risk.

• The operational risk-based capital section of Basel II remains deeply flawed and

should be dropped. Regulatory capital for operational risk will increase risk, not

reduce it, and strong supervision with enforced standards is the right way to address operational risk.

• Simple capital rules are essential for effective supervision. Agencies here and elsewhere cannot administer over-sophisticated rules. Further, laboring to do so will

divert resources from emerging risks that often prove the undoing of individual

institutions or serious risks to the financial system as a whole. Capital is not the

only driver of safety and soundness. Banks have collapsed in the past and will

fail in the future even as they hold more than the minimum amount of regulatory

capital.

Economists and financial analysts have spent literally thousands of hours working

to revise the risk-based capital standards that govern interationally active banks

around the world and all insured depositories in the United States. This effort is

a very important one, as problems in Basel I have led to undue risk-taking and

other concerns that warrant immediate attention. However, in the 5 years in which

Basel II has been crafted, more and more attention has been devoted to the increasingly complex models that attempt to anticipate expected and unexpected losses in

every line of business, under every scenario in each country for all time. The defense

of this effort is that financial markets are now complex, so capital must be too. HowVerDate 11-MAY-2000 10:04 Jul 07, 2004 Jkt 000000 PO 00000 Frm 00103 Fmt 6621 Sfmt 6621 94514.TXT BANK1 PsN: BANK1
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ever, the universe is very complex, yet Einstein found a very simple formula that

helped to explain it. Complexity is a weakness, not a strength, and Basel II should

be difficult only when absolutely necessary to capture subtle risks with potentially

severe consequences.

Basel II rightly rests on three pillars: improved regulatory capital standards, better supervision and more disclosure. If Pillars 2 and 3 work well, then Pillar 1—

the capital standards—need not be as formulaic and far-reaching as currently proposed because supervisors will have ample tools to tailor regulatory capital to individual circumstances and markets will know when this is not being done.

One reason regulators rely so much on regulatory capital is the lack of effective

supervision in many major financial markets. Here, though, supervisors have ample

authority to discipline banks for problems that have nothing to do with capital

standards. Companies must, for example, be ‘‘well managed,’’ as well as ‘‘well capitalized’’ to be financial holding companies and enjoy the privileges provided in

Gramm-Leach-Bliley. Further, supervisors measure banks on a ‘‘CAMELS’’ scale in

which capital—the C—is just one of a range of factors—all weighted equally—on

which critical enforcement actions hinge. The other factors are asset quality, management, earnings, liquidity and sensitivity (to various risk factors). If non-U.S. regulators adopted a similarly wide-reaching supervisory regime—and backed it up

with meaningful sanctions such as those deployed here—then much of the complexity in Basel II could fade away and the rules could focus on ending major

sources of regulatory arbitrage that, on the one hand, threaten safety and soundness

and, on the other, unnecessarily undermine bank profitability.

First Things First

Despite the intention of having a balanced international regulatory framework

that emphasizes more than just regulatory capital, the vast majority of staff time

has been spent on the regulatory capital charges. U.S. regulators, I think, could

have done much for the global financial system and avoided many of the pitfalls in

Basel II if more attention had been paid to exporting our strict supervisory standards and their effective enforcement. Japan, in particular, would benefit greatly

from this—it is a clear case in which nominal adherence to regulatory capital has

done nothing to prevent a grave banking crisis with serious macroeconomic impact.

As Basel II advanced and the capital models grew ever more complex, U.S. regulators rightly became increasingly concerned about how this would work in our

unique banking system. In sharp contrast to Japan and the European Union, we

here have thousands of banks and savings associations; foreign banking systems are

far more concentrated into a few nationwide banks. Regulators also—rightly—became concerned about several pieces of the simpler sections of Basel II that resulted

from complex multilateral negotiations in which the end goal was often obscured.

This is particularly true with the more simple versions of the operational risk-based

capital standards, which are not only flawed, but could also actually increase—not

reduce—banking risk. Further, even the relatively simple sections of Basel II grew

ever more complex as negotiators sought to solve each problem and individual national political objectives as the rules worked their way along over the years.

Based on these fears—some of them quite right—U.S. regulators have come up

with a solution—mostly wrong. They now plan to impose only the most complex

versions of Basel II and then to do so only for the Nation’s largest banks. This may

limit the pain, but it also undermines the gains close at hand in Basel II. Where

Basel II drops regulatory capital—which it does dramatically in traditional lines of

business like mortgages and small-business lending—banks left out of Basel II,

which will still be required to comply with Basel I, will be at a serious competitive

disadvantage to big ones in it. Where the models are overly complex or—worse—

wrong, the fact that only big banks must comply with them does nothing to redress

the adverse impact they might have.

Further, writing off the most flawed sections of Basel II in the United States does

nothing to address potential serious consequences in the global economy. U.S.

banks—especially large ones—compete head-on with non-U.S. banks here and

abroad. If differences in the simpler parts of Basel II—called the standardized approaches—give non-U.S. banks an excuse to rely on overlax rules and inadequate

enforcement, then the major strength U.S. banks now have in the international financial services market will be undermined. Worse still, major financial services

firms could operate under capital rules that do not actually address real risk.

For all its flaws, much in the standardized proposal for credit risk reflects broad

agreement on improvements to Basel I. U.S. regulators should turn this into clear

language and propose it for smaller banks, while refining the advanced models and

offering them to large ones. Where no agreement is in sight—on asset securitization,

for example—regulators should act now on those areas where broad consensus exVerDate 11-MAY-2000 10:04 Jul 07, 2004 Jkt 000000 PO 00000 Frm 00104 Fmt 6621 Sfmt 6621 94514.TXT BANK1 PsN: BANK1
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ists and defer the others until it emerges or regulators are sure—absolutely sure—

they are right and the industry is wrong. U.S. regulators now diverge on many key

areas of Basel II, and they should act in unison on issues where they intend to contradict the best evidence and advocacy the industry can muster.

One Size Won’t Fit All

As U.S. regulators have turned their attention from the international negotiations

to implementation of Basel II at home, a major dispute has arisen over whether to

follow the new rules where they lead. Under Basel II, capital could go down below

current levels, especially for very large banks with major retail or mortgage operations. It is for that reason that the operational risk-based capital proposal has been

superimposed on the credit risk reforms Basel II initially sought. It is also the

reason why some U.S. regulators are now reasserting the importance of the most

primitive of all capital charges—a simple leverage one—on banks and their parent

holding companies. ‘‘Topping off’’ the right amount of credit risk capital with the

operational charge and a surcharge for ‘‘leverage’’ will so undermine Basel II—especially in light of its high implementation cost—as to raise serious questions about

whether the entire exercise is worthwhile.

I shall have more to say about the operational risk charge below. With it, Basel

II should not be implemented at all. Without it, a sound regulatory capital scheme

is in sight.

The leverage rule is a unique U.S. capital standard, and it is one that should be

dropped as Basel II comes into force. Indeed, it is one that should have been

dropped years ago. The leverage standard is a simple ratio of capital to on-balance

sheet assets calculated without regard to risk. Under the leverage standard, a bank

holds the same amount of capital if its book of business is solid gold or unsecured

credit card loans to dubious borrowers. It is a capital standard that could not be

more crude, but U.S. regulators clung to it in 1988 because they weren’t sure they

trusted Basel I. They wanted some form of insurance because they knew then—as

now—that credit risk rules did not capture interest-rate risk. You will recall that

this latter risk was the predicate cause of the collapse of our savings and loans—

which cost taxpayers more than $250 billion and kept this Committee extremely

busy for over a decade.

So, ironically, Basel II still doesn’t address interest-rate risk (IRR). Although the

regulators think they know enough about operational risk to put it in the Pillar 1

mandated capital standards, they have decided to leave IRR in Pillar 2. In 1988,

regulators were right about the problems measuring IRR; now, they are not. Markets price trillions of dollars of IRR each year in a fashion that Fed Chairman

Greenspan has rightly praised.

Why then keep the leverage rule? U.S. agencies appear to be clinging to it because

they are afraid to follow Basel II’s models where they lead. In some cases, the advanced models propose massive drops in regulatory capital. This is particularly true

in mortgages and small-business loans—key lines of business for smaller banks that

will face major competitive problems if big banks get to drop regulatory capital

under Basel II while they are kept in the cold of Basel I. Of course, in other cases,

Basel II will dramatically raise capital—for high-risk loans and certain equity holdings, for example. To adopt Basel II when it goes up and block it when it goes down

is to create a regulatory capital regime that leaves arbitrage largely in place—again

profoundly undermining why all this started in the first place.

The best way to protect the deposit insurance funds from risk and small banks

from competitive harm is to introduce Basel II’s most advanced model-driven sections in an incremental way that—essentially—hedges the model-builders’ bets.

How to do this? Despite the complexity of the advanced internal ratings-based approach to credit risk, it can be introduced in a remarkably easy way. Upon conclusion of Basel II’s comment period and a review of all the analyses of the sophisticated models, regulators should make up their minds about the ‘‘right’’ amount of

credit risk-based capital for specific assets. Where they cannot agree, as noted, they

should defer action. Where they can, they should implement Basel II—but only in

a phased-in fashion. If, for example, the ‘‘right’’ amount of capital is a dramatic

drop, then set a schedule in which capital slides down year after year across the

board for all banks that qualify to use the advanced models. Where it goes up a

lot, capital should similarly be phased in.

This incremental approach has two advantages. First, as noted, it hedges the regulators’ bet on the skills of their model builders and the ability of supervisors to

handle the complex new rules (on which more below). Second, it addresses concern

that Basel II will exacerbate booms and worsen busts—‘‘procyclicality’’ in Basel

speak. To be sure, phasing in Basel over time doesn’t eliminate procyclicality, but

it ensures that regulators are certain of their capital models when these come into

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full force, while giving them time also to assess the value of stress testing and other

measures now under consideration.

Eliminate the Pillar 1 Operational Risk Capital Charge

Basel II’s pending proposal and, we are told, the draft U.S. implementing rules

will include a new regulatory capital charge for operational risk. Operational risk

is that resulting from human or systems failures, natural disasters, and even terrorist attack. There is, though, no accepted definition of operational risk for supervisory purposes—for example, does it include reputation risk? Basel II says no—for

now—but this risk has frequently proven the most serious of all in a business fundamentally founded on investor and depositor confidence. What about events like

September 11—catastrophic operational risk? Basel II now has them in—although

they were out at the end of last year—but who knows how to measure the likelihood

of another attack and then to decide just how much capital is enough and whether

capital the right antidote?

It is particularly hard to understand why Basel II has a specific capital charge

for this risk when one notes that many of its own documents agree that it cannot

be well defined. The Basel Risk Management Group, for example, said its own data

need to be used with ‘‘caution’’ and that a specific capital charge cannot now be

based on them. A major Basel Committee on global financial safety also concluded

earlier this year that there is now no way to determine a quantitative regulatory

capital charge.

Another major unanswered question: Is any amount of capital enough against catastrophic risk? I do not think so, and indeed imposing an operational risk-based capital (ORBC) requirement will create a serious and perverse incentive for banks to

skimp on the forms of operational risk management and mitigation that proved

their worth in the most recent and terrible case of catastrophic operational risk, the

attack on the World Trade Center. What worked after the terrorist attack—apart

from undaunted heroism—were the backup systems and contingency plans that

well-prepared financial firms had put in place. What worked in the terrible days

thereafter—other than sheer courage and determination—was insurance. In Baselspeak, these are operational risk management and mitigation. Both are costly—indeed, the back up systems, which U.S. regulators have mandated since September

11, are very much so. Imposing a simple, arbitrary charge against operational risk

will lead many banks to rely on this, not proven ways to protect themselves, their

customers and the financial system more generally.

Basel II now includes three variations on a regulatory ORBC requirement. Two

of these—the ‘‘basic indicator’’ and ‘‘standardized’’ ones—rely on a simple percentage

of gross income to calculate ORBC. This is, quite simply, nonsensical. There is no

correlation between income and risk. In fact, operational risk also runs counter to

gross income because banks that spend more on risk management and mitigation

have less profits. Banks that generally have trouble making money also tend to be

riskier—again, an inverse correlation between gross income and operational risk,

not the positive, linear one on which Basel II relies.

U.S. regulators have, apparently, realized that the two simple approaches to operational risk in Basel II do not work. As a result, they are planning only to impose

the ‘‘advanced measurement approach’’ (AMA) here. This will, though, leave the

other two methods in place in the EU and Japan, creating a perverse incentive for

big banks there to run undue amounts of operational risk. We cannot wall ourselves

off from the problems this will create, and U.S. regulators should thus push hard

for meaningful supervisory standards for operational risk that bind all financial

services firms, not compromise on a deeply flawed regulatory capital model.

Further, the AMA does not solve the fundamental problems with an ORBC charge

in Pillar 1. Some of these are unique to U.S. banks—which must compete with

major nonbanks in lines of business like asset management and payments processing. Basel II in the United States will not cover nonbanks. Specialized banks will

thus face major competitive pressures that may force them to review whether continuing to remain a bank is worthwhile. ORBC not only creates incentives for increased operational risk, but it also may create one for nonbank charters. This

would drive assets outside our sound, proven system of bank supervision.

The pending ORBC charge will also put U.S. banks at a competitive disadvantage

against EU and Japanese ones because ‘‘legal risk’’ results in a regulatory capital

charge. Our legal system is unique—no other nation has our plaintiffs’ bar or our

extensive array of laws designed to protect consumers, prevent discrimination, and

promote workplace safety. There is no evidence that any of this legal risk has ever

caused any U.S. bank to fail, and current law already requires reserves for material

legal risk (and these must also be disclosed).

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1 Credit Suisse First Boston (CSFB) is a U.S. financial holding company and leading global

investment bank serving institutional, corporate, government, and high net worth clients.

CSFB’s businesses include securities underwriting, sales and trading, investment banking, private equity, financial advisory services, investment research, venture capital, and asset management. CSFB operates in more than 89 locations across more than 37 countries on six continents.

The Firm is a business unit of Zurich-based Credit Suisse Group, a leading global financial services company. 2The Financial Services Roundtable is a national association representing 100 of the largest

integrated financial services companies in the United States providing banking, insurance, securities, and investment products and services to American consumers.

The AMA epitomizes the problems in Basel II where reliance is placed on

unproven models over which U.S. regulators rightly do not agree. Acceptance of

these models now puts banks at undue and unnecessary risk—risk far better addressed through effective supervision with meaningful enforcement.

Can Supervisors Supervise Under Basel II?

Finally, I would like to turn to the question of whether the complexities in Basel

II’s advanced models are so daunting that supervisors at home and abroad will not

be able to ensure that banks actually comply with the new capital rules. This is a

major concern, and one the regulators are already trying to address through a major

Basel Committee focused on supervisory implementation. In the United States, the

agencies now think the best way to handle the complexity problem is to make Basel

II apply only to the biggest banks, whose examiners tend to be those most familiar

with complex financial arrangements. However, as noted, applying Basel II here

only to the biggest banks will create a range of competitive and safety problems,

while leaving the supervisory capability question largely unresolved.

A recent survey of the cost of Basel implementation for the larger banks expected

to use the advanced models indicates that it will reach $200 million per bank. One

has to ask how it can cost so much for banks and not pose a comparable burden

on supervisors who must assess these elaborate models. In point of fact, the rules

must be as costly for the supervisors as for the supervised or undue reliance will

be placed on untested models. If supervisors instead rely on ‘‘benchmarks’’ they will

in effect superimpose standardized credit and operational standards that obviate the

flexibility hoped for from the advanced approaches.

These problems are not addressed by the proposed qualifying conditions for use

of the advanced models—more board and senior management involvement, for example—because none of the proposed standards addresses the fundamental problem

posed by complexity, let alone how top management can divert resources from their

many other pressing investor protection and safety-and-soundness responsibilities.

The right solution to the supervisory resource problem is the same as the right

solution to the other challenges posed by Basel II: Impose a uniform system of improved rules across the board and then change them gradually over time as the

rules are tested and we all learn how to work under them. Back up the more sophisticated models with meaningful supervision that binds banks in the EU and Japan,

not just United States banks and give investors simple, clear disclosures to help

them understand just how much capital banks have and whether the supervisors

are concerned about it.

—————

PREPARED STATEMENT OF D. WILSON ERVIN

MANAGING DIRECTOR

CREDIT SUISSE FIRST BOSTON

ON BEHALF OF THE FINANCIAL SERVICES ROUNDTABLE

JUNE 18, 2003

Introduction

Good morning Mr. Chairman. I want to thank you for holding these hearings

today and inviting me to appear before the Committee. My name is Wilson Ervin

and I am a Managing Director of Credit Suisse First Boston (CSFB).1 I head our

Strategic Risk Management (or SRM) department and also chair its risk committee.

I am presenting testimony today on behalf of CSFB and on behalf of our trade

group, the Financial Services Roundtable.2 CSFB employs approximately 20,000

people, primarily in the United States, and is a major participant in the capital

markets. It ranks among the top firms in raising money for companies around the

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world and is a leading underwriter of mortgage and credit card financing. The firm

is also among the largest managers of funds invested in private companies.

My department is responsible for assessing the risk profile of CSFB on a global

basis and for recommending corrective action where appropriate to protect our capital. This objective is very similar to many of the goals of bank supervisors, including the drafters of the proposed Basel Accord—to deter very large losses and protect

bank solvency.

The Basel II Capital proposals have been the topic of intense discussion and debate in the financial and regulatory community for the past several years. The

industry supports the objectives of the Basel process: To better align regulatory capital to underlying economic risks, promote better risk management, and foster international consistency in regulatory standards. The proposed Accord is not a minor

refinement to the bank regulatory process, but is, instead, a wholesale reform of

bank regulation—a regime that covers roughly $2 trillion of capital and is a key economic engine for most developed markets. The impacts of these seemingly technical

discussions will affect banks, the markets, and the economy in a deep way, and we

would be wise to consider the effects carefully before implementation.

Before I start, I would like to note that I have personally developed tremendous

respect for the diligence and stamina of the regulators who have worked on Basel

II. They have had to address a great many complex and challenging issues, and

have been tenacious in trying to develop a ‘‘best practice’’ solution for each. Balancing all of this and applying it to very different financial markets around the

world—with political sensitivities in each—does not make this an easy job. I wish

to express appreciation for the efforts of Federal Reserve Board Vice Chairman

Roger Ferguson, who has met with CSFB and Roundtable member companies several times in the past few weeks to listen to our concerns on the proposed Accord.

Comptroller Hawke and FDIC Chairman Powell have also had open doors for discussion throughout the long process of developing the new Accord. We look forward

to continuing this dialog as Basel II moves closer toward formal adoption and

throughout the implementation period.

CSFB and the Roundtable have worked hard to be constructive commentators on

the new rules, particularly in respect to practical implementation issues. The recent

revision of the proposals—called CP–3—included significant improvements, and

demonstrated a willingness by regulators to address specific issues raised by industry and academic critics. Just last week, the Federal Reserve announced that, in

implementing Basel II in the United States, the regulators propose to reduce the

capital charges on many types of commercial real estate loans, in response to comments and new data from the banking industry. We support the direction in which

the Accord has been moving recently, and appreciate the regulators’ willingness to

reexamine earlier conclusions and consider further changes.

However, in spite of the hard work of the Basel Committee and industry, we believe substantial areas for improvement still remain. Basel II has considerable momentum, and most people in the industry believe it will likely be implemented in

the relatively near future. On balance, we believe that the advantages of the reform

now outweigh the drawbacks, although that balance remains close, and in several

areas, open issues remain. This is a frustrating outcome for an initiative with so

much potential. We hope these hearings will help illuminate some of the important

remaining issues that need to be addressed, so that the Basel II reforms can live

up to their original, very worthy goals.

Today, without getting too involved in the technical details of the Accord, I would

like to highlight four ‘‘macro’’ issues which we believe are particularly important:

1. The current Basel proposal is unnecessarily complex and costly, and suffers

from an excessive reliance on detailed, prescriptive rules. Under the rubric of comparability, these international rules could bring a more formulaic, inflexible style of

regulation to the United States, which currently enjoys a much better balance between black-letter rules and supervisory consultations.

2. The new Accord and its sensitivity to credit ratings could reduce liquidity in

the credit markets during economic downturns, potentially extending or deepening

economic recessions (procyclicality).

3. The operational risk capital charge proposed by the Basel Committee remains

highly controversial. Some Roundtable members support the proposed Pillar 1 operational risk charge; others believe operational risk should be addressed through Pillar 2 supervisory reviews instead.

4. The disclosures required under Pillar 3 of the new Accord are likely to add perhaps 20 pages of highly technical data to bank reporting requirements, raising costs

and adding little information of value to the reader. While we appreciate that the

Pillar 3 disclosure requirements have been reduced, they continue to be burdensome

and potentially confusing.

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3One editorial recently described this approach as ‘‘prescribing and proscribing in equal measure . . . a monster that cannot clear the first hurdle: flexibility.’’ Risk Magazine, editorial page,

June 2003 edition. 4For example, the eligibility requirements for institutions to qualify to use the Accord’s advanced IRB methods for credit risk capital charges are too detailed and burdensome. In general,

we believe that these eligibility requirements should be scaled back and replaced with more general guidance.

A specific example is the testing requirements for credit exposure in repurchase agreements,

an area with historically very low losses. To its credit, the Basel Committee permits the use

of internal market risk models to estimate potential collateral shortfalls under stress, which is

in line with modern practice. However, the Committee requires substantial additional testing

to use this technique, even though this calculation is based on the same model that governs

overall market risk, which is a much bigger risk and already subject to comprehensive regulatory oversight. 5To mention a few examples:

(i) The Accord significantly overstates the credit risk capital charges for exposures hedged by

guarantees and credit derivatives, by failing to recognize the much lower risk of joint defaults

by debtors and guarantors and by applying overly conservative rules on maturity mismatches.

(ii) The proposed Accord requires capital against Expected Losses, even though these losses

are already covered by loan loss reserves, and Future Margin Income is generally recognized

only for credit card exposures.

Prescriptiveness, Cost, and Adaptability

The first topic I would like to address is the overall cost and prescriptive tone of

the new capital rules, and the effect this will have on whether the rules remain relevant over time. The new rules shift the regulatory regime toward a highly complex,

formula-based system, and will diminish the important role that is currently played

by human judgment. Implementation of these rules will be high cost, but not highly

cost effective. Moreover, we believe the very complexity of the new rules and the

delicate political balance represented in them will make it challenging to update the

rules over time.

Most of this prescriptiveness is to be found in Pillar 1, which describes the ‘‘recipe’’ for calculating capital requirements. The most recent draft of the Pillar 1 calculations ran to nearly 200 pages, roughly 5 times the length of the original Basel

Accord (not including technical papers and additional guidance that is expected to

be issued). This is a common result from this kind of process. Once you start developing a system that attempts to capture the complexity of the real world in a series

of mathematical rules, it is very hard to stop halfway. One issue or another will

always be of major concern for some institution or country. Many of the Pillar 1

rules reflect a political compromise as much as the results of a scientific approach

to risk management. The result is a very elaborate system that tries to address all

circumstances by being ever more complex, and currently staggers under its own

weight. The Basel Committee has done a commendable job in streamlining the earlier drafts in CP–3—the earlier drafts of Pillar 1 rules were even longer—but this

remains a fundamental issue.

Perhaps the underlying issue in this respect is the prescriptive nature of the new

Accord. Conceptually, the Committee has attempted to capture current industry best

practices and boil them down into fixed formulae, adding burdensome qualification,

testing, and reporting requirements.3 These new regulatory requirements, while

well-intentioned, will be unduly burdensome and inconsistent with changing market

reality and evolving best practice.4 It is our recommendation that the Committee

establish some basic requirements largely around the key input parameters and exposure calculations and publish best practices that provide guidance to banks and

supervisors rather than a rigid rulebook.

CSFB and other Roundtable members are also concerned about the cumulative

effect of numerous conservative choices and assumptions that are built into this

complex fabric. Each of these can be debated separately, and many are extremely

technical. But the combined effect of each of these individual items adds up to regulatory capital requirements that can depart significantly from the true economic capital needs that Basel II was aiming to emulate.5

Home/Host Country Issues

The complexity of the new rules poses particular challenges for an international

bank that is regulated by supervisors in multiple countries. CSFB, for example, will

be required to implement Basel II as both a Swiss bank and a U.S. financial holding

company. Our implementation will be governed primarily by the Swiss Federal

Banking Commission, in conjunction with the Federal Reserve in the United States

and the Financial Services Authority in the United Kingdom, and also by other regulators around the world.

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6For example, the originating bank is charged the full risk of the pool if it retains a sufficiently large position in the junior securities. A second bank that purchases the senior securities

also will be charged significant capital, meaning that the capital required of the banking system

will be higher than if the assets had simply been held on an institution’s balance sheet directly. 7 In particular, questions remain regarding the proposed treatment of liquidity facilities for

asset-backed commercial paper programs, which would face capital charges that seem disproportionately high relative to the level of risk. 8Some also have argued that the risk weights on such securitized assets are too high as a

more general matter. Similarly rated corporate loans often attract a much lower capital charge.

Most international banks face a similar set of interlocking regulation in which

both home and host countries interpret and enforce rules. This can give rise to conflicts, even under an international standard like the Basel Accord. At times, we

have been given conflicting requirements by home and host regulators under Basel

I, making compliance an impossible ‘‘Catch-22’’. While we have been able to resolve

these issues to date, the potential tension between ‘‘home and host’’ regulators will

become a bigger issue given the much wider and more detailed Basel II regime. If

each country decides to require its own local rules and local data for each of the

many calculations required under Basel II, the compliance burden will go from bad

to worse. The Basel Committee has formed an Accord Implementation Group to deal

with cross-border implementation issues, but experience shows that some differences between multiple supervisors are inevitable.

We are pleased to note that, in a speech last week, Vice Chairman Ferguson indicated that the U.S. banking regulators expect to accept the Basel II approaches and

calculations followed by a bank’s home country supervisors, when evaluating an

international bank with U.S. branches and for purposes of eligibility of GrammLeach-Bliley Act financial holding company status. This is reassuring to hear. We

hope that other host countries adopt similar policies that defer to home country regulators, and that similar issues related to subsidiary banks also are addressed. We

believe that stronger proposals should be developed to resolve home/host country

conflicts in a timely and more predictable manner.

Securitization

A germane example of Basel II’s complexity and excess prescriptiveness is its proposal for asset securitization. Asset securitizations are a cornerstone of how the U.S.

markets finance residential mortgages, consumer credit card balances, automobile

loans, and other receivables. The draft rules here are daunting, potentially quite

burdensome, and often difficult to interpret. The result is that only a few experts

in each area are likely to understand this and other specialized rules of the Accord.

Yet, the interpretation of these experts on some technical points can have enormous

impact on the capital calculation.

These rules are written to deter possible arbitrages in the new rules, but risk

throwing the ‘‘baby out with the bath water.’’ The industry and regulatory communities generally agree on the objective that capital should be similar before and after

securitization, since the total economic risk is unchanged. However, apportioning

the risks properly among the different securities poses a difficult challenge for any

set of static rules. The Basel Committee’s current proposal under CP–3 takes a conservative approach to this problem, focusing on avoiding improper capital arbitrage

by building a technically complex system with a ‘‘belts-and-suspenders’’ philosophy.

Unfortunately, this approach can also interfere with legitimate transactions and

could undermine a widely accepted risk management tool used by many United

States institutions.

Several problems remain that should be reviewed by the regulators. First, the

mere act of securitization and distribution will tend to increase the capital charge

assigned to the same pool of assets.6 This increased capital is an important issue

for the U.S. markets in particular, as foreign markets are much less reliant on

securitization technology. This could raise costs for funding U.S. consumer loans and

other asset classes where securitization techniques are important. Foreign regulators have much less at stake in their local markets.

Second, the calculations are subject to difficult interpretations, which can give rise

to ‘‘cliff edge’’ uncertainties, where capital charges can change by a factor of 10 or

more depending on whether a particular instrument can be fit into a specific regulatory box. For example, a credit line provided to support a credit card or receivables

facility might attract a risk weighting of 100 percent if the bank can satisfy a number of technical tests about the structure of the credit facility.7 However, this charge

can skyrocket to 1250 percent (that is, an outright deduction from capital) if a bank

cannot meet one of these compliance requirements. This is a conservative approach 8

that will certainly help deter arbitrage, but it may also deter good finance. It also

will tend to restrict the evolution of new markets and new securities, since these

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9For example, banks that qualify for the Advanced IRB approach should be allowed to use

internal ratings to determine risk weights, which is not allowed for securitizations under CP–

3. Ratings based on rating agency methodologies or reasonably equivalent approaches, for example, should provide supervisors sufficient comfort that a market test has been met. Liquidity

facilities and credit enhancements for asset-backed commercial paper conduits are prime examples where this approach could be easily adopted. 10See Risk Magazine, footnote 3 above. 11Our Pillar 2 comments here are strictly focused on the credit risk capital charges. As noted

later in this testimony, Roundtable members have differing views on whether any operational

risk charge should be addressed under Pillar 1 or Pillar 2.

future instruments might not fit easily into today’s compartments. As with other

areas of the Accord, we believe that moving to a more principles-based system that

leaves more discretion to banks—subject to thorough supervisory oversight—will

provide a more durable and flexible solution for the long term. It will be important

to incorporate these changes into both the final text and in the practical implementation of the rules.9

Cost

The monetary cost of complying with the Basel II rules will be significant. For

Credit Suisse Group, our holding company, we estimate that our initial costs will

be $70mm to $100mm just to implement the system, plus substantial ongoing costs.

Multiply that by thousands of banks globally and this will amount to many billions

of dollars of additional costs. Some of these costs will be passed on to consumers

and corporations, and some of these costs may force banks to exit certain activities

leaving these markets to unregulated entities.

A major driver of the cost / benefit ratio of the new rules will depend on how they

are applied. For example, there are more than 50 specific requirements that must

each be met to use the so-called IRB advanced credit system. If each of them is interpreted and tested to rigorous audit standards, there will be enormous costs in

compliance though the relevance to better risk management will be small. I would

note that implementation costs will be substantial for regulators as well as for the

banking community.

Even more important, perhaps, than the direct monetary costs, are the indirect

costs. These will depend on whether the new rules support the real risk management needs of the business, or whether they become an extra bureaucratic burden

or even a diversion. CSFB’s internal assessment is that most of the additional resources required will not be in the risk control departments. Instead, most of these

new resources will be needed in the areas of financial reporting and IT support systems, in order to generate the volume of data and reports that Basel II requires to

a reliable, audit quality standard. While further systems development provide some

important benefits, this result suggests that the gains in risk management quality

from the new proposal are likely to be relatively modest.

Adaptability

The proposed Basel rules are based on the financial markets as they work today,

but are so complex and heavily negotiated that they will be difficult to update over

time. Indeed, some commentators have suggested that the Accord will be outdated

by the time of implementation.10

The draft Accord also requires banks to use the Basel II processes in their internal management in many areas, regardless of whether they remain relevant for

business practices. If bank management is required to compute and manage by the

Basel II rules anyway, further improvements in internal practice could be seen as

both costly and irrelevant. As a result, the Basel Accord could actually slow the

progress of better private sector risk management techniques.

Proposal

Our suggested response to the problems of prescriptiveness and high cost is for

the Basel Committee to place a much greater emphasis on the principles-based approach that underlies the ‘‘Pillar 2’’ section of the proposed Accord.11 Whereas Pillar

1 sets out regulatory capital calculations in a detailed, prescriptive way, the approach of Pillar 2 is to force firms to develop their own internal models, based on

evolving best-practice, and then to scrutinize the results through the examination

process and regulatory guidance. This ‘‘principles-based’’ approach, subject to some

reasonable benchmarks and guidelines to maintain consistency, has some important

natural advantages compared to the complex ‘‘black-letter’’ style rules currently prescribed by regulators under Pillar 1. Pillar 2 encourages banks and regulators to

work together over time to improve risk management practice, rather than forcing

compliance with a potentially dated rulebook. That approach permits steady, evoluVerDate 11-MAY-2000 10:04 Jul 07, 2004 Jkt 000000 PO 00000 Frm 00111 Fmt 6621 Sfmt 6621 94514.TXT BANK1 PsN: BANK1
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12 CSFB has taken particular interest in this issue among Roundtable members. See American

Banker, ‘‘Basel Capital Accord Must Leave Some Room for Human Judgment’’ by Wilson Ervin

and Joseph Seidel, August 30, 2002, and Risk Magazine, ‘‘Procyclicality in the New Basel Accord’’ by Wilson Ervin and Tom Wilde, October 2001.

tionary improvement and should therefore be more durable and relevant than Pillar

1 rules that are designed with today’s markets in mind.

Addressing this issue will not be simple in the short time left before the rules are

finalized. If these rules are all applied as black letter law and interpreted strictly,

the new rules will be both costly and—since the risk management advances that

lead in part to Basel II will not end in 2003—potentially irrelevant to ongoing best

practice. We encourage an approach that emphasizes principles and simplicity as

the rules are finalized, and a less onerous ‘‘trust but verify’’ approach to compliance.

Specifically, we would support adding statements to the Accord to emphasize that

compliance with the rules will be based not on ‘‘box checking’’ but with the spirit

of the rules, based on economic content.

Impact on Competition

We believe that the cost and complex rules of Pillar 1 will have significant impacts on competition, and could tilt the current playing field significantly in various

markets. This will be particularly important in the United States, where nonbank

competitors like investment banks, finance companies, and insurance companies

represent a large part of the financial system. The Basel rules do not apply to them.

If the costs of Basel II are high, banks will earn a lower return on capital, will grow

more slowly and may lose market share. There may even be some incentives to exit

businesses or to de-bank altogether. We believe that the Basel Committee needs to

do significantly more work in assessing the competitive impact of the rules across

the financial marketplace.

Procyclicality

The new rules will change how banks calculate and manage their capital and the

amount of business they choose to do. If banks all act in concert—as they will tend

to do under a common regulatory regime—this can significantly increase or decrease

liquidity in the credit markets and ultimately affect the real economy. We have analyzed this effect over the last 20 years of credit cycles. Our calculations suggest that

the impact on required bank capital will be substantial. In particular, the New

Basel II calculations could require much more bank capital during economic recessions than the current system. The process by which these rules could widen economic swings is called ‘‘procyclicality.’’ 12 This is, in effect, an implicit change in

macroeconomic policy and it would be wise to consider that carefully.

As a practical example, consider the credit environment of the last 2 years. We

have seen a huge number of credit rating downgrades, which have increased the

real risk of bank portfolios. The current system is relatively indifferent to this

change in terms of required regulatory capital, but the proposed system will require

significantly more capital when companies are downgraded. Banks will have to

choose between raising more capital during recessions or reducing the amount of

lending that they do.

Some regulators have suggested that the fear of a capital shortfall will change

banks’ risk assessment and lending behavior so that this issue will disappear. Implicitly, they suggest that bank’s risk assessment will improve so much that mistakes will be a thing of the past. While it would be wonderful if banks could always

foresee the future, I do not think that is realistic. Bank management already makes

risk assessment a top priority—it is perhaps the core judgment that determines

whether a bank thrives or fails. Unfortunately, economies are likely to remain cyclical and predictions about the future will inevitably turn out to include their share

of mistakes.

Cutting lending during a downturn is probably smart, if your perspective is focused solely on bank solvency. However, it raises significant issues for the wider

economy. My personal estimate is that my bank would have cut back its lending

by perhaps an additional 20 percent to 30 percent if the Basel II rules were in place

during 2002. If all banks cut back at the same time, the potential adverse impact

on the real economy could lengthen and deepen the recession. We are currently

working through an economic slowdown; it is difficult to think that adding pressure

on bank capital during this period would be helpful to economic recovery. In fact,

it defeats part of the reason for regulating banks in the first place—in order to have

a stable supply of capital to support the underlying economy. We need to be particularly careful here because the new system is imposed across the whole banking sysVerDate 11-MAY-2000 10:04 Jul 07, 2004 Jkt 000000 PO 00000 Frm 00112 Fmt 6621 Sfmt 6621 94514.TXT BANK1 PsN: BANK1
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13 Basel Committee on Banking Supervision, Working Paper ‘‘Potential Modifications to the

Committee’s Proposals’’, Bank for International Settlements, November 2001. 14 Basel Committee on Banking Supervision, CP–3, April 2003, Paragraph 397–399 and 724.

tem and everyone will have to operate at the same time on the same rules. Herd

behavior can make smaller problems into bigger ones.

The regulatory community has acknowledged this as a potentially serious issue,

but we believe that further attention is warranted, because the consequences of getting this wrong are potentially quite important to the broader economy. When the

first quantitative proposals in January 2001 revealed a significant potential problem, the regulators did react with a revised and somewhat ‘‘flatter’’ risk-weight

curve.13 However, while this reduces the scale of the issue somewhat, it does not

grasp the nettle.

The current Pillar 2 proposals include a credit risk ‘‘stress test’’ which is directly

linked to possible additional capital requirements.14 The exact design of this test remains unclear but the language suggests it amounts to an extra layer of buffer capital so that banks will not need to dig into their core capital in tough times. In

effect, this is like creating a second fire department, because you want to always

keep the first fire department in reserve. Creating two fire departments or requiring

two pools of capital is unnecessarily expensive and doesn’t seem to address the fundamental issue. That issue is that a risk sensitive system will inevitably lead to

varying capital requirements through time, and that is a result that will require explicit management and thoughtful preparation. As with other areas of the Basel Accord, adding some flexibility to the rules is the simplest and most practical way of

preventing these inevitable stresses from building up into major crises.

At a minimum, we suggest that the Basel Committee add to the proposed Accord

an explicit acknowledgment that capital levels may fluctuate, and that Pillar 2 reviews and stress tests not become one-way ratchets that only increase regulatory

capital requirements. If a stress test is to work properly, then when tough times

arrive, banks should be permitted to live within their plans, and regulators should

resist the temptation to continue to require the same untouched capital cushion.

Otherwise, Basel II’s stress test will not in fact reduce procyclicality, but will simply

amount to an unpublished higher minimum capital standard.

Operational Risk

In addition to reforming capital charges for credit risk, Basel II establishes a new

capital charge for operational risk—the risk of breakdowns in systems and people.

This is the most controversial element of the proposed Accord.

Financial Services Roundtable Comment

It is important to distinguish between the concepts of managing operational risk

and imposing a separate, quantitative capital requirement for it. All of the

Roundtable’s member companies agree that evaluating and controlling operational

risk is important and should be required as a supervisory and business matter.

Roundtable members do not agree on whether or how operational risk should be reflected in regulatory capital calculations. Many companies believe operational risk

can best be addressed through case-by-case supervisory reviews under Pillar 2; others favor a quantitative and a publicly disclosed capital charge under Pillar 1.

In several forums, the Roundtable itself has opposed a separate capital charge for

operational risk and has argued for handling the issue through supervisory reviews

under Pillar 2, much as interest rate and liquidity risk are handled. The

Roundtable’s senior management has expressed its concerns directly with Federal

Reserve Board Chairman Greenspan and Vice Chairman Ferguson. Many Roundtable member companies strongly oppose any Pillar 1 operational risk capital

charge. However, several Roundtable member companies just as firmly support

Basel II’s proposed Pillar 1 approach, following the development of the Accord’s ‘‘Advanced Measurement Approach’’ (AMA), which gives banks flexibility to use their

own internal methods for determining the regulatory capital needed for operational

risk. Institutions that support a Pillar 1 operational risk charge believe it would improve transparency and comparability and bring regulatory capital requirements

into closer alignment with the ‘‘economic capital’’ determinations used in these

banks’ internal management decisions. These institutions contend that any approach other than an explicit Pillar 1 charge for operational risk would impede

progress toward a level playing field, by affecting the process of calibrating regulatory capital minimums. That is, these members believe that if an operational risk

charge were not included in Pillar 1, the resulting capital charges on credit risk and

market risk would remain higher to compensate, making it more difficult for international banks to compete with institutions that are not covered by the new Accord.

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The Roundtable continues to have concerns about the proposed operational risk

capital charge, as well as several technical questions about its implementation. One

problem that all of our members agree upon is that the proposed Accord fails to give

enough recognition to the benefits of insurance in mitigating operational risk.

CSFB Comment

CSFB is concerned about the attempt to base an operational risk capital charge

on new, unproven models, and believes this approach is problematic and possibly

even counter-productive. We agree that operational risk is a critical risk to manage,

and we set aside significant capital to cover potential surprises in our internal capital allocation process. However, we do not believe that operational risk can be modeled in the quantitative way proposed under the Basel II rules. Many efforts to

measure operational risk have been proposed, often focusing on limited areas (for

example, operations processing losses) that happen to be susceptible to statistical

techniques. But these methods are not generally relevant to major risks, such as

fraud, a changing legal environment or a major disaster, which are the risks that

require capital. Operational risk capital is primarily to insure against the risk of

being fundamentally surprised by a major event, but it is difficult to predict and

measure what you do not expect.

Basel II and other regulatory initiatives will push banks to devote significant resources toward operational risk systems and loss databases, but I personally feel

that these resources could be better utilized elsewhere. Basel II’s Advanced Measurement Approach to operational risk requires banks to attempt to verify their models statistically. Many are working hard on this, but we have yet to see any model

that has actually been verified in a robust way. In fact, by emphasizing quantitative

numbers for operational risk, we may be creating a real danger—creating a false

sense of security that we have measured operational risk and hence controlled it.

I am a model-oriented, technical person by training, but I do not want to rely on

a model that is built on speculative assumptions.

It is encouraging that the Basel Committee has sent signals suggesting an increased degree of flexibility in operational risk calculations. I am hopeful that this

will bear out through the implementation. But we will still have a long way to go,

and I am concerned that there will be a tendency to revert to prescriptive and unscientific requirements as regulators develop specific rules for approving operational

risk models.

Pillar 3—Disclosure Rules

One of the strengths of the Basel II proposals is that they look beyond just calculating and maintaining capital levels. In designing Basel II, regulators realized that

capital requirements—the so-called ‘‘Pillar 1’’—could never ensure the safety and

soundness of the banking system alone. They understood that ultimately it is more

important to encourage constructive relationships between financial institutions,

their supervisors and the market to produce good risk management. This reasoning,

which has the strong support of the banking industry, has lead to the creation of

the two qualitative Pillars of the Basel Accord. Pillar 2 deals with the supervisory

review process and, in particular, regulatory oversight of banks’ internal economic

risk assessments. Pillar 3 seeks to enhance market discipline through increased

public disclosure requirements.

The concepts behind the proposed rules for Pillar 2 and 3 are well accepted by

the industry and regulators alike. However, many of the detailed proposals in the

Pillar 3 market disclosures section are cause for concern in the industry. Unfortunately, the development of Pillar 3 is an area where consultation between the industry and the regulators came late in the process. Although CP–3 has improved the

situation somewhat, we believe the proposals still are overly prescriptive, burdensome and subject to misinterpretation. The Pillar 3 requirements also reflect a

somewhat narrow view of risk, focusing exclusively on a specific regulatory view of

risk capital.

We currently publish approximately 20 pages of risk information in our annual

report, and we support transparency and disclosure as very worthwhile goals. The

Pillar 3 proposals would add a large mass of additional disclosure which is highly

technical in nature and which we believe will be of little benefit to the reader. Indeed, few people are able to digest all of the information that is already presented

on risks, but now this information could be lost in a deeper, more technical pile of

data. The additional requirements proposed under Pillar 3 are more likely to confuse than illuminate.

As Chairman Greenspan has recently remarked, transparency is not the same as

disclosure: ‘‘Transparency challenges market participants not only to provide inforVerDate 11-MAY-2000 10:04 Jul 07, 2004 Jkt 000000 PO 00000 Frm 00114 Fmt 6621 Sfmt 6621 94514.TXT BANK1 PsN: BANK1
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15 Remarks by Federal Reserve Board Chairman Alan Greenspan, Corporate Governance, at

the 2003 Conference on Bank Structure and Competition, May 8, 2003.

mation, but also to place that information in a context that makes it meaningful.’’ 15

In this, we believe the prescriptive, volume oriented focus of Pillar 3 falls short.

Of particular concern are the numerous required disclosures that relate directly

to the capital calculations performed within Pillar 1. Instead of disclosing measures

of risk used in internal risk management systems, these disclosures mandate an

explicit regulatory capital view of risk. In the most complex areas, such as asset

securitization, these disclosures will surely be mystifying to all but the most expert

audiences.

Moreover, given the likely longevity of the Basel II accord (the current accord is

in its 14th year), there is a need to ensure risk management practice is able to

mature beyond the concepts now embedded in the Basel II proposals. Just as the

market has moved beyond the current accord, there will inevitably come a time

when some Pillar 1 calculations are no longer regarded as good measures of risk

for all products. In that case, it must be possible for banks to alter disclosures to

represent emerging best practices. Under Pillar 3 as currently proposed, banks will

likely find themselves constrained to disclosing risks under a system that is no

longer wholly relevant.

In designing the details of Pillar 3, the Basel Committee has placed too much

emphasis on quantity, rather than quality, of disclosure. It is emphasizing consistency by prescription instead of consensus. In contrast, the demands of the market

have produced broadly comparable and largely voluntary disclosures of market risk

by banks. This is an example of how Pillar 3 should work. It would be more effective

if Pillar 3 established a general set of principles, and then allowed the discipline

of the market to produce continuous improvement in risk disclosure. This would

produce information that the market actually desires, rather than seeking to impose

today’s ideas on future market participants by fiat.

Summary

We are at an important crossroads in the reform effort. A lot of good hard work

on designing the framework and gaining political consensus has been accomplished.

We have a high regard for the efforts of the Basel Committee and the regulators

who have worked so hard to capture the best current practices in risk assessment.

CSFB and the Roundtable have tried to contribute to the specifics of those discussions in a constructive manner. We believe that the current proposal should be

streamlined significantly, reducing the level of prescriptiveness and cost, so that the

advantages of this project are not tarnished by its current shortcomings.

Simplifying the massive weight of detailed rules in Pillar 1 will require continued

discipline in the final round of drafting. It will also require a new emphasis on the

‘‘spirit’’ of the rules, both as the rules are finalized and when they move to the implementation phase with national regulators. If, instead, these rules are written and

interpreted as black-letter regulations, set at a highly technical audit standard, the

cost of overall implementation will be high. Such an approach would mean the calculations could also become increasingly outdated and less relevant to risk management best practice over time. We can hope that all national regulators will avoid

this pitfall, but international banks will tend to be driven by the standards set by

the strictest and most literal of their major regulators.

Much hard work has been put into Basel II, but much also remains ahead. The

timetable for implementation is challenging, particularly since the Accord’s require

a minimum of 3 years of data for the advanced calculations—meaning that banks

will need to revise systems to begin collecting the new information by early next

year. In the pressure to finalize and implement the Accord, we hope that enough

time will be provided for everyone—banks and supervisors alike—to digest and

think about the implications of the new regime, and to develop appropriate transition rules.

As a final comment, I believe that much more can be accomplished by increasing

the emphasis on the concepts of Pillar 2 and Pillar 3, and a focus on the principles

of evolving best practice rather than fixed formulae. This approach would not only

help address ‘‘prescriptiveness, cost and adaptability’’, but could also help address

the issues of operational risk and procyclicality. Pillars 2 and 3 have real people on

the other side—regulators and the market. Human judgment can adapt to changes

and new markets more easily than a rulebook can. This approach, properly applied,

also puts the burden back where it should be—on the shoulders of bank management to demonstrate to the regulators and the public that they are doing a good

job. That is in the spirit of the Sarbanes-Oxley reforms, and I think it is a smart,

durable way to improve discipline and maintain best practice standards.

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Finally, it should also make the new system more responsive to change and therefore more relevant over time. Without adjustments to make Basel II more flexible

and to allow it to evolve over time, I am afraid we might have to start work on a

Basel 3 before the ink is dry on the current effort.

Thank you.

—————

PREPARED STATEMENT OF KEVIN M. BLAKELY

EXECUTIVE VICE PRESIDENT AND CHIEF RISK OFFICER, KEYCORP

JUNE 18, 2003

Introduction

Thank you, Mr. Chairman. I am here today on behalf of KeyCorp, the 11th largest

banking company in the United States. KeyCorp has total assets of approximately

$85 billion, and spans the northern half of the United States from Maine to Alaska.

While the vast majority of our business is domestically based, we do have a modest

level of international business activity.

KeyCorp is not one of the institutions included in the definition of ‘‘top 10 most

internationally active institutions.’’ Accordingly, under the present regulatory guidance, we will not be required to comply with Basel II when it becomes effective in

2006. Nonetheless, it is our intent to qualify as an advanced practice institution. We

simply believe that it is good banking practice to develop the risk management tools

that are the foundation of Basel II: If that qualifies us as an advanced practice company under the new accord, so much the better.

I believe my testimony today provides a rather unique perspective on the issue

of whether or not Basel II is good for the banking industry. For the first 17 years

of my professional career I was a bank regulator with the Office of the Comptroller

of the Currency (OCC). Much of my time with the OCC was spent dealing with

problem and failing institutions. During my last several years with the OCC, I was

Deputy Comptroller for Special Supervision. That is a nice way of saying I was

responsible for the department that dealt with severely troubled and failing financial institutions.

My tenure in the Special Supervision Department ran from 1986 through 1990,

a time when a significant number of banks failed in the United States. I was able

to see first hand the myriad of reasons that caused banks to get into trouble. Not

the least of these was the inability to appropriately identify and manage their risks.

I left the OCC in 1990 to join the deeply troubled Ameritrust Corporation in

Cleveland, Ohio. Ameritrust was a $12 billion company that had encountered difficulties arising from its loan portfolio. I was part of the new management team focused on turning the company around. Over an 18-month period, Ameritrust lurched

from one crisis to another, but we eventually were able to stabilize the company.

During the interim period I lived, first hand, through the effects of a firm that had

little in the way of risk management practices and tools.

My experience with the OCC’s failing banks division and the Ameritrust debacle

convinced me that there had to be a better way of managing risk in the banking

industry.

In 1992, Ameritrust was acquired by Society Corporation, the precursor of today’s

KeyCorp. I was placed in the position Executive Vice President of Credit Policy and

Risk Management. In this capacity, I was given the opportunity to explore and

experiment with new risk management tools that were beginning to bud in the industry. I was encouraged to do so by our CEO who expressed a desire to have a

system whereby he could understand the totality of risk that our company faced on

a daily basis.

Our CEO envisioned a process that could tell him how much aggregate risk the

company was taking, including the risks that emanated from our credit, market,

and operational activities. He wanted a system that could allow us to increase, decrease, or maintain our risk position as circumstances warranted. Neither of us realized it at the time, but he was describing a process that is today commonly called

‘‘enterprise-wide risk management.’’

In 1993, I commenced the first step of his vision by installing a Value-at-Risk

(VAR) system in our company’s trading floor. VAR was a highly complex model

designed to measure risk in the bond, equity, and foreign exchange trading we undertook on a daily basis. Due to the complexity of a VAR model, I had to engage

several Ph.D.’s to help us implement it. During the course of their engagement, I

happened to mention my frustration in finding an enterprise wide system that could

aggregate the risk of each of our banking activities. One of the Ph.D.’s suggested

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that I look into the concept of economic capital allocation, now commonly known as

‘‘risk-based capital.’’

Once I investigated the premise of risk-based capital allocation, I concluded I had

discovered a powerful risk management tool. Implementing such a model at

KeyCorp would enable us to allocate capital to our lines of business based on the

amount of risk they took. Each line of business would be charged for the amount

of credit risk, market risk, and operational risk they encountered. Using the aggregate of that capital charge as the denominator, and the revenue they generated as

the numerator, we could determine which lines of business were getting appropriately paid for the risk they took. For the first time, we would be able to put all

our lines of business on an apples-to-apples comparison basis. Hence, the ability to

know our level of risk and whether or not we would be paid for the risk being taken.

Further, we would be able to aggregate the total amount of capital being allocated

to all our lines of business to understand the totality of risk our company was taking. It was the enterprise-wide solution we had been looking for.

KeyCorp commenced building an economic capital allocation program in the mid1990’s because we firmly believed that it was the right thing to do. It has taken

us nearly a decade to build it, and we are still not finished with it. Nonetheless,

even after nearly 10 years we remain convinced that it is the best way to run our

company. No regulator has told us that we must do this.

We are pleased to note that this powerful risk management tool, economic capital

allocation, is now the underlying driver of Basel II. Our company was highly critical

of the initial version of Basel II and publicly stated as much. We felt that it failed

to address the sophistication and complexity that our industry routinely operated

in. We felt it was inadequate and little better than the original Basel I. Put simply,

it did not adequately address risk sensitivity. However, over the next several years

we were pleasantly surprised to see how Basel II became a much better document.

The regulators working on the new accord have been genuinely receptive to hearing

the concerns that KeyCorp and others have raised. We haven’t always gotten our

way, but at least we have been heard.

We believe that Basel II is now on the right track. Financial institutions will need

to develop more sophisticated risk management tools to support the risk-based capital premise upon which it is built. This is a good thing. In today’s world of complex

financial markets, tools such as value-at-risk, two-dimensional loan grading systems, enterprise data warehouses, and operational loss databases are not a luxury;

they are a necessity. In order to understand their risk positions, banks should be

calculating risk-based capital and using these tools to do so. While models are no

substitute for human judgment, they certainly create a more informed human with

whom to make the decision.

One of the benefits we see in the Basel II proposal is that we will finally be free

to price our products and services commensurate with the risk they entail. As previously mentioned, Basel I provides very little in the way of risk sensitivity. One

of the perversities of this shortcoming is that it has driven high quality borrowers

away from the banking industry. These clients can access providers of credit not

subject to the costly level of capital that banks are currently required to hold. In

essence, banks are forced to overprice for this business, and they lose it to other

cheaper, nonregulated providers. Conversely, Basel I’s simplistic 8 percent capital

requirement has allowed banks to hold less capital than they should against borrowers that are high risk. This has resulted in banks underpricing such credit. It

should be no surprise, then, that Basel I has chased high-quality credits away from

banks, while attracting low-quality credits to them.

If banks are allowed to calculate the proper level of capital to be held based on

a realistic stratification of credit risk, this serious problem will largely disappear.

This is one of the tenets that Basel II is based upon: You hold the level of capital

necessary to support the risk, and price for it accordingly.

I would now like to address some of the criticisms that have been leveled against

Basel II. These would include its cost, complexity, inflexibility, and propensity to

foster procyclicality. I would also like to provide a few comments on the merits of

Basel II’s Pillar 1 versus Pillar 2.

Cost

Much has been said about the cost of building the models necessary to comply

with Basel II. At KeyCorp, we wonder how anyone can afford not to build them.

We, ourselves, have painfully learned the cost of not having them. In 1996, our riskbased capital process was still in its embryonic stage: In truth it did not begin to

take hold until 2000. In 1996, we were still calculating profitability measures

utilizing the primitive 8 percent capital standard stipulated by Basel I. On this

basis, one of our loan portfolios, leveraged lending, was producing an eye-popping

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return on equity close to 30 percent. As a consequence, we unfortunately pursued

expansion of leveraged lending over the next several years. At the end of 1998, the

quality of this portfolio began to collapse and we have written-off many millions of

dollars since.

We have looked retrospectively on our experience with this portfolio. We believe

if we had had our risk-based capital model in place (the kind proposed by Basel II)

our anticipated return would have been in the single digit range. Such knowledge

would have caused us to avoid this particular lending activity and to seek other opportunities that offered better risk/reward ratios.

Through this experience, we have learned an important lesson from which others

can benefit. The entire cost of the nearly 10-year effort to implement our economic

capital model (the same kind proposed by Basel II) pales in comparison to the cost

of not having it in place.

We have read that others estimate the cost of compliance with Basel II to be staggeringly high. We are not convinced this is the case, and it certainly has not been

so at KeyCorp. Yes, we have spent multiple millions of dollars over the years investing in risk management tools and models, but we have done so because we believe

those tools are necessary to conduct our business in a safe and sound manner.

Frankly, they will also make us a better competitor. The more we understand our

risk, the better we will be at managing and pricing for it.

Some have criticized the cost of auditing and back-testing the accuracy of the

models that Basel II is based upon. We view such activities as nothing more than

good common sense. Auditing and back-testing of outputs is critical to ensuring that

the model is producing reasonable numbers. Auditing/back-testing serve as the tuning devices necessary to modify the models’ calculations. For example, auditing and

back-testing of VAR models is an accepted practice in the industry now: Everyone

knows their benefit. We view auditing/back-testing as necessary investments needed

to create a better model. Better models create better understanding of risk and the

ability to better manage it. Better management of risk results in lower losses to

banks. We believe the cost of auditing/back-testing is inconsequential compared to

the losses that can occur due to inferior risk management processes.

Before one accepts the large figures attributed to Basel II compliance, one must

subtract the costs of building the risk management systems that a good financial

institution would invest in, regardless. We do not believe the gap between the two

is significant.

Complexity

We cannot deny that Basel II is a complex document. It is. Yet, it needs to be.

Banking is a complex business that needs complex solutions to the issues it faces.

We should not run from complexity but instead be willing to face it and manage

our way through it.

I have previously mentioned that KeyCorp installed a VAR system for its trading

floors in the early 1990’s. At that time, many were saying VAR systems were

exceedingly complex, expensive, and too mathematically driven. Yet, today VAR systems are widely recognized as the standard by which to manage risk in their trading books. VAR is a superior risk management tool that never would have come to

be had the financial services industry been intimidated by its complexity. I reiterate: When VAR first surfaced, it was accused of being too complex, costly, and

mathematically driven, the same crimes Basel II stands accused of today. Yet, VAR

has become the industry standard.

Inflexibility

Some fear Basel II will trap the industry with year 2000 era risk management

tools and stifle creation of new ones. We believe this concern is overstated. The 1988

Basel Accord was a woefully inadequate document from the start. Its simplistic approach mandated a specific capital level and made no provisions to the contrary.

Yet, over the past 15 years, the financial services industry has continued to develop

new risk management tools never envisioned by the 1988 Accord. These would include: VAR models, two-dimensional loan grading systems, economic capital models,

and enterprise-wide data warehouses. The fact that such tools were not contemplated by Basel I did not interfere with the industry’s pursuit of them. We anticipate a similar situation with Basel II—banks will continue to pursue a better

risk management mousetrap. We will acknowledge, however, that regulators must

be willing to consider the new tools as they are developed, and work with the industry to accommodate them as their effectiveness is demonstrated.

Procyclicality

We have frequently heard that regulators are concerned that Basel II might allow

substantial capital to escape from the banking system. We believe the whole

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premise of procyclicality is evidence that such concerns may be overstated. Basel II

capital levels represent the minimum level of capital that an institution is to hold.

The premise of procyclicality assumes that banks operate at or near the minimum

capital level. We believe it is highly unlikely that any banking company worth its

salt will allow their capital to sink to the lowest acceptable level.

Some argue that under Basel II, economic downturns will cause financial institutions to become more reluctant to lend when liquidity is most needed. Banks would

be placed in a position of making a difficult choice: Immediately raise new capital

or stop lending. In truth, there is a third choice that most banks will probably follow: Retain a buffer level of capital to accommodate cyclical changes in risk that

everyone knows will inevitably occur.

We believe that even in times of economic stress, banks genuinely desire to make

new loans to drive their own revenue streams. Our current economic situation is

a prime example: Banks are anxious to lend money. The demand is not there.

Pillar 1 versus Pillar 2

One of the basic principles of Basel II is to make risk transparent so that it is

comparable from one institution to another. Pillar 1 encourages a formulaic based

system that will enable this to occur. Consistency of methodology is critical to empower investors, regulators, and depositors with the information they need to gauge

the risk of the institution with whom they are dealing. Without Pillar 1’s consistency of approach, a Tower of Babel syndrome can occur.

Pillar 2 relies more on flexible judgment as to how much capital is warranted at

an institution. We acknowledge and accept that regulators must have the flexibility

to invoke their authority to ignore the results of Pillar 1 when circumstances so dictate. However, completely abandoning Pillar 1 in favor of Pillar 2 yanks any comparability benefit away from investors and depositors. The invisible hand of the

market will be impeded in its ability to quickly discipline a wayward institution.

For example, much has been said about the need to place operational risk under

a Pillar 2 approach. In this regard, the individual regulator that happened to be examining a particular bank would largely determine the adequacy of capital held for

its operational risk. This lends itself to varying assessments, interpretations, methodologies, and enforcements. An investor attempting to compare the level of capital

held for operational risk at multiple banks must assume that different examiners

will utilize the exact same thinking in their operational risk assessments. That simply doesn’t happen. A more formulaic approach, where all banks are using the same

scorecard, lends itself much more to consistent comparability.

The mere presence of a Basel II draft has caused many in the industry to start

contemplating new ways of tracking operational risk. This would include KeyCorp.

We have commenced building an operational risk database that will give us better

information regarding the source, size, and amount of operational losses. This database will ultimately serve as the system that feeds our operational risk model. We

believe it can be supplemented by exchanging information on operational risk losses

with other financial institutions. This will help us build the critical mass necessary

to create reliable, predictive loss forecasting models. I will readily admit that we

have a way to go in this particular area, but the presence of Basel II over our heads

encouraged KeyCorp and others in the industry to get moving on building the databases sooner.

Conclusion

In conclusion, KeyCorp believes that Basel I is hopelessly broken and that a new

accord needs to be implemented. Basel II is a major step forward and we applaud

its approach. It is not perfect now, nor will it be perfect when implemented, nor perfect 10 years after implementation. Regardless, it is light years ahead of Basel I,

as well as any other proposal we have seen to date. It should be supported.

We acknowledge it is complex, but banking is a complex business. A simple solution to complex issues is probably not the right medicine. As an industry, we should

not shy away from the remedy simply because it is complex. Instead, we should

work collectively with the regulators to find the right solution, not the easy one.

We have our doubts as to the high cost figures attributed to Basel II. Our own

experience to date has proven to the contrary. Further, we believe many Basel II

costs are simply expenditures we should otherwise be making as a matter of sound

banking practice. Good risk management costs money, but it is intended to help

avoid even bigger costs that arise from bad risk management.

We do not believe adoption of Basel II will trap the financial services industry

in a time warp. Banks will continue to develop better methods of managing risk regardless of what Basel II requires. However, regulators must be open and responsive as these new tools are developed.

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We believe there is substantial merit to including as much as we can in Pillar

1 versus Pillar 2. One of the greatest benefits that Basel II promises is that it will

utilize the invisible hand of the market to discipline wayward institutions. In order

to do that, investors must have adequate information to compare the risk of one institution against another on an apples-to-apples basis. Pillar 1 is the best vehicle

for ensuring that banks report on a consistent basis.

Mr. Chairman, KeyCorp appreciates the opportunity to share our views on Basel

II. We want to make sure our industry operates within a safe and sound environment. We know this is the goal of the Committee as well as our friends in the regulatory world. While Basel II is far from perfect, it certainly moves us further down

the path.