EXAMINING THE IMPACT OF THE 

PROPOSED RULES TO IMPLEMENT 

BASEL III CAPITAL STANDARDS 

JOINT HEARING 

BEFORE THE

SUBCOMMITTEE ON 

FINANCIAL INSTITUTIONS 

AND CONSUMER CREDIT 

AND THE

SUBCOMMITTEE ON 

INSURANCE, HOUSING AND 

COMMUNITY OPPORTUNITY 

OF THE

COMMITTEE ON FINANCIAL SERVICES 

U.S. HOUSE OF REPRESENTATIVES 

ONE HUNDRED TWELFTH CONGRESS 

SECOND SESSION 

NOVEMBER 29, 2012 

Printed for the use of the Committee on Financial Services 

Serial No. 112–161 

( 

EXAMINING THE IMPACT OF THE PROPOSED RULES 

TO IMPLEMENT BASEL III CAPITAL STANDARDS 

U.S. GOVERNMENT PRINTING OFFICE

WASHINGTON : 

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

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

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

79–691 PDF 2013

EXAMINING THE IMPACT OF THE 

PROPOSED RULES TO IMPLEMENT 

BASEL III CAPITAL STANDARDS 

JOINT HEARING 

BEFORE THE

SUBCOMMITTEE ON 

FINANCIAL INSTITUTIONS 

AND CONSUMER CREDIT 

AND THE

SUBCOMMITTEE ON 

INSURANCE, HOUSING AND 

COMMUNITY OPPORTUNITY 

OF THE

COMMITTEE ON FINANCIAL SERVICES 

U.S. HOUSE OF REPRESENTATIVES 

ONE HUNDRED TWELFTH CONGRESS 

SECOND SESSION 

NOVEMBER 29, 2012 

Printed for the use of the Committee on Financial Services 

Serial No. 112–161 

( 

(II) 

HOUSE COMMITTEE ON FINANCIAL SERVICES 

SPENCER BACHUS, Alabama, Chairman 

JEB HENSARLING, Texas, Vice Chairman 

PETER T. KING, New York 

EDWARD R. ROYCE, California 

FRANK D. LUCAS, Oklahoma 

RON PAUL, Texas 

DONALD A. MANZULLO, Illinois 

WALTER B. JONES, North Carolina 

JUDY BIGGERT, Illinois 

GARY G. MILLER, California 

SHELLEY MOORE CAPITO, West Virginia 

SCOTT GARRETT, New Jersey 

RANDY NEUGEBAUER, Texas 

PATRICK T. MCHENRY, North Carolina 

JOHN CAMPBELL, California 

MICHELE BACHMANN, Minnesota 

KEVIN McCARTHY, California 

STEVAN PEARCE, New Mexico 

BILL POSEY, Florida 

MICHAEL G. FITZPATRICK, Pennsylvania 

LYNN A. WESTMORELAND, Georgia 

BLAINE LUETKEMEYER, Missouri 

BILL HUIZENGA, Michigan 

SEAN P. DUFFY, Wisconsin 

NAN A. S. HAYWORTH, New York 

JAMES B. RENACCI, Ohio 

ROBERT HURT, Virginia 

ROBERT J. DOLD, Illinois 

DAVID SCHWEIKERT, Arizona 

MICHAEL G. GRIMM, New York 

FRANCISCO ‘‘QUICO’’ CANSECO, Texas 

STEVE STIVERS, Ohio 

STEPHEN LEE FINCHER, Tennessee 

FRANK C. GUINTA, New Hampshire 

BARNEY FRANK, Massachusetts, Ranking 

Member 

MAXINE WATERS, California 

CAROLYN B. MALONEY, New York 

LUIS V. GUTIERREZ, Illinois 

NYDIA M. VELA ́ ZQUEZ, New York 

MELVIN L. WATT, North Carolina 

GARY L. ACKERMAN, New York 

BRAD SHERMAN, California 

GREGORY W. MEEKS, New York 

MICHAEL E. CAPUANO, Massachusetts 

RUBE ́ N HINOJOSA, Texas 

WM. LACY CLAY, Missouri 

CAROLYN MCCARTHY, New York 

JOE BACA, California 

STEPHEN F. LYNCH, Massachusetts 

BRAD MILLER, North Carolina 

DAVID SCOTT, Georgia 

AL GREEN, Texas 

EMANUEL CLEAVER, Missouri 

GWEN MOORE, Wisconsin 

KEITH ELLISON, Minnesota 

ED PERLMUTTER, Colorado 

JOE DONNELLY, Indiana 

ANDRE ́ CARSON, Indiana 

JAMES A. HIMES, Connecticut 

GARY C. PETERS, Michigan 

JOHN C. CARNEY, JR., Delaware 

JAMES H. CLINGER, Staff Director and Chief Counsel 

(III) 

SUBCOMMITTEE ON FINANCIAL INSTITUTIONS AND CONSUMER CREDIT

SHELLEY MOORE CAPITO, West Virginia, Chairman 

JAMES B. RENACCI, Ohio, Vice Chairman 

EDWARD R. ROYCE, California 

DONALD A. MANZULLO, Illinois 

WALTER B. JONES, North Carolina 

JEB HENSARLING, Texas 

PATRICK T. MCHENRY, North Carolina 

KEVIN McCARTHY, California 

STEVAN PEARCE, New Mexico 

LYNN A. WESTMORELAND, Georgia 

BLAINE LUETKEMEYER, Missouri 

BILL HUIZENGA, Michigan 

SEAN P. DUFFY, Wisconsin 

FRANCISCO ‘‘QUICO’’ CANSECO, Texas 

MICHAEL G. GRIMM, New York 

STEPHEN LEE FINCHER, Tennessee 

FRANK C. GUINTA, New Hampshire 

CAROLYN B. MALONEY, New York, 

Ranking Member 

LUIS V. GUTIERREZ, Illinois 

MELVIN L. WATT, North Carolina 

GARY L. ACKERMAN, New York 

RUBE ́ N HINOJOSA, Texas 

CAROLYN MCCARTHY, New York 

JOE BACA, California 

BRAD MILLER, North Carolina 

DAVID SCOTT, Georgia 

NYDIA M. VELA ́ ZQUEZ, New York 

GREGORY W. MEEKS, New York 

STEPHEN F. LYNCH, Massachusetts 

JOHN C. CARNEY, JR., Delaware 

(IV) 

SUBCOMMITTEE ON INSURANCE, HOUSING AND COMMUNITY OPPORTUNITY

JUDY BIGGERT, Illinois, Chairman 

ROBERT HURT, Virginia, Vice Chairman 

GARY G. MILLER, California 

SHELLEY MOORE CAPITO, West Virginia 

SCOTT GARRETT, New Jersey 

PATRICK T. MCHENRY, North Carolina 

LYNN A. WESTMORELAND, Georgia 

SEAN P. DUFFY, Wisconsin 

ROBERT J. DOLD, Illinois 

STEVE STIVERS, Ohio 

LUIS V. GUTIERREZ, Illinois, Ranking 

Member 

MAXINE WATERS, California 

NYDIA M. VELA ́ ZQUEZ, New York 

EMANUEL CLEAVER, Missouri 

WM. LACY CLAY, Missouri 

MELVIN L. WATT, North Carolina 

BRAD SHERMAN, California 

MICHAEL E. CAPUANO, Massachusetts 

(V) 

C O N T E N T S 

Page 

Hearing held on: 

November 29, 2012 ........................................................................................... 1 

Appendix: 

November 29, 2012 ........................................................................................... 85 

WITNESSES 

THURSDAY, NOVEMBER 29, 2012 

Admati, Anat R., George G.C. Parker Professor of Finance and Economics, 

Graduate School of Business, Stanford University ........................................... 51 

Duffy, Terrence A., Executive Chairman and President, CME Group Inc. ........ 53 

French, George, Deputy Director, Policy, Division of Risk Management Supervision, Federal Deposit Insurance Corporation (FDIC) .................................... 12 

Garnett, James M., Jr., Head of Risk Architecture, Citi ...................................... 54 

Gibson, Michael S., Director, Division of Banking Supervision and Regulation, 

Board of Governors of the Federal Reserve System .......................................... 14 

Gonzales, Greg, Commissioner, Tennessee Department of Financial Institutions, on behalf of the Conference of State Bank Supervisors (CSBS) ............ 17 

Jarsulic, Marc, Chief Economist, Better Markets, Inc. ........................................ 56 

Loving, William A., Jr., President and Chief Executive Officer, Pendleton 

Community Bank, and Chairman-Elect, Independent Community Bankers 

of America (ICBA), on behalf of ICBA ................................................................ 57 

Lyons, John C., Senior Deputy Comptroller, Bank Supervision Policy, and 

Chief National Bank Examiner, Office of the Comptroller of the Currency ... 15 

McCarty, Kevin M., Commissioner, Florida Office of Insurance Regulation, 

and President, the National Association of Insurance Commissioners 

(NAIC), on behalf of NAIC .................................................................................. 19 

Poston, Daniel T., Chief Financial Officer, Fifth Third Bancorp, on behalf 

of the American Bankers Association (ABA) ..................................................... 59 

Smith, Paul, CPCU, CLU, Senior Vice President and Chief Financial Officer, 

State Farm Mutual Automobile Insurance Company ....................................... 60 

Wilson, Gina, Executive Vice President and Chief Financial Officer, TIAA– 

CREF ..................................................................................................................... 62 

APPENDIX 

Prepared statements: 

Miller, Hon. Gary ............................................................................................. 86 

Admati, Anat R. ................................................................................................ 88 

Duffy, Terrence A. ............................................................................................ 126 

French, George .................................................................................................. 148 

Garnett, James M., Jr. ..................................................................................... 168 

Gibson, Michael S. ............................................................................................ 176 

Gonzales, Greg .................................................................................................. 198 

Jarsulic, Marc ................................................................................................... 226 

Loving, William A., Jr. ..................................................................................... 242 

Lyons, John C. .................................................................................................. 248 

McCarty, Kevin M. ........................................................................................... 296 

Poston, Daniel T. .............................................................................................. 304 

Smith, Paul ....................................................................................................... 317 

Wilson, Gina ...................................................................................................... 326 

Page

VI 

ADDITIONAL MATERIAL SUBMITTED FOR THE RECORD

Capito, Hon. Shelley Moore: 

Written statement of America’s Mutual Banks ............................................. 369 

Written statement of the Council of Federal Home Loan Banks ................. 374 

Written statement of the Mid-size Bank Coalition of America .................... 394 

Miller, Hon. Gary: 

Letter to Federal Reserve Chairman Ben Bernanke, FDIC Acting Chairman Martin J. Gruenberg, and Comptroller Thomas J. Curry from 

Senator Susan M. Collins, dated November 26, 2012 ................................ 417 

Perlmutter, Hon. Ed: 

Speech delivered to The American Banker Regulatory Symposium by 

Thomas M. Hoenig, FDIC Director, on September 14, 2012 ..................... 419 

Stivers, Hon. Steve: 

Supplemental testimony supplied for the record by Daniel T. Poston ......... 425 

(1) 

EXAMINING THE IMPACT OF THE 

PROPOSED RULES TO IMPLEMENT 

BASEL III CAPITAL STANDARDS 

Thursday, November 29, 2012 

U.S. HOUSE OF REPRESENTATIVES, 

SUBCOMMITTEE ON FINANCIAL INSTITUTIONS

AND CONSUMER CREDIT, AND

SUBCOMMITTEE ON INSURANCE, HOUSING

AND COMMUNITY OPPORTUNITY, 

COMMITTEE ON FINANCIAL SERVICES, 

Washington, D.C. 

The subcommittees met, pursuant to notice, at 10:03 a.m., in 

room 2128, Rayburn House Office Building, Hon. Shelley Moore 

Capito [chairwoman of the Subcommittee on Financial Institutions 

and Consumer Credit] presiding. 

Members present from the Subcommittee on Financial Institutions and Consumer Credit: Representatives Capito, Renacci, 

Hensarling, McHenry, Pearce, Westmoreland, Luetkemeyer, 

Huizenga, Duffy, Canseco, Fincher; Maloney, Gutierrez, Watt, 

McCarthy of New York, Lynch, Miller of North Carolina, and Scott. 

Members present from the Subcommittee on Insurance, Housing 

and Community Opportunity: Representatives Biggert, Hurt, Miller 

of California, Garrett, Westmoreland, Duffy, Dold, Stivers; Gutierrez, Waters, Watt, Sherman, Capuano, and Cleaver. 

Also present: Representatives Hayworth; Green and Perlmutter. 

Chairwoman CAPITO. I would like to call the hearing to order. 

I first would like to say that Mrs. Maloney, who is my ranking 

member—there is a lot going on in the Democrat caucus right now. 

I am sure they will be here shortly. So they said to go ahead and 

start, and we have Mr. Scott here to carry the flag. So I am going 

to go ahead and call the hearing to order. 

I would like to thank Chairwoman Biggert, Ranking Member 

Maloney, and Ranking Member Gutierrez for their cooperation in 

holding this joint hearing on capital requirements for financial institutions. 

We have two panels with very diverse witnesses, and they will 

be presenting various concerns about the proposed rule to implement the Basel III capital requirements. Because this is a joint 

hearing with two large witness panels, I would ask my fellow colleagues, if they would—I am going to gavel us down at 5 minutes 

on questioning because we have a lot of interests and we have a 

large panel at the same time. 

2 

Before I begin my formal opening statement, I would like to take 

a minute to thank my good friend, Chairwoman Judy Biggert from 

Illinois. This will probably be her final hearing. She has been a 

mentor to me, and a good friend. She has been wonderful, had wonderful service on this committee. She understands the issues very 

deeply, and she cares. And I think all of you who have dealt with 

Judy through the years are going to miss her as much as I am, and 

this committee will miss her. 

So, Judy, I want to say thank you. Thank you for getting the 

flood bill through. 

I tease her about being ‘‘Miss Flood,’’ but she got it through. And 

it was her perseverance and her dedication to that issue that actually saw it all the way through to the President’s desk. So if we 

could give Judy a little round of applause. 

[applause] 

Chairwoman BIGGERT. We will never get to the hearing. 

Chairwoman CAPITO. Judy said, ‘‘We will never get to the hearing.’’ She is always working. 

In early June of this year, the Federal Reserve Board, the Office 

of the Comptroller of the Currency, and the FDIC jointly proposed 

three rules to revise risk-based capital requirements to make them 

consistent with the Basel III Accords. 

Like many of my colleagues—and it is really surprising to me 

how vocal the concern has been—I have heard a lot of concern from 

financial institutions of all sizes about the effect that implementation of these capital requirements will have on the health of financial institutions, their ability to lend, and the subsequent effect on 

the economy. 

Although there was near-unanimous expectation that these capital requirements would only apply to the largest banks, many 

were surprised when the U.S. Federal agencies applied standards 

that were designed for large complex institutions to regional community banks, as well. 

Higher capital requirements for large complex institutions are 

entirely appropriate. Over the last year, we have seen firsthand 

that a well-capitalized financial institution can sustain a significant loss because they are holding sufficient capital. Furthermore, 

higher capital requirements may help prevent our Nation’s largest 

financial institutions from becoming even more systemic. The Basel 

III Accords were designed to address many of the issues posed by 

large, complex, systemic financial institutions. It is less clear 

whether these specific capital requirements are appropriate for regional and community banks. 

The United States is very fortunate to be served by a highly diverse financial system. The diversity in our system is evident in 

the different banks that are testifying here today. Pendleton Community Bank, near and dear to my heart, from West Virginia is a 

$260 million asset bank located in rural West Virginia. Fifth Third 

Bancorp is a $117 billion regional bank serving 12 States. And 

Citigroup is a nearly $2 trillion bank serving clients across the 

globe. 

These institutions have unique business models designed to serve 

different types of customers. The one-size-fits-all approach to regulatory capital in the proposed rules does not take into consideration 

3 

the diversity of our Nation’s financial system and the unique challenges faced by different size institutions. 

Furthermore, as we will learn from several witnesses today, the 

proposed rules will apply to insurance companies that own their 

own thrifts. Again, there needs to be significant flexibility in the 

way these rules are finalized that properly takes into account the 

differences in their business models. 

I know that the regulatory agencies are currently reviewing 

thousands of comments on the proposed rules, and I thank them 

for their diligence in reviewing the comments. 

We can all agree that higher capital requirements are an important tool in ensuring that we have a safe and sound financial system. However, it is my hope that today’s hearing will demonstrate 

to the regulatory agencies the importance of appropriately tailoring 

these requirements to the different size financial institutions in the 

United States. 

So that is my opening statement. I now recognize Mr. Sherman 

for an opening statement. 

Mr. SHERMAN. Thank you. 

Increasingly, we find in this committee that what the regulators 

do is more important than what we do. That is in part because 

Congress finds it so difficult to pass a statute. It is an old saying 

in the English language, the American language, ‘‘It takes an act 

of Congress.’’ 

Still, we are a democracy. And if regulators are going to pen the 

important laws, they should be listening to the elected representatives of the people, even if those representatives can’t come together to the point of drafting statutes that are binding on them. 

I think that there will be a general consensus here that while 

certain basic principles would apply to all banks and relevant insurance companies, we need to have substantial differences in the 

ultimate principles as they apply to those that are the largest and 

the smallest, and perhaps some other differentiations, as well. 

With that, I yield back. 

Chairwoman CAPITO. The gentleman yields back. 

I recognize Mrs. Biggert for 2 minutes for an opening statement. 

Chairwoman BIGGERT. Thank you, Madam Chairwoman. 

Contributing to the recent collapse of many financial institutions 

across the country was a flawed regulatory system, ineffective 

rules, and asleep-at-the-switch regulators. Sufficient capital, sound 

risk management, and prudent regulation are critical components 

to ensure the availability and reliability of financial products to 

consumers and the solvency of financial institutions large and 

small alike. 

Federal bank regulators proposed rules to implement the new 

Basel Accord, Basel III, increase capital for the sake of increasing 

capital, while treating insurance like banking; multifaceted large 

banks, like small banks; and 1-day and 5-day derivatives contracts 

the same. They don’t make much sense. What could be the cost of 

negligence should these proposed rules not improve? It is not the 

most sound and effective regulation, and at a time when we can 

least afford increased costs to families and businesses as well as no 

or slow job and economic growth. Regulations should first aim to 

do no harm. 

4 

To comply with Basel III, our regulations must strike the right 

balance. They should be tailored to different and changing business 

models, account for a wide variety of financial products and inherent risks, and set capital requirements accordingly. The proposed 

rules don’t achieve these goals. 

Today, I look forward to a commitment from the Federal Reserve 

that they, in fact, will improve this rule and not simply commit to 

review and consider submitted comments. 

I thank Chairwoman Capito for her hard work in putting together today’s very important hearing, and I thank the witnesses 

for their participation. 

And I yield back. 

Chairwoman CAPITO. Thank you. 

I would like to recognize Mr. Miller for—do you have an opening 

statement? 

Mr. MILLER OF NORTH CAROLINA. No. 

Chairwoman CAPITO. Before I move on to Mr. Scott, I would like 

to thank Mr. Miller, as well, for his service to this committee and 

to this Congress. He will be leaving us. As we all know, Mr. Miller 

is a very dedicated and ardent advocate in his beliefs. And I believe 

he has enhanced the quality of the committee, and I want to thank 

him for his service. 

Thank you. 

[applause] 

Chairwoman CAPITO. Even though he is a Carolina fan and I 

went to Duke, but that is okay. 

I would like to recognize Mr. Scott for as much time as he may 

consume for an opening statement. 

Mr. SCOTT. Thank you very much, Madam Chairwoman. 

And I, too, want to commend Mr. Miller for his excellent service. 

We came into the Congress together and went on many trips 

abroad together, and we are good friends. 

I wish you the very best, Mr. Miller. 

This is indeed an important hearing, and it is very important to 

me because I represent Georgia, a State that has led the Nation 

in bank closures. So I know firsthand some of the difficulties that 

banks are facing now—not only a struggling economy, overvaluation of real estate portfolios that had an effect, but also these 

regulations that we are putting in place to prevent such a calamity 

from happening again. We are trying to propose sufficient regulations in the midst of economic recovery and difficulties for our 

banks. 

So I am very, very concerned about banks. And it is very important for us to note that many banks are still struggling under the 

pressure of a recovering economy, along with these tighter regulations that are being put in place. 

But I am very supportive of efforts to improve capital standards 

for banks in order to ensure that every banking institution, regardless of size, has a sufficient financial buffer to absorb losses. However, through regulators’ efforts to strengthen the banking system 

by means of new requirements, community banks, especially in my 

State of Georgia, have suffered from the burden of maintaining unnecessarily high levels of capital, and we need to examine that. 

What really works best? 

5 

Community banks have expressed to me direct concern regarding 

the proposed Basel III rules on capital requirements and the effect 

they would have on bank lending and especially on the local economy in my State of Georgia. They maintain that these regulations 

would require them to increase their capital and liquidity holding 

on small business loans and mortgages, in turn reducing Georgia 

consumers’ access to these loans. 

So this causes me great concern during this time of economic recovery, and especially in Georgia, as well, because we have a high 

unemployment rate which is above the national average. Our unemployment rate right now is hovering at 9 percent. 

I expressed my concerns on this issue just last week in a letter 

that I wrote to Chairman Bernanke, Comptroller Curry, and Acting 

Chairman Gruenberg, where I asked for regulators to take appropriate time to adopt rules that distinguish between the systemic 

risk and megabanks and to study the potential impact that each 

rule change would have on the banking industry. There is a difference between your big megabanks, your regional banks, and 

your community banks. One size just does not fit all. 

I am also concerned about the overall impact of the Basel III proposals in conjunction with other regulations, such as those mandated by the Dodd-Frank Act and other regulatory and accounting 

rule standards on credit availability, the cost of credit. This is a 

monumental issue of great complexity, and we have to make sure 

that we get it right, that we understand the impact, and that we 

really don’t have too many unnecessary consequences that will result in negative impact on our customers and our consumers, because that is what we are all here to try to solve. 

With that, I yield back, Madam Chairwoman. 

Chairwoman CAPITO. Thank you. 

I recognize Mr. Hurt for 1 minute. 

Mr. HURT. I thank the Chair for yielding and I appreciate Chairwoman Biggert and Chairwoman Capito for convening this important hearing today. 

I wanted to echo my thanks to Chairwoman Biggert for her service. It has been a privilege to be able to serve on the Insurance and 

Housing Subcommittee with you, and I thank you for that. 

As our committee has heard throughout this Congress, the proposed Basel III capital requirements appear to have been made 

without regard for their unintended consequences and negative impacts on the economy. While sufficient capital requirements are essential to a strong banking and financial system, they must be appropriately tailored to consider the intricacies of a diverse financial 

business model rather than a one-size-fits-all system. 

Community banks in Virginia’s Fifth District, my district, have 

told me that the proposed rules’ complexity will impose significant 

costs. In light of other regulatory impacts they face from DoddFrank, these banks will be hard-pressed to transition to these new 

capital standards without eliminating key portions of their business that serve our communities. 

Additionally, I am concerned by the way that proposed rules 

treat insurers with depository institution holding companies. The 

assets, liabilities, and accounting practices of insurers are quite difVerDate Nov 24 2008 11:52 Apr 26, 2013 Jkt 079691 PO 00000 Frm 00013 Fmt 6633 Sfmt 6633 K:\DOCS\79691.TXT TERRI
6 

ferent than those of banks, yet the rules do not differentiate between these entities. 

As the regulators promulgate the final rules, I hope they will 

take these concerns into account so that these capital requirements 

can accommodate the needs of different enterprises that will be impacted by these regulations and minimize the potential harm to our 

economy. 

I look forward to hearing from our witnesses, and I yield back 

the balance of my time. 

Chairwoman CAPITO. I recognize Mrs. Maloney for an opening 

statement. 

Mrs. MALONEY. First of all, I thank you for calling this incredibly 

important hearing. 

And I want to join my colleagues in applauding Judy Biggert for 

her outstanding service to our country. During this time when flood 

relief is so important in New Jersey and New York and Westchester, her work on the flood bill last year, modernizing it, getting 

it in shape, really, really is being felt in our neighborhoods. And 

I want to congratulate her on that work. 

I also want to mention a bill that we put in that became law and 

is still law, and that was on Afghan women. The Taliban are prosecuting women. We put in a bill that $60 million of our aid to Afghanistan would go to NGOs either headed by women or helping 

women, and created a human rights commission where men and 

women, children, all people could appeal for their rights. It was important legislation. 

Judy, I just appreciate all of your hard work in so many ways. 

And Brad Miller is such an outstanding member of our caucus 

and of this committee, authoring and passing many important bills. 

And I have so such regard for his intellect and his integrity and 

his judgment that, literally, I tried to hire him as my personal lawyer when he left. He is telling me he is not going to practice law, 

but he is a brilliant lawyer, and a brilliant member of this committee. 

We are going to deeply, deeply miss you. 

I congratulate both of them on their outstanding, incredible service to this incredible body, our Congress. 

I want to thank everyone here and welcome the witnesses today. 

Four years ago, we learned a couple of very important lessons. 

We learned that banks were undercapitalized, overleveraged, and 

vulnerable to economic shock. We also learned that some types of 

capital can protect a financial institution better than others in a 

crisis. And since that time, Congress, the financial institutions 

themselves, and the regulators have taken a number of critical 

steps to ensure that the banking system can withstand the next financial crisis. 

Several provisions of the Dodd-Frank Act, including the Collins 

Amendment, are aimed at strengthening banks’ capital and shoring 

up their Tier 1 capital. And banks are better capitalized now than 

ever before. Total capital is up by 10 percent since 2009. And the 

number of unprofitable banking institutions has dropped from 28 

percent of the total in 2009 to 11 percent in 2012. 

The global regulatory community has also been working to implement Basel III, and the U.S. regulators issued a three-part rule to 

7 

do so in June. The rules that were issued in June reflect the recommendations of the Basel Committee and focus on three areas: 

imposing minimum regulatory capital ratios and buffers; defining 

rules for risk-weighted assets; and setting the supplementary leverage ratios for large, internationally active banks. 

Since the proposed rule was issued, concerns have been raised by 

a number of entities with respect to how these rules will impact 

small community banks and regional banks as well as insurance 

companies that will have to comply with them. I do not support the 

rule at this time, and I share a number of concerns. 

First, I do not believe that smaller community and regional 

banks should be swept into Basel III and forced into it. If they 

want to opt in, fine. But Basel is meant for larger, cross-border 

banks that do business internationally, and not for small community and regional banks that are already well-capitalized. And I repeat, they were not part of the crisis. 

They are an important part of the banking system. Even in the 

great City of New York, where we have many large banks, they 

serve the community. And to put these compliance costs on them 

and these regulations, when they are not involved in international 

business—they are really supplying services to the community. I 

am concerned that these requirements may force a lot of community and regional banks out of business. So I am very, very concerned. 

Second, I am concerned that the proposed risk weights are punitive and will mean the consumers who cannot afford to put down 

a 20 percent downpayment will be penalized. We need real riskbased criteria and real metrics, not a further restriction of the 

housing market. And I feel that should be more completely defined. 

And, finally, I am concerned about the proposed rules that are 

overly complex and could prove incredibly costly to implement. Despite their complexity, they do not take into account the various 

business models of covered entities, specifically insurance companies that will have to comply with them even though they are covered by many other regulations in other areas. 

Those who are working on the rule announced a couple of weeks 

ago that they will not issue a final rule until after the first of the 

year. I think that is a positive thing. And I am pleased to see that 

they are taking the time to get it right, to address the concerns 

from the industry, and to hopefully coordinate with our global partners. But I hope they will be able to shed some light on their timeframe for issuing a final rule. 

Between the two panels here today, we have a range of regulatory bodies and industry represented, as well as leaders on these 

subjects. So I look forward to hearing from them. I feel this is a 

critically important hearing, and I compliment my colleague for 

calling it. 

Chairwoman CAPITO. Thank you. 

Mr. Hensarling for 2 minutes. 

Mr. HENSARLING. Thank you, Madam Chairwoman. I appreciate 

you and Chairwoman Biggert holding this particular hearing. 

We have had many debates in this hearing room about the DoddFrank Act. I suspect there will be more in the future. And regardless if it is perceived in real benefits, many of us believe that there 

8 

has been a substantial cost by the imposition of very complex, expensive, weighty rules upon our financial markets, ultimately making capital more expensive and less available. 

Unfortunately, on top of that now comes Basel III, weighing in, 

I believe, at over 1,000 pages, when I am not so certain we were 

well-served by either Basel I, Basel II, or Basel II-and-a-half. We 

know that the regulators decided, in their wisdom, that financial 

institutions should reserve less against both sovereign debt and 

agency MBS, and I think we know how that all played out. 

I have heard some very encouraging things on both sides of the 

aisle, particularly Members indicating a concern about one-size-fitsall. I would agree with the ranking minority member that it is a 

very open question whether Basel III should even apply to our community-based financial institutions. So let’s hope the bipartisan 

concern and support is a harbinger of things to come in the 113th 

Congress. 

Clearly, the case can be made that we need more capital. A case 

can be made that we need higher quality capital. It is a very poor 

case for more complex capital standards that do not recognize the 

difference between large money center banks and our community 

financial institutions. 

Somebody recently sent me a quote from Einstein that I will 

close with, Madam Chairwoman. The quote is this: ‘‘We cannot 

solve our problems with the same level of thinking that created 

them.’’ I believe that applies to Basel III. 

I yield back. 

Chairwoman CAPITO. The gentleman yields back. 

Mr. Lynch for 2 minutes. 

Mr. LYNCH. Thank you, Madam Chairwoman. 

I want to welcome all the witnesses and thank you for coming 

before this committee and helping us with our work. 

One of the important lessons that we learned from the recent financial crisis is that some banks were not required to hold sufficient capital, either because it wasn’t enough capital or the capital 

itself was not of sufficient quality to withstand the significant 

losses unleashed by the housing bubble bursting. 

As a result of the actions by the Basel Committee and the requirement in the Dodd-Frank Act, U.S. banking regulators are 

moving forward with the rules to modernize our outdated and inadequate minimum capital rules. I have heard a lot of folks here and 

elsewhere describe these minimum capital rules as complex, but I 

think that is perhaps a little bit misleading. The idea behind the 

rules is actually fairly simple and straightforward: the level of capital banks have to hold because of assets on their books should be 

determined by how risky those assets are. 

What has become complex is not this idea but the business of 

banking itself. And as a result, the rules putting this simple idea 

into play, that minimum capital levels should reflect risk, have become more convoluted. 

No one here today would argue that Basel I rules, which treat 

a commercial loan to a blue chip company and a commercial loan 

to an Internet startup as equally risky, are too complex. In fact, 

nearly everyone concedes that those rules are too simplistic and are 

outdated in our modern world of financial innovation. We need 

9 

rules that reflect the dynamic and sometimes volatile world of modern finance, and those rules also may wind up reflecting modern 

finance’s complexity. 

I am sympathetic, I admit, to the community banks. And I would 

like to hear from some of our witnesses who represent the community banks, particularly the regulators who oversee them, about 

how we can make these rules easier for the community banks to 

implement, whether by making some of the more convoluted riskweighting calculations prospective and providing the community 

banks with an extended on-ramp time or some other way to ease 

the burden of community banks. 

Again, I thank the witnesses for coming here today, and I look 

forward to hearing your testimony. 

Thank you. 

Chairwoman CAPITO. Thank you. 

Mr. Miller for 1 minute. 

Mr. MILLER OF CALIFORNIA. I would like to thank the chairwoman for hosting this hearing today. 

There is no question that robust capital standards, when properly applied, will help protect our economy. But when we proceed 

with caution, such standards can actually be detrimental to our 

economy if not properly applied. 

Capital standards need to be set appropriately so they can ensure the safety and soundness of financial institutions without 

harming the availability of credit to fuel economic growth and the 

ability of small banks to serve their communities. 

I am really concerned about the proposed rules’ treatment of insurance companies that own depository institutions. The bank-centric approach to the proposed rules is inconsistent with the safe supervision of insurance companies and could actually harm the solvency of the insurance industry, which is actually the opposite of 

what Congress intended. 

Earlier this year, Chairman Bernanke acknowledged before the 

committee that appropriate capital standard regulations should 

take into account the different compositions of assets and liabilities 

of insurance companies. Just yesterday, Senator Collins, the author 

of the language in the Dodd-Frank Act, sent a letter to the Federal 

Reserve, the FDIC, and Treasury stating that, ‘‘It was not Congress’ intent that Federal regulators supplant prudential Statebased insurance regulations without bank-centric capital standards.’’ 

I ask unanimous consent for that letter to be introduced into the 

record. 

Chairwoman CAPITO. Without objection, it is so ordered. 

Mr. MILLER OF CALIFORNIA. I would be concerned that the proposed rules do not take into account the different business models 

and risk profiles of insurance companies. 

I yield back. 

Chairwoman CAPITO. Thank you. The gentleman yields back. 

Mr. Duffy for 1 minute. 

Mr. DUFFY OF WISCONSIN. Thank you, Madam Chairwoman. 

For Basel III, I support increasing capital requirements on our 

larger banks to insulate the American taxpayer from bailing out 

large financial institutions again. However, I come from rural WisVerDate Nov 24 2008 11:52 Apr 26, 2013 Jkt 079691 PO 00000 Frm 00017 Fmt 6633 Sfmt 6633 K:\DOCS\79691.TXT TERRI
10 

consin, where we are served by a number of small community 

banks, and I am concerned about the impact Basel III will have on 

their ability to continue serving our communities. 

So today, I hope the panel will discuss a few issues. First, under 

Dodd-Frank, small bank holding companies were allowed to hold 

trust-preferred securities as Tier 1 capital. Basel III requires these 

small banks to phase out their trust-preferred securities, which will 

create significant problems for them to access capital. Second, address the extra burden placed on small banks from calculating gain 

or losses on available-for-sale securities rather than continuing to 

use book value. And third, the rationale used for setting riskweighting for mortgages. 

Thank you, and I yield back. 

Chairwoman CAPITO. The gentleman yields back. 

I would like to recognize Mr. Dold, but before I do that, I would 

like to thank him for his service. He did jump ship from the Financial Institutions Subcommittee over to the Capital Markets Subcommittee, but I got over it quickly. He has been a great Member 

of Congress and a great member of this committee, and we will 

miss him. 

Mr. Dold for 1 minute. 

Mr. DOLD. Thank you, Madam Chairwoman. And I certainly appreciate your leadership. 

I also wanted to thank my good friend and neighbor in Illinois, 

Judy Biggert, for her leadership. It is certainly an honor to serve 

with you, and also my good friend Quico Canseco. 

I want to thank our witnesses for being here today. And while 

my colleagues and I generally support increasing the level of highquality capital in the banking system, I have some serious concerns 

about the proposed rules implementing Basel III and their impact 

on our fragile economy. 

First, I am concerned that the overall complexity of the proposed 

risk-based capital requirements would result in meaningful and 

unnecessary new compliance costs for domestic banks, particularly 

our community banks. And we have heard that from a number of 

folks on both sides of the aisle. 

I am also concerned that the specific risk weights are misguided 

and could raise costs for many consumers, including small-business 

owners, who want to use equity perhaps even in their homes to invest in their business and create additional jobs. 

I do think that is one of the things that we all have to be focusing on: How do we create an environment that enables the private 

sector to create more jobs with an unemployment rate as high as 

it is today? We can’t have a one-size-fits-all mentality for our banking system and capital requirements. 

I yield back. 

Chairwoman CAPITO. The gentleman yields back. 

I would like to recognize Mr. Canseco for 1 minute, and thank 

him for his service. Certainly, on my subcommittee, he has been a 

force of great knowledge. He has great background in banking. 

We will miss you, Quico, but I don’t think we have heard the last 

from you. So Godspeed, but also, 1 minute for an opening statement. 

11 

Mr. CANSECO. Thank you. Thank you, Madam Chairwoman. And 

I thank you and Chairwoman Biggert for your leadership in holding this hearing today. 

The financial crisis of 2008 exposed two glaring problems with 

our financial system in existence at that time. First, the financial 

system was woefully undercapitalized to deal with the buildup of 

shaky mortgage assets. And, second, the rules governing capital of 

the largest institutions, known as the Basel regime, were deeply 

flawed and, in my opinion, exacerbated the crisis. The Basel regime 

incentivized banks to over-weight mortgages and considered the 

debt of countries such as Greece and Spain to be bulletproof. 

The fact that today we are discussing Basel III reminds us that 

regulators have been here twice before, but, unfortunately, I don’t 

see much in the proposed rule which fixes the flaws that already 

exist within the Basel system. Instead, I see another iteration of 

the belief that greater complexity leads to better regulation. 

Sufficient capital is essential to a safe and sound financial system, and I feel today’s hearing will be successful if we have a serious conversation about the problems with the Basel regime and 

look to chart a proper course ahead of the regulation of capital in 

our financial system. 

Thank you, Madam Chairwoman. 

Chairwoman CAPITO. Thank you. 

Mr. Fincher for 1 minute. 

Mr. FINCHER. Thank you, Madam Chairwoman. I appreciate the 

opportunity to participate in the discussion and examination of the 

proposed rules to implement Basel III capital standards. 

I am also pleased that Mr. Greg Gonzales, commissioner of the 

Department of Financial Institutions in Tennessee, is here to share 

his views on these proposed rules on Basel III. 

Madam Chairwoman, as I begin to review these proposed rules 

and hear from my constituents in Tennessee, I can’t help but think 

of the law of unintended consequences. It seems to me that much 

of the legislation and hearing activity in this committee results 

from the unintended consequences of previous laws that were intended to do one thing but ended up doing another. 

I have heard from banks all across Tennessee and the concerns 

about the impacts these proposed rules would have on the economies of their communities. The message I have been hearing is 

that these rules, as written, will hurt economic growth and slow 

down our already fragile economy. I hope, as we examine these 

rules, that we remember to do no harm. 

I look forward to the testimony this morning and thank the 

chairwoman for this hearing. I yield back. 

Chairwoman CAPITO. The gentleman yields back. 

Our final opening statement comes from my friend and colleague, 

Ms. Hayworth from New York. We will miss her on our committee 

and in Congress. I consider her a very good friend, and I want to 

thank her for her service. 

I am very generous here: 1 minute, Ms. Hayworth. 

Dr. HAYWORTH. Thank you, Madam Chairwoman, for your generosity and for your commitment and service in so many ways. And 

I can’t wait to see what your future holds for all of us and our Nation. 

12 

Thanks to our witnesses on both panels today. 

Obviously, from the State of New York, I represent the Hudson 

Valley. Capital standards and those rules and the potential unintended consequences of those rules have profound consequences for 

the economy of my State and Hudson Valley in particular. 

Our economy, as we know, already faces serious headwinds from 

our link with Europe, and from our own debt crisis, from our own 

fiscal cliff. And it is certainly important that we honor and reflect 

the agreements that we have with our international partners on 

standards. It is also crucial that our Congress ensure that standards for capital and liquidity in the United States reflect our best 

interests and concerns. 

So I look forward to your testimony and, in particular, how you 

address the issues that our community bankers and insurers have 

raised with folks like me. Thank you so much again. 

And thank you, Madam Chairwoman. 

Chairwoman CAPITO. Thank you. 

With that, we will begin our witness testimony. I want to thank 

all the witnesses. I will introduce, and some other Members are 

going to introduce, some of the panel, but I will introduce each of 

you before you give your 5-minute statement. 

For the first panel, our first witness is Mr. George French. He 

is the Deputy Director of the Division of Risk Management Supervision at the Federal Deposit Insurance Corporation. 

Welcome, Mr. French. 

STATEMENT OF GEORGE FRENCH, DEPUTY DIRECTOR, POLICY, DIVISION OF RISK MANAGEMENT SUPERVISION, FEDERAL DEPOSIT INSURANCE CORPORATION (FDIC) 

Mr. FRENCH. Thank you. Good morning, Chairwoman Capito, 

Chairwoman Biggert, Ranking Member Maloney, Ranking Member 

Gutierrez, and members of the subcommittee. I am pleased to testify on behalf of the FDIC about the agency’s proposed regulatory 

capital rules. And my statement will focus on the two notices of 

proposed rulemaking (NPR) that apply to community banks and 

some of the comments that we have received. 

One of these NPRs deals with the Basel III capital reforms. The 

core elements of Basel III would strengthen the quality of bank 

capital and increase its required level. These are basic concepts of 

capital adequacy that are relevant for any bank, and the Basel III 

NPR would apply them to all insured banks. 

The Basel III reforms also include a number of complex provisions that are targeted at large, internationally active banks. We 

have proposed to apply these only to the largest banks, so these 

banks would need to comply with the basic changes to the definition and level of capital that are proposed for all banks and also 

with the additional standards that address the unique issues faced 

by large banks. 

The Basel III NPR also preserves the fundamental role of the 

U.S. leverage ratio. The FDIC strongly supports the introduction of 

the leverage ratio in the Basel framework as a transparent and objective measure of capital adequacy. 

The second NPR that is relevant for community banks is the 

Standardized Approach NPR. It proposes a number of changes to 

13 

the way banks compute risk-weighted assets and removes references to credit ratings, consistent with the Dodd-Frank Act. I do 

want to clarify that the changes to risk-weighted assets in this 

Standardized Approach NPR are not part of the international Basel 

III reform package. 

The FDIC has devoted significant efforts to outreach and technical assistance to help community banks understand how these 

proposals may affect them. We have received more than 2,000 comments at last count, and many of these comments express concern 

that the proposals will negatively affect community banks’ ability 

to serve the credit needs of their local communities. As the primary 

Federal regulator of the majority of community banks, the FDIC 

takes these comments very seriously. 

In the last 5 years, we have seen over 460 insured banks fail and 

many hundreds more in problem-bank status. This painful episode 

has imposed significant costs on our national and local economies 

and illustrates the importance of banks having a strong capital 

base so that they can continue to lend in their communities even 

during periods of economic adversity. 

Now, many commenters do acknowledge the importance of strong 

bank capital, but they also have concerns about specific aspects of 

the proposals, their complexity, or the totality of their potential effects. Among the more frequently mentioned specific issues are the 

residential mortgage rules and the Standardized Approach NPR 

and their interaction with the Dodd-Frank mortgage rules. In the 

Basel III NPR, many commenters have focused on the proposed 

treatment of available-for-sale debt securities and many others on 

the phaseout of preexisting trust-preferred securities of smaller 

banking organizations. 

Careful review of these and other comments is a critically important part of our process that gives us a better understanding of the 

potential unintended consequences and costs of these proposals. It 

is important to note that we have not reached decisions on any of 

these matters. These are proposed rules, not final rules, and we anticipate making changes in response to comments. 

The basic purpose of the Basel III framework is to strengthen the 

long-term quality and quantity of the capital base of the U.S. banking system. In light of the recent financial crisis, that would appear 

to be an appropriate and important goal. However, that goal should 

be achieved in a way that is responsive to the concerns expressed 

by community banks about the potential for unintended consequences. 

This concludes my statement. 

[The prepared statement of Deputy Director French can be found 

on page 148 of the appendix.] 

Chairwoman CAPITO. Thank you. 

Our next witness is Mr. Michael S. Gibson, Director, Division of 

Banking Supervision and Regulation, Board of Governors of the 

Federal Reserve System. 

Welcome, Mr. Gibson. 

14 

STATEMENT OF MICHAEL S. GIBSON, DIRECTOR, DIVISION OF 

BANKING SUPERVISION AND REGULATION, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM 

Mr. GIBSON. Thank you, Chairwoman Capito, Chairwoman 

Biggert, Ranking Member Maloney, Ranking Member Gutierrez, 

and members of the subcommittees. Thank you for the opportunity 

to testify on the proposed interagency changes to the regulatory 

capital framework for U.S. banking organizations. 

The recent financial crisis revealed that too many U.S. banking 

organizations were not holding enough capital to absorb losses during periods of severe stress. In addition, some instruments that 

counted as capital were not able to absorb losses as expected. In 

short, banks were too highly leveraged. In response to the lessons 

of the crisis, the banking agencies’ capital proposal would increase 

both the quantity and quality of capital held by banking organizations of all sizes. 

Another lesson from the crisis was that the largest banking organizations were the most severely impacted. As a result, many items 

in the agencies’ proposal and in other regulatory reforms are appropriately focused on larger banking firms and would not apply to 

community banking organizations. 

We have assessed the impact of these proposed changes on banking organizations and the broader financial system. These analyses 

found that the stronger capital standards in our proposal would 

significantly lower the probability of banking crises and their associated economic losses while having only a modest negative effect 

on gross domestic product and the cost of credit. The modest negative effects would be mitigated by the extensive transition periods 

provided in our proposal. 

Our impact analysis also showed that the vast majority of banking organizations, including approximately 90 percent of community banking organizations, would not be required to raise additional capital because they already meet the proposed higher minimum requirements on a fully phased-in basis. Our impact analysis 

is appended to my written testimony. 

Community banking organizations play a vital role in the U.S. financial system. They can provide relationship-based lending in 

their local communities in a way that larger institutions would find 

difficult to duplicate. In developing the proposal, the agencies 

sought to strike the right balance between safety and soundness 

concerns and the regulatory burden associated with implementation, including the impact on community banking. 

We also conducted extensive industry outreach across the country, and we provided a tool to help smaller organizations estimate 

their capital levels under the proposal. As we consider the large 

volume of comments submitted by the public, the Federal Reserve 

will remain sensitive to concerns expressed by community banking 

organizations. 

Community banking organizations are particularly concerned 

about the proposed treatments of unrealized gains and losses on securities, otherwise known as AOCI, and residential mortgage exposures. They believe that elements of our proposal do not adequately 

take into account the community banking business model and that 

some aspects would have potential disproportionate effects on their 

15 

organizations. We will be mindful of these comments when we consider potential changes to the proposal, and we will work to appropriately balance the benefits of a revised capital framework against 

its costs. 

The proposal would apply consolidated capital requirements to 

all assets owned by a depository institution holding company and 

its subsidiaries, including assets held by insurance companies. By 

treating all assets equally, the proposal would eliminate incentives 

to engage in regulatory capital arbitrage across different subsidiaries of the holding company. The proposal is also consistent with 

the Collins Amendment in Section 171 of the Dodd-Frank Act, 

which requires that bank capital requirements be a floor for depository institution holding company requirements. 

Depository institution holding companies with insurance activities have raised concerns that the proposed regulatory capital requirements are not suitable for the insurance business model. The 

Federal Reserve takes these comments seriously and will consider 

them carefully in determining how to appropriately apply regulatory capital requirements to depository institution holding companies with significant insurance activities. 

We are working as quickly as possible to evaluate the many comments and to issue a final rule that would provide appropriate 

transition periods to come into compliance. 

Thank you for the opportunity to describe the Federal Reserve’s 

efforts to reform the regulatory capital framework for U.S. banking 

organizations, and I will be happy to answer any questions you 

have. 

[The prepared statement of Director Gibson can be found on page 

176 of the appendix.] 

Chairwoman CAPITO. Thank you. 

Our next witness is Mr. John Lyons, Chief National Bank Examiner, Office of the Comptroller of the Currency. 

Welcome, Mr. Lyons. 

STATEMENT OF JOHN C. LYONS, SENIOR DEPUTY COMPTROLLER, BANK SUPERVISION POLICY, AND CHIEF NATIONAL BANK EXAMINER, OFFICE OF THE COMPTROLLER 

OF THE CURRENCY 

Mr. LYONS. Thank you. 

Chairwoman Capito, Ranking Member Maloney, Chairwoman 

Biggert, Ranking Member Gutierrez, and members of the subcommittee, I appreciate the opportunity to discuss the proposed 

capital rules issued by the Federal banking agencies and their potential impact on the industry. 

We have received extensive comments on the proposals from 

banks of all sizes. In response to the concerns raised by commenters, we announced earlier this month that we will delay the 

January 1st effective date. 

We are especially mindful of the concerns the community bankers have raised about the potential burden and the impact these 

rules could have on their institutions. 

Our goal is simple: to improve the safety and soundness of our 

Nation’s banking system by ensuring that banks of all sizes have 

16 

sufficient capital to weather adverse conditions and unforeseen 

losses. 

Strong capital plays a vital role in promoting financial stability 

and moderating downturns by facilitating banks’ capacity to lend. 

During the recent cycle, the banks that were best able to meet the 

credit needs of their customers and communities were those with 

strong capital bases. This underscores the principle that higher 

capital standards that apply to all banks is essential to the financial strength of the industry and our Nation’s economy. 

Capital rules also need to reflect risks appropriately. And so, 

under the proposals, riskier loans, such as certain types of nontraditional mortgages, would require more capital. We believe the 

proposals reinforce the key objectives of promoting financial stability and requiring higher capital for riskier firms and activities. 

The June rulemaking package consists of three notices of proposed rulemakings. Each NPR calibrates requirements to the size 

and riskiness of institutions so the larger banks will hold more capital and meet stricter standards than smaller banks. These are not 

one-size-fits-all regulations. 

The first proposal introduces a new measure for regulatory capital called common equity Tier 1 and two new capital buffers: a 

capital conservation buffer that would apply to all banks; and a 

countercyclical buffer that would apply only to the largest institutions. 

For community banks, this would result in a common equity Tier 

1 requirement of 7 percent of risk-weighted assets. For large, internationally active banks, this requirement could be as high as 13 

percent when combined with a SIFI surcharge that is being considered internationally. 

The second proposal, the Standardized Approach NPR, would 

modify certain risk-weighting so that riskier loans and activities require more capital. Here, two distinctions are made between small 

and large banks as certain provisions of the NPR, such as those related to securitization and credit risk mitigation, would have little 

or no application to most community banks. 

The third proposal, the Advanced Approaches NPR, applies only 

to the largest internationally active institutions and does not affect 

community banks. 

To reduce possible adverse effects, especially for community 

banks that have less access to capital market sources of capital, the 

proposals include lengthy transition provisions and delays in effective dates. 

Our preliminary assessment is that many community banks hold 

capital well above the existing and the proposed regulatory minimums. Nevertheless, we took steps to maximize opportunities for 

community bankers to learn about and comment on the proposals. 

These steps included short summaries aimed at community banks, 

extensive outreach with community bankers, and a tool to help 

them assess the impact of the proposals. 

While we have received comments on many issues, three overarching concerns have been raised. First, many have cited the complexity of the rules. Community bankers, in particular, have questioned whether the proposals should even apply to them. 

17 

Second, many have raised concerns about including unrealized 

losses and gains and available-for-sale debt securities and regulatory capital and the volatility that could result in capital levels 

and other limits tied to regulatory capital, such as legal lending 

limits. 

Third, bankers have expressed concerns about their recordkeeping burdens resulting from the proposed use of loan-to-value 

measures for residential mortgages and the higher risk-weightings 

that would be assigned to balloon residential mortgages. 

As we consider these issues, we will continue to look for ways to 

reduce burden and complexity while maintaining our key objectives 

of raising the quantity and quality of capital and matching capital 

to risk. These enhancements will lead to a stronger, more stable financial system. 

I appreciate your interest in this matter and would be happy to 

answer your questions. 

[The prepared statement of Senior Deputy Comptroller Lyons 

can be found on page 248 of the appendix.] 

Chairwoman CAPITO. I thank the gentleman. 

I will now yield to Mr. Fincher to introduce our next witness. 

Mr. FINCHER. Thank you, Madam Chairwoman. 

It is my honor to introduce Mr. Greg Gonzales, commissioner of 

the Tennessee Department of Financial Institutions. 

Commissioner Gonzales is a native of Cookeville, Tennessee, and 

received his law degree at the University of Tennessee in 1984. 

Commissioner Gonzales has served at the Tennessee Department 

of Financial Institutions since 1986 and was appointed to the position of commissioner in 2005. 

In his position with the department, Commissioner Gonzales is 

the chief regulatory officer of Tennessee’s 157 banks, 101 credit 

unions, 8 trust companies, and hundreds of other financial service 

companies. In 2011, Mr. Gonzales was reappointed to his position 

by Tennessee Governor Bill Haslam. 

Commissioner Gonzales is here before us this morning representing both the citizens of Tennessee and as chairman of the 

Conference of State Bank Supervisors. 

It has been a privilege to get to know Commissioner Gonzales 

and his staff. His office is a great resource to me and my staff as 

this committee works on issues, such as Basel III, that impact financial institutions across all of our congressional districts. 

I am pleased the committee invited Mr. Gonzales to testify before 

this panel today, and I look forward to his testimony. 

Chairwoman CAPITO. Thank you. 

Welcome, Mr. Gonzales. 

STATEMENT OF GREG GONZALES, COMMISSIONER, TENNESSEE DEPARTMENT OF FINANCIAL INSTITUTIONS, ON BEHALF OF THE CONFERENCE OF STATE BANK SUPERVISORS 

(CSBS) 

Mr. GONZALES. Good morning, Chairwoman Capito, Chairwoman 

Biggert, Ranking Member Maloney, Ranking Member Gutierrez, 

and distinguished members of the subcommittees. Thank you for 

the opportunity to testify today on one of the most significant public policy matters facing the banking industry. 

18 

CSBS believes it is in all of our best interests for the Federal 

banking agencies to make significant changes to both the Basel III 

and the Standardized Approach proposals. These proposals would 

introduce sweeping changes to the regulatory capital framework 

and would significantly impact banks’ credit allocation decisions 

and tolerance for risk. 

As currently drafted, these proposals would have significant and 

negative consequences for local, State, and national economies. To 

be clear, State regulators absolutely support elevated and enhanced 

capital requirements. However, we believe Federal banking agencies should address these issues outside of the Basel III process 

and should apply Basel III only to the largest internationally active 

banks. 

We are concerned that the proposals are too complex and highly 

reactionary to the latest financial crisis. As regulators, we must 

seek an appropriate balance. We must ensure safety and soundness 

of the entities we regulate, but we must also provide a system of 

supervision that still allows these entities to serve their communities and achieve economic success. 

Banks must have the possibility of failure in order to have the 

opportunity for success. We believe the capital proposals will inhibit banks’ ability to take prudent risk. For most banks, risk management is based on an inherent understanding of the underlying 

credit risk, a deep knowledge of its customer base, and an alignment between the success of the bank and its customers. 

It is important to remember that many institutions do not treat 

loans as anonymous commodities and that these proposed rules 

will have real consequences for institutions and communities. 

Back in Tennessee, there is a rural community that has one 

small bank. You probably have a similar community in your district. The bank has been around for about 100 years and provides 

a vital channel of credit for its residents, including mortgages. The 

president of that bank recently shared with me that, based on the 

proposed rules, he will have to limit the number and volume of 

loans it can originate. 

We owe it to these institutions to ensure the policies we develop 

do not unnecessarily impede their ability to serve their communities. I am hearing this all over my State, and my colleagues have 

described it all over the country. We need to seek policies that 

focus on improving risk management and supervision, not on trying 

to steer individual credit decisions. 

Furthermore, we need to encourage a supervisory process that 

prudently supports economic recovery, not policies that will further 

suppress the flow of credit or drive business from the regulated deposit system. 

State regulators are also concerned about the lack of sufficient 

understanding regarding the impact of these proposals. We need to 

clearly understand how these proposals will change the type of 

credit available, the manner in which banks lend, and the full impact on economic recovery and job growth. 

Lawmakers, Federal banking agencies, and State supervisors 

share the collective goal of supporting the effort to strengthen our 

financial system and generate stability for the American people. 

19 

Unfortunately, the Basel III and Standardized Approach proposals 

run counter to this goal. 

I believe that, with meaningful debate and significant engagement, we can determine the appropriate approach to capital policy 

development for a diverse economy and a diverse financial system. 

CSBS stands ready to work with Members of Congress and our 

Federal counterparts in seeking the appropriate regulatory balance. 

Thank you for the opportunity to provide my views here today. 

I look forward to responding to any questions you may have. 

[The prepared statement of Commissioner Gonzales can be found 

on page 198 of the appendix.] 

Chairwoman CAPITO. Thank you, Mr. Gonzales. 

Our next witness is Mr. Kevin M. McCarty, insurance commissioner, Florida Office of Insurance Regulation, on behalf of the National Association of Insurance Commissioners. 

Welcome, Mr. McCarty. 

STATEMENT OF KEVIN M. MCCARTY, COMMISSIONER, FLORIDA OFFICE OF INSURANCE REGULATION, AND PRESIDENT, 

THE NATIONAL ASSOCIATION OF INSURANCE COMMISSIONERS (NAIC), ON BEHALF OF NAIC 

Mr. MCCARTY. Thank you, and thank you for the opportunity to 

testify today. My name is Kevin McCarty, and I am the insurance 

commissioner from the State of Florida. I am also the president of 

the National Association of Insurance Commissioners. 

Increasingly complex and global financial institutions pose challenges for regulators to provide consumers with the appropriate 

level of protection while not stifling competition, innovation, or 

growth. The NAIC recognizes that certain insurance groups have 

chosen to engage in the business of banking, which could subject 

them to consolidated supervision by the Federal Reserve. However, 

we are concerned that the current capital proposal appears to apply 

a one-size-fits-all bank-centric approach to these institutions, 

whose banking activities typically represent only a small portion of 

their overall business and overall assets. 

The prospect of bank-centric regulatory rules being imposed on 

insurance groups is problematic, and it is critical that the regulatory walls around legal entity insurers that have successfully protected policyholders for decades not be jeopardized. Insurance products and insured assets and liabilities are fundamentally different 

from banking. Banking products involve money deposited by customers and are subject to withdrawal on demand at any time. 

Insurance policies involve upfront payments in exchange for a 

legal promise to pay benefits upon specific loss-triggering events in 

the future. The very nature of insurance significantly reduces the 

potential of a run-on-the-bank scenario. Insurance products, unlike 

banking products, do not transform short-term liabilities into 

longer-term assets. This is a critical distinction. A key reason many 

other financial firms suffered during the financial crisis was that 

the duration of assets and liabilities were not matched in a way 

that enabled them to fund their liabilities when they became due. 

The national State-based system of insurance regulation was specifically designed to address the unique nature of insurance prodVerDate Nov 24 2008 11:52 Apr 26, 2013 Jkt 079691 PO 00000 Frm 00027 Fmt 6633 Sfmt 6633 K:\DOCS\79691.TXT TERRI
20 

ucts. The system’s fundamental tenet is to protect policyholders by 

ensuring the solvency of the insurer and its ability to pay claims. 

My written testimony details the key aspects of our insurance 

solvency regulatory framework, including the licensing process, detailed reporting and disclosure requirements, conservative accounting standards, continuous financial analysis, our own risk-based 

capital system, and a windows-and-walls approach to group supervision. 

It is critical to emphasize that while capital requirements are important, such requirements alone cannot ensure the safety and 

soundness of complex financial institutions. Parallel to the development of the Basel III rules we are discussing today, there were 

some in the international community in favor of universal global 

capital standards for insurance groups. We fear the same overreliance on capital could become a reality in our sector with no diversity of regulation to mitigate the wrong incentives or to prevent 

systemic risk-taking. 

The existence of global capital standards in the banking sector 

did not prevent the last crisis and did little to prevent large institutions from becoming larger while chasing each other off their own 

fiscal cliff. Overlaying such an approach on the insurance sector is 

not likely to yield better regulation of banks or thrifts owned by insurers and could, in fact, exacerbate the next crisis. 

While the focus of our comment letter on the rules was to provide 

technical clarifications on the specific insurance-related questions, 

I also want to emphasize our interest in promoting an open dialogue with the other agencies on this panel to help them better understand the insurance business model and our regulatory framework. We believe it is imperative that in their efforts to regulate 

thrift and holding companies, Federal agencies should have all the 

information necessary to craft rules appropriate to the risk profiles 

of the regulated entities. 

To that end, we have provided input on the proposed definition 

of separate accounts which may be in conflict with State law and 

the treatment of policy loans which may need to be reevaluated for 

risk-weighting purposes. We also discuss the use of risk-based capital for managing underwriting risk, and the requirements for surplus note reporting, and lay out the differences between statutory 

and GAAP accounting. 

Of particular concern is the proposed treatment of risk-based 

capital (RBC). RBC is a trigger for intervention, not a minimum 

standard. Given that insurers typically hold significantly more capital than RBC trigger levels, the proposed rule suggests either a 

misunderstanding of an insurer’s capital or an implication that 

capital above the minimum RBC levels is excess and therefore may 

be available to support capital deficiencies created by affiliated 

banks or thrifts. We strongly object to policyholder funds being 

used to subsidize losses of a holding company, bank, or thrift without insurance regulator approval. 

In conclusion, we look forward to sharing our experience and expertise regulating U.S. insurers with our Federal and international 

colleagues, which will assist them in developing a regulatory approach that appropriately captures the complete risk profile of an 

insurance enterprise while respecting regulatory walls already in 

21 

place to protect our policyholders. Thank you again for the opportunity to testify today, and I look forward to answering your questions. 

[The prepared statement of Commissioner McCarty can be found 

on page 296 of the appendix.] 

Chairwoman CAPITO. Thank you, Mr. McCarty. 

I am now going to recognize myself for 5 minutes to begin the 

question portion. This is directed to the three regulators—the Fed, 

the OCC, and the FDIC—who are with us today. I was wondering, 

have any of your agencies conducted a cost-benefit analysis? We 

have heard, and we are going to hear on the second panel, too, I 

think, the cost to the institutions, but a cost-benefit analysis which 

would ensure that the new capital requirements achieve that appropriate balance between safety and soundness and what economic effects there might be. 

I will start with you, Mr. French, from the FDIC. 

Mr. FRENCH. Thank you. We have conducted various kinds of 

analysis. We have done some statutorily required analysis of the 

cost of the proposals for small institutions, banks under $175 million in assets. Those analyses really looked at the compliance costs. 

So— 

Chairwoman CAPITO. And briefly, what did that show? 

Mr. FRENCH. I think we concluded that there would be substantial, as measured by a percentage of non-interest income, a substantial cost, particularly for the implementation of a standardized 

approach or a large number of small institutions. Having said that, 

that is an initial analysis that we are getting comments on and I 

think we are getting a lot better appreciation through the 2,000 

comment letters of more specific aspects of different aspects of the 

proposals. 

In terms of the economics of lending and growth and all that, 

there has also been a lot of work done that the agencies participated in with the Basel Committee, looking at the effect of higher 

capital requirements. I think the general consensus there, as Mr. 

Gibson outlined, is that there is a substantial benefit to the economy from reducing the incidence of banking crises, and that outweighs the sort of transitional cost of getting the industry to a 

higher level, especially here in the United States where banks are 

already at a fairly high level of capital. 

Chairwoman CAPITO. Mr. Gibson, is there a cost-benefit analysis 

at the Fed? 

Mr. GIBSON. I don’t have too much to add to what Mr. French 

said. As he said, we did do an analysis of the impact of the proposal which looked at the macroeconomic benefits of higher capital, 

weighed against the costs. We did find that the benefits outweighed 

the costs on the macroeconomic level. 

Chairwoman CAPITO. Was this at institutions of various sizes or 

was it the— 

Mr. GIBSON. This was an aggregate economy-wide analysis. We 

also looked at the impact on different size categories of banks. As 

I mentioned in my remarks, many banks already meet the higher 

capital requirements. Large banks have built a lot of capital in the 

last few years and will continue to build capital to meet the proVerDate Nov 24 2008 11:52 Apr 26, 2013 Jkt 079691 PO 00000 Frm 00029 Fmt 6633 Sfmt 6633 K:\DOCS\79691.TXT TERRI
22 

posed requirements. We estimate that 90 percent of community 

banks already meet the higher capital requirements. 

I think it is important to say, as Mr. French said in his remarks, 

that we are learning a lot from the comment process about the 

compliance costs of everything that is contained in the proposal. So 

beyond just meeting the capital requirements, those additional 

costs are something where we are learning a lot from the comments and we will take that into account going forward as we work 

toward the final rule. 

Chairwoman CAPITO. Mr. Lyons? 

Mr. LYONS. I really don’t have much to add. All three agencies 

did a similar type analysis and we all came up with similar conclusions in terms of impact to the industry and to the broader economy. And I would just reinforce the fact that as we go through the 

comment period, we are receiving additional information from the 

banks. We will include that in a further analysis before we issue 

any type of final rule. 

Chairwoman CAPITO. I guess it is a little bit of a disconnect for 

me that on the front side—since I know that you all reach out to 

your institutions quite regularly—these considerations couldn’t 

have come up as a surprise to you in the comment period. But that 

is just a comment on my part. 

The other thing I would like to ask quickly is, after the first of 

the year we are going to be getting the definition of a QM and it 

is going to have a significant impact on every financial institution 

that writes mortgages. And part of the Basel III, as I understand 

it, the residential mortgage portion of a bank’s portfolio will have 

significant influence on how you calculate the risk. Have you taken 

into consideration how the definition of a QM could influence the 

standards that you are requiring in these new capital standards? 

Mr. French, I will ask you first. 

Mr. FRENCH. We certainly looked at the proposed QM standards 

as we were developing those mortgage proposals and these rules. 

And having said that, we have gotten sort of the message from the 

commenters that the QM rules are still uncertain, no one knows 

what their final form will be. 

Chairwoman CAPITO. Right. 

Mr. FRENCH. And people are very concerned about how these two 

will interact. So I think those are very significant observations that 

we have to look at as we develop how to proceed with these rules. 

We recognize the close linkage and the importance and the potential interactions that have to be taken into account. 

Chairwoman CAPITO. Does anybody else have a comment on 

that? 

I would urge great caution here because one of the things that 

we have all heard about from our bankers large and small is that 

if the QM is written too narrowly or not to the satisfaction of compliance officers and regulators, the caution that will be exercised by 

the financial institutions could really hurt the housing market and 

hurt those who may be on the bubble a little bit in terms of whether they can secure a mortgage. 

And so, I think this is an exceedingly important topic and hopefully—I am glad to know you are looking at it closely. I know it 

23 

is very complicated, but at the same time, it is extremely important. 

I recognize Mrs. Maloney for 5 minutes. 

Mrs. MALONEY. Thank you very much. 

I would like to ask Mr. Gibson from the Federal Reserve about 

including regional and community banks in Basel III. Our banking 

system is very different from Europe and Japan and China, which 

is very much dominated by large global banks. We have large global banks, but we also have community banks. And in the financial 

crisis, I would say they were the ones who continued to provide 

credit to our communities and to respond to localities. Many have 

expressed concern that the way it is drafted now, it will just end 

the existence of them, and they will be forced to merge and everything else, which I don’t think is a good objective. 

So what is the objective of applying it to the smaller banks that 

are not involved in any way in international commerce? If they 

want to get involved, if they want to be part of the global community, then you could say they have to have these standards. But if 

they are serving a community and are only in the community, why 

in the world are we putting them into the same capital requirements? We do have the capital requirements of Dodd-Frank that 

apply to them. So what policy objective are we meeting by sweeping in the local community and small regional banks? 

Mr. GIBSON. I would agree that community banks did and continue to play a vital role in their communities. And it is certainly 

true that it was the large banks that had the most significant problems during the crisis. As a result, our reform package is significantly aimed at large banks and there are many requirements, 

both in this proposal and in other areas, that only apply to large 

banks. For example, our stress-testing regime only applies to large 

banks, and enhanced prudential standards under Section 165 of 

the Dodd-Frank Act only apply to large banks. Higher capital 

charges for trading activities and, as Mr. Lyons mentioned, eventually a capital surcharge for systemically important banks all will 

only apply to large banks. 

Now, it is true that some of the provisions in the capital proposal 

do apply to all banks. Some of that is because of the requirements 

of the Dodd-Frank Act that apply to all banks, and some of that 

is an effort to raise the quality and quantity of capital for all 

banks. We think that strong capital is important. We are sensitive 

to the comments of community banks, and there are many aspects 

of the proposal where we have learned a lot from the comments 

about the details of where there might be some impacts that we 

need to look at, but stronger quality and quantity of capital for all 

banks is an important reform. 

Mrs. MALONEY. Most community banks are already well-capitalized, and they are objecting to being put into the whole rule. If they 

want to opt in, I would say let them opt in. But if they don’t and 

they are just serving the community, I would let them continue. 

Your rules also have a dramatic effect on capital requirements, 

and by extension the pricing of loans, because of the new method 

of applying risk weights to specific asset classes, and the Basel 

rules allow the internationally large complex banks to create their 

own methods of coming up and their own models. But you are havVerDate Nov 24 2008 11:52 Apr 26, 2013 Jkt 079691 PO 00000 Frm 00031 Fmt 6633 Sfmt 6633 K:\DOCS\79691.TXT TERRI
24 

ing the regional community banks that compete against each other 

in local markets, they must follow the standard approach. So I am 

questioning the reasoning for that. And also I would say that in 

Dodd-Frank, we certainly intended for the regulators to notice the 

difference between banks and insurance companies. And yet your 

approach seems to create a holistic floor rather than an asset-byasset minimum requirement or take into considerations the differences between insurance and international banking, which have 

been successful in our country. Why again put this added burden? 

Mr. GIBSON. In the Dodd-Frank Act, Congress did direct us to set 

consolidated capital requirements for bank holding companies and 

savings and loan holding companies, including the ones that choose 

to own an insurance company. You are right that the requirements 

of the Collins Amendment in the Dodd-Frank Act do require that 

the bank capital requirements serve as a floor for the holding company requirements. That was a significant constraint on what was 

in our proposal. But also, on your first comment about the differences between Advanced Approaches where banks are estimating some of the parameters compared with the Standardized 

Approach, there is a floor now under the Collins Amendment that 

will prevent the capital requirements for large banks falling below 

what would be the generally applicable capital requirements, 

which, for example, could be the Standardized Approach. 

Mrs. MALONEY. My time has expired. Thank you. 

Chairwoman CAPITO. Mrs. Biggert for 5 minutes. 

Chairwoman BIGGERT. Thank you, Madam Chairwoman. Mr. 

Gibson—and this is just a yes-or-no question—isn’t the Basel III a 

framework that regulators of each country participating in the 

agreement are required to implement through more specific regulations? In other words, is there some flexibility for the regulators of 

each country to conform to the framework through regulations that 

are unique to each country? 

Mr. GIBSON. Yes. 

Chairwoman BIGGERT. Okay. Wouldn’t it be prudent of our Federal banking regulators to provide the same kind of accommodation 

and courtesy to our financial institutions, such as insurance companies and State insurance regulators, within the Basel III rules? 

That is a yes or no, again. 

Mr. GIBSON. Yes, we take the Basel agreements and we implement them according to our domestic circumstances. 

Chairwoman BIGGERT. Is there accommodation and courtesy to 

the financial institutions or the insurance companies and State insurance regulators? 

Mr. GIBSON. Yes. 

Chairwoman BIGGERT. Yes. Okay. 

Mr. Gibson. We tailor it to our domestic circumstances. 

Chairwoman BIGGERT. All right. Are your counterparts in Europe 

developing or applying Basel III, like regulations to insurance companies? 

Mr. GIBSON. Mr. McCarty probably knows more about what the 

insurance regulators in Europe are doing. But for us, we are required to impose consolidated capital requirements on bank holding 

companies and savings and loan holding companies, some of which 

are owning insurance companies. 

25 

Chairwoman BIGGERT. Then, I will ask Mr. McCarty. Are the 

counterparts in Europe developing or applying Basel III, like regulations to insurance companies? 

Mr. MCCARTY. Europeans are in the process of adopting Solvency 

II, which provides for a consolidated look at the group. The companies are allowed to use internal modeling to determine their target 

capital standards, which is to contemplate all the risks, which is 

very, very different than the U.S. regulatory model, which is based 

upon the individual legal entity, and we look at walling off that entity, whereas the European model contemplated under Solvency II 

looks at group capital determined by an internal model. 

Chairwoman BIGGERT. Okay. Then a fundamental objective of 

Dodd-Frank was to reduce systemic risk, and I am concerned that 

the Fed’s Basel III proposal would result in bank clearing members 

having to hold—that is, like, the Merc—having to hold significantly 

more capital when their customers use less risky instruments, 

which seems just the opposite of the way it should be. This backwards incentive could make it more expensive to use exchange 

traded futures and customized swaps. Shouldn’t the rule be designed to encourage the use of lower risk profile products and not 

discourage it? 

Mr. GIBSON. It is an important aspect of regulatory reform to encourage central clearing of OTC derivatives, and part of the Basel 

III accord is to make sure that capital incentives are in place to 

do that. We have received a lot of comments on that aspect of our 

proposal and we are certainly looking at those to make sure we get 

the incentives in favor of central clearing. 

Chairwoman BIGGERT. In my opening statement, I asked if the 

Federal Reserve is committed to improving the Basel III rules. 

Mr. GIBSON. Yes. 

Chairwoman BIGGERT. Yes. How long is all this going to take? 

Mr. GIBSON. We received a lot of comments. We extended the 

comment period longer than it was originally open for to make sure 

that many interested parties had a chance to comment. At this 

point, we are working through the comments and working as quickly as possible towards a final rule, but I wouldn’t want to give a 

prediction of a specific date. 

Chairwoman BIGGERT. You said there is a lot of comments. Is 

that 1,000, 2,000, 5,000? 

Mr. GIBSON. We counted around 2,500. 

Chairwoman BIGGERT. Twenty-five hundred. I yield back. 

Chairwoman CAPITO. Ms. Waters for 5 minutes for questions. 

Ms. WATERS. Thank you very much, Madam Chairwoman. 

A question for Mr. French of the FDIC. One area that I am particularly focused on is the proposed risk weights on mortgages, particularly as they relate to small and community banks and community development financial institutions. We all recognize that imprudent mortgage lending was at the center of the last financial 

crisis. But by and large, small and community banks as well as 

CDFIs didn’t engage in the kind of activity that really created systemic risk in our economy in 2008. Their lending was much more 

likely to focus on meeting the long-term needs of the borrower and 

facilitating a lasting customer relationship. We have also seen that 

small and community banks have been much better in terms of 

26 

providing loan modifications to borrowers than some of the larger 

mortgage servicing operations. 

So with that said, I want to ask about the proposed changes in 

risk weights on mortgages under the Standardized Approach as it 

relates to small and community banks and CDFIs. As you move towards the finalized rule, how are you acknowledging the unique 

business models of these institutions in the mortgage lending 

space? 

Mr. FRENCH. Congresswoman, we have heard these comments 

throughout 2012. Ever since we proposed the rule, we have met 

with many, many community banking groups face to face and 

CDFI bankers as well. So what we are hearing is that the rules 

will significantly change the economics of the business model and 

affect loans that they have been making successfully for many 

years in ways that they don’t think they will be able to continue. 

That is what we are hearing. That concerns us greatly. So we are 

in a position here where I cannot prejudge what the outcome of the 

rulemaking process would be, but we do intend to make changes 

to the rule in response to comments, and this is certainly one of 

the areas that is of great importance and that we are looking at 

very carefully with our fellow— 

Ms. WATERS. Thank you very much. 

Mr. Gonzales, can you weigh in on this and elaborate on what 

you said in your testimony about how mortgage securitization does 

not encompass the entirety of the mortgage lending industry? Further, what do you think the impact of the Standardized Approach 

would be on the underserved areas? 

Mr. GONZALES. In my discussions with community banks in Tennessee, a number of them are making the 5- or 7-year adjustable 

rate mortgage, maybe a balloon payment. Those are bread and butter products that community banks, just as you have alluded to, 

have been making for a long time, and have done it well for many, 

many years. I have had some of these institutions tell me that— 

in fact the one that I alluded to in my opening statement asked me, 

what am I going to tell some of my customers when I have to pull 

back in this area because the risk-weighting is basically telling 

community banks we don’t want you in this area? It is not giving 

enough differentiation between the largest institutions in this 

country and the smallest. So that gives us a great concern because 

some of these areas that I am talking about are basically served 

by the community bank that is located there, and if it is not able 

to do the work, then there are big questions as to who is going to 

be served. 

Ms. WATERS. Mr. Gonzales, help me to understand the definition 

of a community bank. Some have proposed that the definition extends to banks with upwards of $50 billion in assets. This strikes 

me as a little high. How can we strike the right balance? 

Mr. GONZALES. In Tennessee, most of our institutions are less 

than a billion. We do have some that are above which have the 

characteristics of a community bank in their decision-making and 

who they serve. So there are certain situations where there are institutions of some size that do have the characteristics of a community bank. I don’t have an absolute definition for you, but we are 

relying on them heavily in my State and in States all over this 

27 

country, and we certainly need to deal with these rules in a way 

that allow them to go forward in a positive way. 

Ms. WATERS. What about any of the other panelists, do you have 

any thoughts about what a community bank, how it should be defined, and is $50 billion too high? What is the right balance? Anybody? 

Mr. GIBSON. I would agree with Mr. Gonzales that it is important to look at the characteristic of the bank in addition to just the 

size. Internally, we have a cut-off around $10 billion, but depending 

on the characteristics of the bank, there are certainly banks larger 

than $10 billion that behave a lot like community banks. 

Ms. WATERS. Thank you, Madam Chairwoman. I yield back. 

Chairwoman CAPITO. Thank you. 

Mr. Renacci for 5 minutes. 

Mr. RENACCI. Thank you, Madam Chairwoman. And I want to 

thank the witnesses for being here. 

I am going to start, but this is more of a comment. I know you 

have heard a lot from many Members, my colleagues here about 

community banks, and I know many of you testified in front of the 

Senate that the vast majority of community banks will already be 

compliant with the capital rules and won’t suffer any ill effects. I 

think you are hearing a lot of those comments from all of us, that 

community banks are very important to the communities and those 

that they serve that and we need to make sure that, just as you 

have stated, they will not suffer any ill effects. We are hoping that 

is strongly considered as you move forward. 

But I want to change the discussion a little bit on the impact the 

proposal will have on the economy, my constituents, and really 

credit in the marketplace. Obviously, as the cost of doing business 

goes up, consumers will end up footing the bill or being left out of 

the market altogether. What studies have you conducted that specifically address the impact on consumers? What will be the impact 

of Basel III on mortgage lending? Have you determined what the 

additional costs of Basel III will be for consumers with lower credit 

scores or FICA scores? And have your agencies undertaken a comprehensive study of the banks they supervise to estimate the compliance costs of this proposal? Let’s start with Mr. Gibson. 

Mr. GIBSON. We have estimated some of the elements of the impact that you talked about. As I said earlier, we compared the benefits of higher quality and quantity of capital in terms of a stronger 

financial system, fewer financial crises, and compared that with 

the costs in terms of higher costs of credit and growth of GDP. We 

determined—this was the joint analysis with the Basel Committee—that the benefits outweighed the costs, but in addition to 

some of the elements that you mentioned, we have been getting a 

lot more detailed feedback through the comment process where we 

are learning a lot about impacts of different parts of the proposal. 

And those are very helpful and useful as we work towards the final 

proposal. We are definitely taking those comments into account and 

we want to make sure we balance the impact against the benefits 

of a safer and stronger financial system. 

Mr. RENACCI. Mr. French? 

Mr. FRENCH. I don’t think I have a great deal to add to that. You 

mentioned the area of mortgages in your question and I think that 

28 

is a particular example where the goal is to be more risk sensitive 

to get more capital for some of the alternative structures, but then 

when you look at the comment letters you are seeing a lot of useful 

information about areas where we might need to reconsider. So I 

think that is a good example of what Mr. Gibson is talking about. 

Mr. RENACCI. Mr. Gonzales, you say in your testimony you believe that there—we do not believe there is sufficient understanding of impact these proposals would have on the industry and 

credit availability. Do you agree with that comment, because that 

is pretty much what I am trying to hit on. 

Mr. GONZALES. I don’t think there is enough information to determine the impact of these rules. We certainly know that, for instance, the FDIC, as I think has been mentioned, has engaged in 

a study of $175 million asset institutions and less and reflected a 

significant impact on those institutions. So if there is additional 

work that is done on the rest of the industry, it may prove that 

there is also troublesome information as far as the impact on additional institutions in this country from these rules. 

Mr. RENACCI. Mr. Lyons, do you have anything to add? 

Mr. LYONS. As I said earlier, the three Federal agencies did a 

very similar analysis and came up with similar conclusions. And as 

additional comments come in we will take these into consideration 

as we do additional analysis. 

Mr. RENACCI. Thank you. This may have been answered before, 

but I guess I didn’t hear the answer. When it comes to insurance 

companies, they have traditionally been regulated at the State 

level, yet the proposed rule would apply to holding companies that 

own insurance companies. I understand that dual oversight can 

exist, but how will disputes between Federal and State regulators 

be reconciled? Anyone want to— 

Mr. GIBSON. We are currently the supervisor of bank holding 

companies and now, after the Dodd-Frank Act, of savings and loan 

holding companies, so we have a lot of experience working with 

functional regulators in banking like the OCC or the FDIC, as well 

as with insurance regulators because some bank holding companies 

have owned insurance companies before. We focus on looking at the 

consolidated company and capital requirements at the highest level 

of the consolidated firm. And in the case of insurance, the State 

regulator sets the capital requirement for the insurance operating 

company that is at the State level. 

Mr. RENACCI. So how would disputes be reconciled, I guess, is 

who would have the— 

Mr. GIBSON. Each regulator has authority over their own piece 

of it. In cases where it is something related to the holding company, we would have the authority and we would consult with the 

State regulator. And I assume in cases where it is the State-regulated insurance company that is at issue, the State insurance regulator has the authority and would use it appropriately. 

Chairwoman CAPITO. The gentlemen’s time has expired. Mr. 

Watt from North Carolina for 5 minutes. 

Mr. WATT. Thank you, Madam Chairwoman. And I thank the 

Chairs for convening this hearing. Let me say to the Federal regulators that I share a number of the concerns that have been raised 

by my colleagues already about community banks. Although I am 

29 

aware of a number of small and community banks that went out 

of business as a result of the economic downturn or had to be reorganized or taken over by others, they are unique to our communities, and to the extent we can accommodate them, we need to be 

trying to do that. And I am happy to hear that you all have heard 

the comments and are taking those into account as you move toward adopting the final rule. So I won’t belabor that. I share the 

concerns and it sounds to me like you are taking those concerns 

into account and will try to address those. 

I do want to address an issue that has been raised by one of my 

local banks, which is what appears to me to be a legitimate concern 

about the treatment of defined benefit pension plans in the calculation of Tier 1 capital. This particular bank, which I won’t identify, 

has a defined benefit plan and is in the unique position, I guess, 

that it is overfunded. And they apparently have gotten an ambiguous response, or it is ambiguous in the rule, in the proposed rule 

whether that excess capital or excess funding would be allowed to 

be counted toward their capital. So if you all could comment on 

whether you can make that explicit or whether, if you can’t make 

it explicit, there is some reason that it shouldn’t be explicit, that 

would be helpful to me in addressing the concern that they have 

raised. 

Mr. FRENCH. We have certainly heard about this issue. From a 

safety and soundness perspective, the overall goal was to have assets that can absorb loss. So in this particular case of the overfunded pension fund asset, the question is, is this reflective of sort 

of estimates of what is out there in the future. So there is the safety and soundness case, it may not be an asset, but is as reliable 

as other assets. So that is the reason for the proposal to deduct it. 

We have also heard comments from a number of banks about 

their concern that this is going to disincent them from offering pension plans and that could have an unintended consequence. So we 

are keenly aware of the issue. 

Mr. WATT. But don’t you monitor these pension plans and the 

regulators don’t monitor them to determine, by your own standards, whether they are overfunded or underfunded, and couldn’t 

that overfunding be counted toward capital until there is some 

problem with it and then ask them to build up more capital? 

Mr. FRENCH. That would be another way to address it and we 

would be happy to take that thought back as we look at the final 

rule. So like I said, it is a trade-off. We have the concern about the 

reliability of the asset on the one hand, and on the other hand, we 

have the concern about disincentives to offering these pension 

plans. I think the way the rules work, it actually is not so much 

of an issue for insured banks as it is for bank holding companies. 

But it is important to provide this clarity and I think you raise an 

important point. 

Mr. WATT. This bank happens to be an insured bank, so it obviously is an issue for them. It is of particular concern to them because they think they are fairly substantially overfunded and really 

want to stay overfunded, which is, I think, the prudent and wise 

thing to do. You are either going to disincentivize people to have 

defined benefit plans or you are going to disincentivize them to 

overfund if you don’t address this issue, it seems to me. And I hope 

30 

that you will take this comment back and be direct about how you 

plan to address it, because ambivalence in this area or a standard 

that is not clear is not good either. So I appreciate it. 

And I yield back, Madam Chairwoman. 

Chairwoman CAPITO. The gentleman yields back. Mr. Garrett for 

5 minutes for questions. 

Mr. GARRETT. I thank the Chair for the hearing, and I thank the 

witnesses as well. I apologize—I had to step out with some constituents—if one of my questions may be redundant. Let me start, 

though, with just a sentence or two from a speech given back in 

September by Thomas Hoenig, Director of the FDIC. He said this: 

‘‘In judging the role of capital it is useful to look back at bank capital levels in the United States before the presence of our modern 

safety net. Prior to the founding of it, things were a lot simpler.’’ 

And then he said, ‘‘Going forward, how might we better assess capital adequacy?’’ He said, ‘‘Experience suggests that to be useful capital must be simple, understandable and enforceable. It should reflect the firm’s ability to absorb loss in good times and in crisis. It 

should be one that the public and the shareholders can understand, 

that directors can monitor, that management cannot easily game, 

and that bank supervisors can enforce. An effective capital rule 

should result in a bank having capital that approximates what the 

market would require without the safety net in place.’’ 

Not that I claim to be an expert on Basel III, I guess I question 

whether what we are looking at fits those requirements—simple, 

understandable, enforceable, and approximate what the market 

would require without the safety net in place. So let’s get into parts 

of it, let’s get into the issue of risk weighing and some of the aspects on that. And I throw this open to the panel. Is there any underlying data that was used or would be used to calibrate the risk 

weights for the various proposals? I know we had some discussion 

with some of the folks in the office on some of this. We are hearing 

that, as proposed, the risk-weighting may not accurately reflect 

true risk, riskiness of lending exposures, and in particular mortgages. And if that is the case, then won’t failure to accurately calibrate the capital with risk results in a bank reducing overall lending going forward? So a two-part question. Anyone? Was it done 

and what effect will it have? 

Mr. GIBSON. With respect to the proposed risk weights on mortgages, they were calibrated to the types of mortgage products 

where in the aggregate we saw much greater losses during the financial crisis. What we have learned from the comments, especially 

from the community banks, is that the experience at community 

banks may have been different than the experience at large banks 

in terms of what types of products turned out to be the riskiest. 

We have gotten a lot of comments on the particular risk factors we 

put into the risk weight proposal and we are going to look at those 

comments as we go forward. 

Mr. GARRETT. Which is one of the aspects I could get into if I had 

more time, is to say this is always retrospective, looking back to 

see what the last crisis was as opposed to looking forward as opposed to what the markets would be, which would be constantly 

looking forward, which is not being done here. So do you also look 

at what the combination of that risk weights that you would apply 

31 

to them have on with all the other regulations that we are imposing and whether or not that will hinder, it will hinder or help, 

probably hinder, our ability to reduce the government’s footprint or 

presence in the housing financial market? 

Mr. FRENCH. You raise an important question about the interaction of the various parts of the Dodd-Frank Act with these rules. 

And in the case of mortgages, that is an extremely important issue 

because, as you know, we have the Qualified Mortgage (QM) rules 

which will come. We don’t know what they are yet. The Qualified 

Residential Mortgage (QRM) concept for securitization. Risk retention also has to be developed, along with various other assorted 

rules about appraisals and other things. 

Mr. GARRETT. Is that something you sit and consider? 

Mr. FRENCH. Absolutely. The comment letters are very clear on 

this, that there is a concern about the interaction, how this is all 

going to fit together. And that is one of the important things we 

have to deal with before we make decisions about how to proceed 

on those mortgage. 

Mr. GARRETT. I have a quote here from Mark Zandi. In Moody’s 

Analytic, he said that the current rules that you are referring to— 

not yours, rules—would add 1 to 4 percentage points spending on 

the parameters of the mortgages being originated and the discount 

rates apply, and the rule as written could significantly impede the 

return of private securitization markets and permanently cement 

the government’s role in housing. And so as I understand it, some 

of the rules that are being considered here as far as basically treating guaranteed assets of those guaranteed by Fannie Mae and 

Freddie Mac having a better rating risk factor than the private 

securitization market would once again just put the government’s 

role in here and, as he puts it, cement us permanently in this marketplace and the private label market out of a situation. Is that 

something you are going to consider before final rules? 

Mr. FRENCH. The issues about the role of the government and 

mortgage finance are certainly very important. I think I am not in 

a position to respond on how that is going to play out going forward. I think we have some concrete proposals about what the risk 

weight should be on the various assets that typical community 

banks hold, and we are certainly going to consider how those interact with the other Dodd-Frank provisions before we make any decisions. 

Mr. GARRETT. That is the point, thanks a lot. 

Chairwoman CAPITO. Thank you. The gentleman’s time has expired. Mr. Miller for 5 minutes. 

Mr. MILLER OF NORTH CAROLINA. Thank you, Madam Chairwoman. And, Madam Chairwoman, I wanted to compliment you on 

the tasteful color of your jacket today. 

Mr. Gibson, just in the last few weeks, Dan Tarullo, a Fed Governor, and Bill Dudley, President of the New York Fed, have said 

that the biggest banks are still too-big-to-fail. If they did fail they 

would collapse in a disorderly heap with dire consequences for the 

financial system and for the economy as a whole. And as a result 

of that, there is a widespread assumption in the market that the 

government would not allow that to happen, and they can borrow 

money more cheaply as a result. Do you agree with that and do you 

32 

agree that is an unfair subsidy that the biggest banks get that 

gives them an advantage over the ‘‘small-enough-to-fail’’ banks that 

Mr. Gonzales supervises? 

Mr. GIBSON. As I said earlier, we are focusing on the whole regulatory reform program, many elements are aimed at the largest 

banks. We require the largest banks to go through stress testing. 

With the Basel Committee, we are working on a capital surcharge 

for large banks. The ultimate goal of that is to even out the playing 

field so that the systemic impact that a large bank failure would 

have on the rest of the economy is internalized by them through 

things like higher capital. 

Mr. MILLER OF NORTH CAROLINA. One of the ways that the DoddFrank Act, that Congress tried to deal with that, working closely 

with regulators, particularly the FDIC, was the living wills requirement. The FDIC and the Fed have now completed their first round 

of living wills, and Mr. Dudley in his speech in just the last few 

days, he said that too-big-to-fail is an unacceptable regime. But he 

also described the first round of living wills as the beginning of an 

iterative process, it confirmed that we are a long way from the desired situation in which large complex firms should be allowed to 

go bankrupt without major disruptions to the financial system and 

large costs to society. Significant changes in structure in an organization will ultimately be required for this to happen, and that the 

initial exercises had given the regulators a better understanding. 

It seems a very complacent approach to think we can go through 

round after round after round of this to get it right, that the regulators can make polite suggestions, and the institutions subject to 

the living wills requirement can make tweaking changes, and at 

some point in the future, we will have credible resolution plans 

that won’t collapse the entire economy. 

The economist Simon Johnson said that he concluded from Mr. 

Dudley’s remarks that the living wills process was ‘‘a sham, meaningless boilerplate and box checking.’’ With still a $67 trillion shadow banking system, a lot of uncertainties in our financial system, 

how long is it going to take to have credible living wills, credible 

resolution plans? And why not now? That was to you, Mr. Gibson, 

since you work for the Fed. 

Mr. GIBSON. I would agree with the thrust of your comments— 

I would agree with President Dudley’s comments that the living 

will process is an iterative process because we are learning from 

the first round of living wills, we are going to go back to the institutions with feedback. It is going to be a repeated process. This is 

something that is completely new for us. We are working jointly 

with the FDIC, building a new process to use the living wills to 

make large firms resolvable. And, frankly, it is the first time we 

are doing this particular type of exercise in this level of detail. We 

are getting something going that is new for us and it will take a 

little time. But I agree with you it is urgent to get it going and it 

is urgent to get it right. 

Mr. MILLER OF NORTH CAROLINA. Yes, ‘‘ultimately’’ is not a particularly harsh deadline; that seems to be kind of an indulgent 

deadline, to use your term. Can you give us some idea how long 

it is going to take before we can feel reassured that there are resolution plans in place that if one of these enormous banks that are 

33 

too-big-to-fail now gets in trouble, it won’t collapse in a disorderly 

heap, that it will be resolved in a way that doesn’t bring down the 

financial system and the economy with them? 

Mr. GIBSON. So we have new tools, the FDIC has a new tool, the 

Orderly Liquidation Authority (OLA), that could be used in the 

event of disorderly stress at one of the largest companies. But the 

living will process is designed as an annual process. So there is intended to be improvement. We do have to get to the goal of being 

fully confident that those large institution are resolvable. We 

haven’t put a deadline on that, but it is important to get there and 

to get there quickly. I would agree with that. 

Chairwoman CAPITO. The gentleman’s time has expired. 

Mr. Miller? 

Mr. MILLER OF CALIFORNIA. Thank you, Madam Chairwoman. 

I guess it is just time to pick on you, Mr. Gibson, so I have a 

couple of questions for you, and they are not really picking, but 

they are focused on you. When the United States works to implement the Basel Accord, do we implement exactly like the other 

countries do or do we customize the rules to our banking structure 

so to outcomes equivalent to the Basel Accord framework? And do 

you agree the United States should customize them to an equivalent? 

Mr. GIBSON. We do customize it, yes. 

Mr. MILLER OF CALIFORNIA. So, yes, good. Under the proposed 

rule, the bank-centric standards will be detrimental to insurance 

companies. And I introduced the Collins Amendment language to 

that, that he introduced in the Senate which really clarifies that 

issue, and wouldn’t it be more appropriate to apply insurance-specific capital standard to insurance companies so long as they are 

equivalent the capture risked as the banks do? 

Mr. GIBSON. What we are doing in our proposal as required by 

the Dodd-Frank Act is to impose consolidated capital requirements 

at the holding company level. 

Mr. MILLER OF CALIFORNIA. We are trying to capture equivalent 

risk as bank standards, isn’t that the goal? 

Mr. GIBSON. What we have proposed is that if the same asset is 

held by an insurance subsidiary of a depository institution, a holding company or a bank subsidiary, that we would have the same 

risk weight on that. 

Mr. MILLER OF CALIFORNIA. Yes. What I am saying is you are 

going to appropriately apply insurance-specific capital standards to 

the insurance companies so that they are equally capturing the 

risk as banks would do, but they are different, but you are equally 

going to capture the risk, that is the goal, right? 

Mr. GIBSON. The goal is to capture the risks. I wouldn’t say it 

is equal because, for example, insurance companies have unique 

risks associated with insurance underwriting. 

Mr. MILLER OF CALIFORNIA. That is what I am saying, they are 

different. Different risk and different standards, but you want to 

capture the risk equally based on their given standards. 

Mr. GIBSON. Yes, the standards are different for insurance underwriting risk. 

Mr. MILLER OF CALIFORNIA. That was a concern I had. Is it true 

that the types of assets that the insurance typically holds, such as 

34 

long-term corporate bonds, are assigned to high risk-weighting 

under the proposed capital standards? 

Mr. GIBSON. The risk rates are different according to the riskiness of the asset. 

Mr. MILLER OF CALIFORNIA. Are long-term corporate bonds assigned a higher risk? 

Mr. GIBSON. Higher compared to what? 

Mr. MILLER OF CALIFORNIA. Under your weighting standards 

that you are proposing. 

Mr. GIBSON. The risk weights are based on the riskiness of the 

asset. 

Mr. MILLER OF CALIFORNIA. How would you categorize a longterm corporate bond? 

Mr. GIBSON. Riskier than a Treasury bond. 

Mr. MILLER OF CALIFORNIA. That is what I am saying. They are 

categorized as a high risk. I am hearing these things, but I want 

to make sure we get them on the record, and that is what we are 

doing so we truly understand it. And because of the proposed rule, 

won’t an insurer that holds long-term corporate bonds, which we 

are talking about, or their assets with high risk-weighting, have a 

lower capital ratio as a consequence of holding these assets? 

Mr. GIBSON. If the riskiness of the assets goes up, then the capital ratio goes down. 

Mr. MILLER OF CALIFORNIA. So that is a yes? 

Mr. GIBSON. Yes, that is a mechanical— 

Mr. MILLER OF CALIFORNIA. That is what I am trying to get to, 

those are some concerns we are having here. Does it then follow 

that the insurer, in order to meet the capital ratios, may have to 

divest certain assets with high risk-weighting such as those longterm corporate bonds again? 

Mr. GIBSON. What we have proposed is a series of risk weights 

that are— 

Mr. MILLER OF CALIFORNIA. And those are weighted higher and 

so they are going to be considered riskier at the end, they might 

have to divest themselves of those assets to drop to a better standard. 

Mr. GIBSON. Every company chooses its own asset mix. 

Mr. MILLER OF CALIFORNIA. I know, but if you are saying that 

the capital ratios are based on high risk and low risk, if you are 

then saying long-term corporate bonds are a higher risk, that is 

going to change your capital ratios. 

Mr. GIBSON. Yes. And if you are holding a lot of long-term corporate bonds— 

Mr. MILLER OF CALIFORNIA. That is also one of the concerns we 

are having. Because many of these insurance companies hold those 

that have proven to be beneficial to them in the long run, but it 

is going to change their risk and it is going to change the whole 

matrix within they have to work with. That is where we are trying 

to get and that is where some of our concerns are. And doesn’t this 

make the proposed rules totally inappropriate for insurers? Think 

about this, if it is focusing on those, it can’t be appropriate for the 

insurers where they must divest long-term assets to meet longterm commitments they have made to their customers, they bought 

those for a reason. Wouldn’t it be more appropriate for financial 

35 

stability for insurers to be able to invest in long-term assets that 

match up with the long-term liability of life insurance companies? 

Mr. GIBSON. In general, the risk weights don’t depend on the maturity of the instrument, so a corporate bond would be rated according to the risk of the company that issued it, not the maturity 

in general. 

Mr. MILLER OF CALIFORNIA. But if you are dealing with longterm corporate bonds the maturity is long term. 

Mr. GIBSON. Yes. 

Mr. MILLER OF CALIFORNIA. And your liability is long term, but 

the investor is invested in that. 

Mr. GIBSON. Right. 

Mr. MILLER OF CALIFORNIA. We have a problem. I yield back. 

Thank you. 

Chairwoman CAPITO. The gentleman’s time has expired. Mr. 

Scott for 5 minutes. 

Mr. SCOTT. I certainly agree with Mr. Miller, we do have a problem here. And it seems to me that it might be good for us to pause 

here for a moment to get some clarity on, from you, Mr. French, 

Mr. Gibson especially, and Mr. Lyons, where do we go going forward now on what I think is the fundamental issue here, and that 

is one thing we know about Basel III is one size does not fit all. 

Now, do the three of you agree that we have a problem as affecting 

this rule regarding our small community regional banks, on requiring them to have this higher capital standard? 

Mr. FRENCH. I think that again, when we look back at the last 

5 years, we see over 460 bank failures, hundreds of problem banks, 

and that is a significant issue for the national economy, for many 

regional and local economies around the country. There is an important policy interest in having a well-capitalized banking system. 

So I think that is the goal we are trying to achieve. 

And as Mr. Gibson said, we have differentiated significantly in 

terms of the levels of different requirements applied to small and 

large banks. I think the question we are hearing from the comments is whether we have differentiated enough and that there 

may be a number of areas, there certainly are a number of areas 

we are hearing about where they are telling us you need to differentiate more. And we have to be very careful as to how we review those comments and decide how to proceed. So we completely 

agree. 

Mr. SCOTT. Would you say then that one of the directions that 

you might take would be to disengage the smaller community 

banks from this Basel III requirement? I did a little studying on 

the history of this Basel, this has been going on, Basel I started 

I think under the supervision of the Switzerland bank back in 

1988. Basel II comes along to fix what Basel I could not do. Basel 

III now comes along for this. 

My feeling is that it might be smart of us to allow Basel III to 

see how we can get that to work for what it was essentially created 

for, and that is the larger banks. It is clear from the discussion of 

the risk weights complexity that it is going to require another set 

of thought processes for our smaller community banks. Is that not 

a way we could go on this? 

36 

Mr. FRENCH. The core concept of capital adequacy, having a 

strong quality of capital and level of capital, we believe that is a 

relevant concept for any bank and that is something we are trying 

to achieve. So what we need to do is decide which parts of the proposals are appropriate for community banks, and that includes the 

mortgages and everything else. We are looking carefully at those. 

Mr. SCOTT. And one other area that concerns me is I wonder if 

you have given any consideration to the overall impact of the Basel 

III proposals in conjunction with other regulations, such as those 

mandated by Dodd-Frank and their regulatory and accounting rule 

standards on credit availability, the cost of credit, and essentially 

the overall mortgage lending. 

Mr. GIBSON. In terms of other Dodd-Frank rulemakings that we 

are doing, we are certainly looking at the costs and benefits of 

every rule we propose, and where there are rules that are linked 

with each other we try to look at those together. We did that with 

our enhanced prudential standards proposal under Section 165, for 

example. And certainly in the mortgage area, there are many 

Dodd-Frank provisions that are all interacting, and we are trying 

as best we can to look at those together. 

Mr. SCOTT. For example, the due diligence with the Consumer 

Financial Protection Bureau (CFPB), which is finalizing its own 

due diligence, so we have two due diligence requirements and it 

makes for some confusion there. 

Mr. GIBSON. We are consulting with the CFPB as they roll out 

some of their Dodd-Frank regulations, and we are working with 

them on that. 

Mr. SCOTT. And finally, Mr. Gonzales, let me get your take on 

this. What do you feel going forward, is there some value in what 

I said about disengaging and understanding that if there ever was 

an example of one size does not fit all, this is certainly it, and that 

we might need to look at these two sizes of banks differently? 

Mr. GONZALES. Absolutely. I think you made a good suggestion, 

we ought to reconsider and rework these rules. Basel III can move 

forward. They were never intended to apply to community banks, 

they are intended for the large internationally active institutions, 

as you pointed out. So they can go forward on that basis and then 

we can have a separate dialogue with respect to community banks. 

We are in total agreement with that. 

Mr. SCOTT. Thank you, Madam Chairwoman. 

Chairwoman CAPITO. Thank you. 

Mr. Luetkemeyer for 5 minutes. 

Mr. LUETKEMEYER. Thank you, Madam Chairwoman. 

I am just kind of curious, Mr. French, Mr. Gibson, Mr. Lyons, do 

you gentlemen talk with each other with regard to rulemaking between your agencies? Especially in this situation with Basel III, are 

you guys communicating about your concerns with each other here? 

Mr. FRENCH. Yes. 

Mr. GIBSON. Yes, we do. 

Mr. LUETKEMEYER. You have regular meetings on that? 

Mr. GIBSON. Yes, we do. 

Mr. LUETKEMEYER. Do you consult with Mr. Gonzales’s group at 

all? Does he have any input with your decision-making process? 

Because what I hear from him is a whole lot of red flags going off. 

37 

Mr. GIBSON. In terms of the rulemaking, it is the Federal agencies that are responsible for the rulemaking. We work a lot with 

State bank supervisors in the supervision process, and we work 

closely with them at the— 

Mr. LUETKEMEYER. Are you hearing what they are saying about 

Basel III? 

Mr. GIBSON. Yes. 

Mr. LUETKEMEYER. Are you going to react to it? 

Mr. GIBSON. The comments we have heard from our State bank 

supervisor colleagues, we have heard those comments, and they are 

very similar to the comments we have heard from many community 

bankers. We are taking those very seriously. 

Mr. LUETKEMEYER. Okay. Because they are a supervisory agency, 

as well. They deal with supervising banks as well as you do. So, 

they have the same concerns and have the oversight that you do, 

in many respects. 

It is kind of curious, I was having—one of my bankers brought 

this to my attention, with regard to the enforcement of some of the 

rules that you have. With regard to HMDA exams, one of my bankers did some research. And over the last 21⁄2 years, from during 

2010, 2011, to June of 2012, the FDIC in Missouri had over 160 

fines that they levied with regard to penalties on HMDA violations. 

Now, the SEC and the Fed combined had a total of five during that 

period of time. 

Mr. French, can you give me a reason why there is such a disparity? 

Mr. FRENCH. My understanding, Congressman, is that we are 

working on a response to the questions that you have just asked— 

Mr. LUETKEMEYER. I realize that, and I appreciate that. Your office said you are going to get me a letter sometime by the end of 

the week, but I thought while we had you here, it would be a good 

time to put you on the record. I would like to know what is going 

on. 

Mr. FRENCH. Yes. I will say that we have a separate division of 

compliance and consumer protection, depositor and consumer protection— 

Mr. LUETKEMEYER. The other agencies also have compliance and 

consumer protection. 

Mr. FRENCH. I don’t know the answer to your question, so we 

will have to wait for them to respond to you. 

Mr. LUETKEMEYER. That certainly is a red flag to me. And it 

makes me wonder, when I asked the previous question, if you all 

worked together with regard to implementation of rules, enforcement of rules, working with the State bank supervisors, whether 

you actually work together. 

How in the world can you all answer that question in a positive 

fashion when there is that big of a discrepancy between the three 

of your supervisory agencies on this particular issue? How can that 

happen? We are not communicating. There is some discrepancy 

there, and I want to know what it is. So I appreciate your response, 

and I thank you for that. 

With regard to other problems we have discussed today, and we 

have had a lengthy discussion here with regard to all the different 

concerns that the individual banks, especially community banks, 

38 

have with Basel III. And a lot of it has been brought about by some 

of the actions that were taken by the big banks back in the early 

2000s and up till the 2008 meltdown. 

It would seem to me that what is going on is a lot of the new 

products, a lot of new financial services are outrunning the ability 

to regulate them. Because we are getting out in front with new 

policies, new programs, new products that we are having difficulty 

getting our hands around or arms around to be able to regulate 

them in a way that can control the risk and minimize its impact 

to the banking community, the financial industry as a whole. 

Is there any thought to trying to pull back on some of those products at all? Or do you think you are going to be able to, by continuing to run, to try and catch up with the new products, that you 

think you can eventually catch up to them and regulate them? 

Mr. Lyons, you haven’t answered a question for a while. Let me 

try to get you in the game here. 

Mr. LYONS. I am not quite sure what specific products you are 

referring to. 

Mr. LUETKEMEYER. It deals probably mostly with the big banks, 

I would imagine, because the smaller banks are probably not in 

this exotic financial products game. 

But it is very concerning to me whenever you have especially the 

investment banks going off and doing a lot of different things and 

then you bring them underneath the retail banks, expose the retail 

banks and the deposit base to FDIC insurance and the too-big-tofail situation whenever we can’t regulate those in a way that is 

going to minimize the risk. 

Is there any thought to trying to do something? 

Mr. LYONS. The entire process is part of what we are doing today 

and talking about is building capital buffers to be able to absorb 

any loss in those types of products, as well as— 

Mr. LUETKEMEYER. Yes, but that is after the fact, sir. What you 

are saying there is, we are not sure we can regulate these, so the 

best way to protect ourselves is to put more capital in here. That 

is covering your rear. 

Is there a reason that we can’t regulate some of this stuff? Is it 

beyond our ability? 

Mr. LYONS. For those products that we think we can, we permit 

the use of those products. And for those that we don’t, we have not 

permitted banks to use certain products. 

Mr. LUETKEMEYER. Okay. I see my time has expired. 

Chairwoman CAPITO. The gentleman’s time has expired. 

Mr. LUETKEMEYER. Thank you, Madam Chairwoman. 

Chairwoman CAPITO. Thank you. 

Mr. Perlmutter? 

Mr. PERLMUTTER. I thank the committee for allowing me to sit 

in and participate today. 

Mr. Gibson, I am reading from a speech that the vice chair, Mr. 

Hoenig, from our region out in Colorado/Kansas area gave in September. And I don’t know if anybody has spoken about this yet, but 

it was in September of this year. And his comments sort of reflect 

my feelings about this because I have tried to dive into some of the 

Basel III rules and assumptions and algorithms. You guys are trying to deal with a panoply of assets and liabilities that are worldVerDate Nov 24 2008 11:52 Apr 26, 2013 Jkt 079691 PO 00000 Frm 00046 Fmt 6633 Sfmt 6633 K:\DOCS\79691.TXT TERRI
39 

wide and just complex, and I understand the effort that is going 

into this. 

But having said that, there are a couple of paragraphs in his 

speech I would like to just read, and then I have some questions. 

It says—and this is a speech that he gave on the 14th of September 

of this year—‘‘Basel III will not improve outcomes for the largest 

banks since its complexity reduces rather than enhances capital 

transparency.’’ 

And as I was trying—and I am a lawyer, I did a lot of Chapter 

11 bankruptcy work, I looked at a lot of balance sheets, I have 

dealt with bank dissolutions and a whole variety of things. And 

your work, as regulators, you have a tough job, especially with different kinds of assets and how you apply risk. But when I look at 

Basel III, to me, it just adds—it obscures the ability for a regulator 

or for a stockholder or for somebody else to figure out what a bank 

is worth and what really is on its balance sheets. 

He goes on and says, ‘‘Basel III will not improve the condition 

of small and medium-sized banks. Applying an international capital standard to a community bank is illogical, particularly when 

models have not supplanted examinations in these banks. To implement Basel III suggests we have solved measurement problems 

in the global industry that we have not solved. It continues an experiment that has lasted too long.’’ 

Now, I appreciate everybody trying to tackle the subject of when 

is a bank solid and when is it ready to fold. But for us as Members 

of Congress, for you all as regulators, in my opinion, we need to 

try to simplify it. Einstein said, ‘‘Make everything as simple as possible, but not simpler.’’ This though, in my opinion, goes way too 

far, that even somebody who took banks apart, like I did as part 

of my law practice, I can’t figure it out. Then, that really allows 

for the system to be gamed. And that is my fear. 

So having given you that editorial comment and asking you to 

go back and take a look at his speech, I think really reflects where 

I am coming from with respect to the whole array of rules that you 

are proposing, or that are being proposed. 

Now, let’s go into a really tiny, narrow area. And it says—and 

this is on trust-preferreds. So I was part of this committee when 

we did Dodd-Frank, and one of the areas that we took a good look 

at, especially for smaller banks, community banks, was trust-preferred as part of their capital structure. 

And under Basel III, the exception that we made in Dodd-Frank 

to allow for smaller banks to use trust-preferred stock as part of 

their capital structure seems to be quietly dispensed with. Am I 

right or wrong? 

Mr. Gibson, I will ask you that. 

Mr. GIBSON. In the Dodd-Frank Act, trust-preferred was phased 

out of regulatory capital for all U.S. banks. But— 

Mr. PERLMUTTER. But after 2010, right? 

Mr. GIBSON. Right. 

Mr. PERLMUTTER. So before 2010—and we really, across the Nation, we haven’t added a lot of banks over the last 2 years, have 

we? 

Mr. GIBSON. A few, but not too many. 

40 

Mr. PERLMUTTER. Okay. So for those banks that existed before 

2010 that relied on trust-preferred, they are grandfathered in; am 

I right? 

Mr. GIBSON. No new trust-preferred is allowed to be issued; that 

is correct. 

Mr. PERLMUTTER. But old trust-preferred can exist and be part 

of the capital? 

Mr. GIBSON. There are separate provisions in the Dodd-Frank 

Act for larger financial institutions above $15 billion where Congress specified a phaseout period, and Congress didn’t specify a 

phaseout period for below $15 billion. In the proposal, we proposed 

a phaseout period of 10 years. 

Mr. PERLMUTTER. Okay. What happens under Basel, under the 

proposed rules in Basel? So that— 

Mr. GIBSON. I was talking about our proposed rule, which is different from— 

Mr. PERLMUTTER. Okay, which is different than Dodd-Frank? 

Mr. GIBSON. No, no. Our proposed rule is consistent with the 

Dodd-Frank Act but more aggressive than Basel because of the 3- 

year phase-out period for trust-preferred under our rule, which is 

consistent with the Dodd-Frank Act. 

Mr. PERLMUTTER. I am sorry. When you say ‘‘our rule,’’ is ‘‘our 

rule’’ the Basel rule, or is ‘‘our rule’’ the Dodd-Frank rule? 

Mr. GIBSON. Our proposed joint capital rule would have the 

phaseout by 2015 for trust-preferred for $15-billion-and-above companies, which is faster than under the international Basel agreement. 

Mr. PERLMUTTER. Okay. And I would like to visit with you afterwards about this subject. 

Thank you, Madam Chairwoman. 

Chairwoman CAPITO. Thank you. 

Ms. Hayworth for 5 minutes. 

Dr. HAYWORTH. Thank you, Madam Chairwoman. 

A question for Mr. Gibson regarding the Collins letter that stated 

or asserted that bank capital rules with regard to insurers should 

not supplant capital rules for insurers. 

Mr. Gibson, are you viewing things any differently in view of 

that? 

Mr. GIBSON. I haven’t seen the letter, but I did read some news 

articles that quoted from it. 

Dr. HAYWORTH. Right. 

Mr. GIBSON. It is certainly true that when we made our proposal 

for holding company capital requirements, the Collins Amendment 

was an important constraint because it says the bank capital rules 

have to be a floor for holding company capital rules. 

We have certainly gotten a lot of comments from insurance companies and others about alternative ways to interpret what Congress wrote in the Dodd-Frank Act. I look forward to reading the 

letter that I haven’t had time to read yet. But it is one of the issues 

we are considering very much as we look at the comments going 

forward. 

Dr. HAYWORTH. So we still—and, Mr. McCarty, this obviously 

goes to your assertions regarding the obligations of holding compaVerDate Nov 24 2008 11:52 Apr 26, 2013 Jkt 079691 PO 00000 Frm 00048 Fmt 6633 Sfmt 6633 K:\DOCS\79691.TXT TERRI
41 

nies—the relationship of holding companies and insurers’ capital 

holdings to what holding companies should do in that sphere. 

Mr. MCCARTY. Absolutely. To that point, we are very much concerned about the overlaying of the capital requirements of Basel III 

on a company that primarily does insurance business; only a small 

part may be subject to a thrift or bank. Again, applying that to 

that would cause a lot of conflict with already existing regulatory 

framework and State laws that have proved, I think, very successful throughout the financial crisis. 

Dr. HAYWORTH. This could be a rather destabilizing event. 

Mr. MCCARTY. Yes, it would be a destabilizing event, and then 

it could cause a number of dislocations in the marketplace, unintended consequences. For instance, if you have higher capital requirements, a lot of people purchase insurance based upon the 

brand, the strength of the company. If there is a view that new 

capital standards is a stronger company, you will have a flight to 

perceived better-quality products— 

Dr. HAYWORTH. Right. 

Mr. MCCARTY. —which is, obviously some unintended consequences that could occur. 

Dr. HAYWORTH. In listening to this discussion, obviously we are 

speaking extensively about risk-weighting. That is the crux of the 

whole thing: what is the level of risk that an institution is undertaking with its holdings and how much—obviously, how much ballast should they have to make sure that the ship stays stable, if 

you will. 

I firmly believe that Peter Wallison’s dissent from the FDIC was 

the most cogent analysis of the 2008 crisis. And one of the underlying factors in that crisis was the fact that the ratings agencies 

themselves fundamentally, from the standpoint of essentially a 

layperson like myself, couldn’t be trusted. 

How does that play into the—how should it play into the decisions that you are making? How should we take what you are 

doing and say, you know what, if we are going to do these things, 

then we have to make sure that the ratings certainly of our government bonds actually have validity. 

Is that a fair question to ask? I will throw it out to— 

Mr. FRENCH. Yes, it is a fair question. I think most importantly 

for the answer is that the Dodd-Frank Act requires the agencies to 

remove references to credit ratings from all of our regulations. So 

part of what this proposal does is implement that so that instead 

of using external credit ratings of Moody’s or Standard & Poor’s or 

whatever, there are various alternative approaches. So, essentially, 

we have moved away from that in these proposals. 

Dr. HAYWORTH. That sounds reassuring. 

Thank you so much, members of the panel. 

And, Madam Chairwoman, I yield back. 

Chairwoman CAPITO. Thank you. 

Mr. Lynch for 5 minutes. 

Mr. LYNCH. Thank you, Madam Chairwoman. 

Mr. Lyons and Mr. French, this is particularly addressed to you. 

I recently have had extensive opportunities to sit with my local 

chambers of commerce, populated significantly by community 

banks and leaders of community banks. 

42 

And, Mr. Lyons, in your remarks you posed a somewhat rhetorical question: Why should community banks be treated this way 

under Basel III? Why should these limitations, the enhanced capital requirements, be applied to them, given the fact that they really weren’t at the root of the financial crisis? For the most part, they 

know their customer. They did not engage in these wildly complex 

derivatives. And, I got an earful from my bankers about the rules 

coming out. 

I did hear from each of you that you acknowledged the difficulty 

or the challenges in applying some of this to both insurance companies and also to community banks. So I like what I am hearing, 

in a way, that you are sensitive to the issues. 

But to answer your own question, why are we applying all of this 

to community banks? 

Mr. LYONS. Thank you, Congressman. 

I think it is important to point out that, while they may not have 

caused the crisis, they did suffer substantial damage because of the 

crisis in terms of failures. We had well over 400 failures. And, as 

Mr. French said earlier, a large number of banks are still in troubled condition. 

The stronger banks that did survive were those that had higher 

capital. And we felt it was appropriate to try and strengthen the 

quality and quantity of capital for individual banks and within the 

system overall so that in the next crisis, they can survive and continue to serve their customers and communities. 

Mr. LYNCH. The longer on-ramp, is that something that has been 

accepted, at least among yourselves as regulators, for the ability of 

the community banks that may not have the staff and the compliance mechanisms to absorb all of this? Is that something that has 

been accepted by your group or with regulators in general? 

Mr. LYONS. I think, as Mr. Gibson said earlier, we did do an impact analysis. Most banks already achieved that capital level. The 

impact analysis also looked at the financial cost to an institution 

to be able to implement the new regs. And there is a concern 

around the cost burden to the institutions, especially up front when 

they have to implement new systems and controls to implement the 

requirements. 

So we are taking a close look at those analyses, and we will do 

further analysis as we move forward. But I assure you, we are trying to strike the right balance between achieving appropriate capital levels and not overburdening community banks. 

Mr. LYNCH. You mentioned that about 90 percent of the community banks already satisfy what you think would be the—I am 

sorry, Mr. Gonzales, would you like to respond? 

Mr. GONZALES. Yes, I was just going to address that 90 percent 

issue. 

We would agree that a large number of community banks would 

be able to meet the minimum standards today, a snapshot today. 

But the real question is, where do these rules put community 

banks going forward? That is the real question. 

And, just a couple of examples. Are we going to accept the volatility of the capital with respect to movements in interest rates? 

And with the risk of weighted standards, we are basically telling 

institutions whether you have good operating procedures or not, we 

43 

don’t want you in these areas, commercial real estate and certain 

mortgage products. 

So that is very concerning. It is a one-size-fits-all approach. 

Mr. LYNCH. Yes. That is what I am hearing. 

Let me ask, the general number is 90 percent of the community 

banks will meet the new capital requirements already. That remaining 10 percent, are we looking at banks that are particularly 

large within the community bank population, or is it just random? 

Mr. LYONS. Our analysis showed that it is generally the smaller 

banks, a small population of smaller banks that would not achieve 

it immediately. That is why we implemented the transition periods. 

And our feeling is that over the transition period, those banks 

would be able to accrete and achieve the minimum capital levels. 

Mr. LYNCH. Okay. I see I am running short on my time here. I 

would just, in closing, ask you to be very sensitive to the concerns, 

as you say, valid concerns, raised by our community banks. They 

are doing the lending right now in many of our communities, and 

we rely on them very heavily right now to keep the economy going 

in the right direction. So I would just ask you to be very sensitive 

to the concerns that they have raised. 

Thank you, I yield back. 

Chairwoman CAPITO. Thank you. 

Mr. Duffy for 5 minutes. 

Mr. DUFFY OF WISCONSIN. Thank you, Madam Chairwoman. 

As I mentioned in my opening statement, I come from rural Wisconsin. We have a lot of small community banks, and a lot of credit 

unions that we are not necessarily talking about today, but those 

are the folks who serve the financial needs of my community, getting dollars out to our families, and our small businesses that are 

the economic drivers of our community. 

Many of the comments that you have heard today and concern 

you have heard today, I, too, have heard that same concern from 

my small financial institutions, about how Basel III’s implementation will affect their ability to be successful moving forward. 

Have you all considered the overlay of all the proposed 

rulemakings and its impact on the consolidation of community 

banks across the country? 

Because I keep hearing about all the new rules, all the new regulations, and the need for small banks to continue to consolidate. 

And one of the benefits we have is you can get decisions in your 

community. Say, you are in Medford, Wisconsin. Your banker there 

can make a decision for you, instead of having to go to Minneapolis 

or Chicago or Milwaukee, and have a regional bank make those 

calls for you. 

Are you concerned about that consolidation? 

Mr. FRENCH. If the outcome of the rules was to drive significant 

consolidation of community banking, we would be very concerned. 

We recognize the important role that community banks play in 

local communities, and we do not want to finalize rules that will 

put such a degree of compliance cost on them or change the economics of what they are doing so significantly that they cannot fulfill those roles and are forced to consolidate. 

So we have heard—as I said earlier, we have met with community bank groups around the country, our acting chairman as well 

44 

as the staff, and we host them here in Washington. We had a good 

discussion of these issues at our Community Bank Advisory Committee a couple of weeks ago. So we are very focused on these comments, I can assure you. 

Mr. DUFFY OF WISCONSIN. Good. 

And when the Basel Committee met, you have a group of people 

who usually come from countries that have larger banking institutions. They don’t have a community bank structure like America 

does; they have a larger bank structure in the countries that all 

met on Basel. Is that correct, or is that fair to say? 

Mr. GIBSON. For many of the countries, yes. 

Mr. DUFFY OF WISCONSIN. For many, yes, right. 

And so as we look at this rule that has come out of Basel and 

Basel III, and now you have proposed it here—my guys are concerned that they didn’t really have an effective voice because we 

were concerned about the megabanks and there wasn’t really this 

concern about its impact on the small community banks. 

So you have a rule that is being proposed that had a lot of folks 

sitting around a table who were concerned about the larger institutions, and the voice of the smaller institutions wasn’t considered. 

And if it had, there might have been some different proposals made 

for the community banks, or they, as they had hoped, would have 

been excluded. 

Mr. GIBSON. When we discuss in the Basel Committee, we agree 

to apply those Basel agreements to our internationally active 

banks, which is a very small number of banks. We have proposed 

something that very closely tracks the Basel agreement for the 

largest banks. But what we have proposed for smaller banks is different from what the Basel Committee agreed. We have tailored it 

to the specific circumstances of our community banks and our 

banking model. 

Now, we have gotten a lot of comments that we need to do more 

tailoring, and we are looking at those. But we have never applied 

Basel agreements to all—or we are not proposing to apply Basel 

agreements to all U.S. banks. 

Mr. DUFFY OF WISCONSIN. I want to ask a quick question on the 

available-for-sale securities and how frequently the proposal is that 

they will be required to do that calculation. Is it once a day? It is 

once a month, a quarter? How frequently do they have to make 

that calculation? 

Mr. FRENCH. For purposes of their quarterly financial reports to 

the regulators, the proposal would be that they would include in 

their regulatory capital any unrealized gains or losses in their 

available-for-sale debt securities, which is a change, a proposed 

change, from current practice, where they do not include that in 

their regulatory capital. 

The safety and soundness argument for that is that if they are 

forced to sell these securities in a dire scenario or a stress scenario, 

they are going to have to take those losses, and that really is what 

reflects their capital strength. 

The counterargument is that they hold these things for liquidity. 

It is going to introduce significant volatility to regulatory capital 

from their perspective and complicate their management of interest-rate risk, legal lending limits, and other things. 

45 

So, we have to look at those comments very seriously and relative to the underlying objective. 

Mr. DUFFY OF WISCONSIN. And I see my time has expired. I yield 

back. Thank you. 

Chairwoman CAPITO. Mr. Sherman for 5 minutes. 

Mr. SHERMAN. Mr. French, you talk about, in effect, marking to 

market the available-for-sale securities. Some banks will want to 

strengthen their position by identifying their winning securities 

that have gone up in value as available for sale and those that 

would be marked down as not available for sale. 

How strict is the definition? And what is the consequence of declaring, this security is available for sale, that security is not available for sale? 

Mr. FRENCH. I think in the proposal they would have to recognize all of the unrealized gains and losses on all the available-forsale securities. You raised the issue— 

Mr. SHERMAN. But what is the definition of an available-for-sale 

security? We are not going to sell it anytime soon. 

Mr. FRENCH. You raised the issue of gaming it and moving it to 

the held-to-maturity. That is an important consideration that we 

have to think about, I think, as we decide. 

Mr. SHERMAN. Do the regulations define ‘‘available for sale?’’ And 

can that just be in the mind of the holder? 

Mr. FRENCH. It is a defined term in accounting, so, yes. 

Mr. SHERMAN. Well, perhaps you could get back to me with 

something for the record that is more definitive than that, and not 

so much dealing with gaming the system. It is just, if you have an 

opportunity to easily decide whether or not something is available 

for sale or not being intended for sale, you might happen to notice 

what effect that would have. 

Mr. Gibson, Basel III standards provide favorable supervisorial 

treatment for short-term assets and unfavorable treatment for 

long-term assets held by insurers. Long-term assets would include 

corporate bonds. Banks tend to deal more short-term. Insurers—I 

have a life insurance policy. I hope that is a very long-term obligation of my insurance company. 

If the Federal Reserve compels insurers to remake their balance 

sheets in compliance with Basel III standards, what is the impact 

on insurers? Will that push them out of long-term assets into shortterm assets? And is that contrary to the sound economic principle 

that if you have a long-term liability, which I hope my life is, that 

you match that with a long-term asset? 

Mr. GIBSON. For banks and bank holding companies, we have 

other regulatory requirements on liquidity that look at the kind of 

maturity mismatch you are talking about. 

For capital, we are looking at the potential for losses, so we look 

mostly at the credit risk of the asset. If it is a risky company, the 

capital charge would be higher. If it is a less risky bond, the capital 

charge would be lower. 

Mr. SHERMAN. But in terms of an insurance company, if you have 

a long-term asset, yes, its market value will be affected more dramatically by swings in interest rates no matter how creditworthy 

the issuer, but the offsetting liability to those who are insured is 

also long term. 

46 

Would you be treating insurance companies the same as banks 

when you are looking at how to unfavorably treat long-term assets? 

Mr. GIBSON. For the purposes of risk weights based on credit 

risk, we have proposed the same risk weights. This proposal 

doesn’t deal with liquidity risk, but it would be very different for 

an insurance company than for a bank. 

Mr. SHERMAN. So you are going to be dealing with—I know that 

we have a representative from those who currently regulate insurance companies. Do we need another level of regulation, or have 

the States done a good enough job? 

Mr. MCCARTY. Certainly, if you look at the evidence during the 

financial crisis, we think the States fared very well in the current 

regulatory system. But it is very fundamentally different than 

banking. As you were pointing out, the matching of the assets and 

liabilities is very critical. There is a reason why you don’t have a 

run on an insurance company, because of the structural difference 

in how products are regulated. 

We look at the entity, separate and corporate, individual insurer 

entity as opposed to one consolidated view of it. And we think it 

is important to keep assets and the policyholder’s money there 

available to pay claims. 

Mr. SHERMAN. I want to commend the State regulators. Those 

regulated insurance subsidiaries did very well in surviving the crisis. And it is interesting that AIG had both regulated and unregulated operations. That which was regulated by the States might be 

profitable enough to bail out that portion of AIG that I think in a 

perfect world would have been regulated by insurance regulators 

but was not. 

I think my time has expired. 

Chairwoman CAPITO. Mr. Pearce for 5 minutes. 

Mr. PEARCE. Thank you, Madam Chairwoman. 

The comments by Ms. Waters and Mrs. Maloney I think headed 

in the direction that my interest lies, and that is sort of a fascination with community banks from your perspective. 

When I look at the capital requirements, I see a very complex 

system. In other words, you really have generated a lot of parameters. And I kind of wonder if the same parameters were used in 

evaluating the failures. I have heard 2 or 3 of you talk about the 

460 failures, and you give a lot of attention to real estate. Did you 

slice and dice the real estate as much as you sliced and diced the 

risk that you are going to have community bankers hold? 

In other words, I suspect that there were greater failures per 

capita maybe in Florida or Las Vegas, Nevada, than, say, 

Tucumcari, New Mexico. I suspect that we didn’t have a lot of outof-State people coming in. I don’t think people were rolling real estate. 

Did you do any analysis of the actual failures themselves before 

you said to community bankers, you are going to hold these kinds 

of assets? Because you are shutting down the future of small 

States. You are limiting it. And I am asking, does your analysis of 

the failures go as deep and as finely sliced as your analysis of what 

you are going to have the banks hold? 

Mr. French, you can start, if you would like. 

Mr. FRENCH. Sure. 

47 

Every time we have a failure over a certain size, we do a material loss review. Our Inspector General does that. And, typically, 

the profile of the failed banks in the last 5 years was—the most 

frequent profile was a lot of construction lending and funded by 

broker deposits, would be the typical failed bank. So that was the 

kind of a bank that got hit. 

Mr. PEARCE. And then did—if I can interrupt right at that point. 

So a lot of construction loans. Now, then, were there a lot of construction loans in certain areas versus other areas? How many 

banks in New Mexico failed over construction loans, for instance? 

And I don’t expect you to answer that. But I suspect if you look 

at the 460 bank failures, if you had a map of the United States and 

sticking pins in the places where the banks failed, I suspect they 

are going to be clustered in locations. And yet, you are painting 

with the same broad brush across the entire country, saying that 

you are not doing one-size-fits-all. 

So my question is not so much about what caused them to fail. 

My question is about your process. Did it get as infinitely evaluative as you did on requiring capital for community banks? That is 

my question. 

So, Mr. French, yes or no? Have you sliced and diced it in that— 

Mr. FRENCH. I don’t believe we have sliced and diced the failed 

banks using the metrics in the— 

Mr. PEARCE. No, that is not my question. My question is, if you 

put those pins in the map, did you say, there are some places that 

inherently took advantage of the system and some places did not? 

I suspect we could have a different measurement criteria for 

Tucumcari, New Mexico, or Alamogordo, New Mexico, as we do in 

maybe one of the high resort areas of Florida. Did you slice and 

dice it that finely? 

Mr. FRENCH. I don’t think we would see many pins in the map 

in New Mexico, and I think— 

Mr. PEARCE. We have the same requirements as if we were located right there in one of the high-traffic areas. 

Mr. FRENCH. And one of the frequent themes in the comment letters is exactly what you are suggesting, that we have painted sort 

of too broad a brush with the— 

Mr. PEARCE. Do you know how miserable you all make my life 

when you do this broad, random stuff? 

And one other thing. My time is rolling down rapidly, and I am 

probably only going to get to make the point. Did you slice and dice 

by size? In other words, did you make sure that most of the regulatory requirement fell on those who, by percent, failed in the 

greatest percentages? If I were to look at Wall Street banks—there 

are very few of them—the failure rate was fairly great as a percent. 

And when I do your percentages, you are rolling the 460 over 

and over and over again as if that is going to convince us. But 

when I divide 460 by 7,000 small community banks, I get a failure 

rate in the 5 to 6 percent range. And I wonder if you put that metric into your measurement before you went out and just put these 

rules out that frightened the daylights out of not just the community bankers but the small States themselves, who see capital drying up because of what you have done just proposing your rules. 

48 

And I think before you put these complex matrices together for 

community banks to put out what they are going to have to capitalize, you ought to do a better, more infinite study on what 

caused the failures and where they occurred than what have you 

done. 

I yield back, since my time is gone. Thank you. 

Chairwoman CAPITO. The gentleman yields back. 

Mr. Stivers? 

Mr. STIVERS. Thank you, Madam Chairwoman. 

I would like to ask unanimous consent to enter two things into 

the record: a letter from Senator Collins; and a letter on behalf of 

regional banks and some of the challenges that they face. 

Chairwoman CAPITO. Without objection, it is so ordered. 

Mr. STIVERS. Thank you. 

My first question is for Mr. Gibson. 

Mr. Gibson, do you believe Dodd-Frank requires you to apply 

capital rules identically to insurance companies as banks? 

Mr. GIBSON. No. We only apply capital requirements to depository institution holding companies, which includes ones that happen to own an insurance company. We have tailored in the proposal— 

Mr. STIVERS. I guess that is—I am sorry if I was not specific 

enough, but— 

Mr. GIBSON. Okay. Go ahead. 

Mr. STIVERS. —where there are insurance company assets inside 

a bank holding company, do you believe that it requires identical 

capital to as if that was a bank asset? 

Mr. GIBSON. No. And we tailored the proposed requirements to 

insurance businesses in several areas—for example, separate accounts and policy loans. However, we are constrained by the Collins Amendment, which sets a floor on holding company capital requirements equal to what the bank capital requirements are. 

Mr. STIVERS. Well, I have a letter from Senator Collins to your 

boss that says she believes they can actually, within the constraints of her amendment, sort of work with the standards and 

work with folks like NAIC to make sure that the standards are appropriate for insurance companies. 

So I would ask you to take a look at that. I submitted it for the 

record. 

My second question for you is, what credit do you think Statebased regulation and State-based risk capital should be given to insurance companies because they have State-based risk capital? And 

when those laws conflict, do you think you actually supersede the 

State laws? Because I don’t see that in Dodd-Frank. 

Mr. GIBSON. No. What we do is, we are setting a capital requirement at the holding company level. And at the level of individual 

operating companies, whether it is a bank or an insurance company, they are separate capital requirements by the functional regulators. 

Specifically, with respect to insurance companies, they have capital requirements set by their insurance regulator on insurance underwriting risk, for example. We don’t set any capital requirement 

on that. We just take the number that comes out of the State insurance regulatory system and we just plug that number into ours. 

49 

Mr. STIVERS. And there is going to be additional systems cost to 

folks who happen to own insurance assets that they don’t have 

today because they currently calculate their capital based on the 

State-by-State approach. Did you calculate any of that into your 

costs when you did your cost-benefit analysis? 

Mr. GIBSON. We generally consider the impact of what we have 

proposed. But we have heard comments, especially from depository 

institution holding companies that own insurance companies, that 

they would need more time to adjust to the changes because the 

changes would be greater for them. They were not subject to this 

kind of consolidated regulation before. 

Mr. STIVERS. Correct. And I didn’t see anything that allows you 

to do that. Are you working hard to make that happen? That is a 

yes-or-no question, with my limited time. 

Mr. GIBSON. We have heard those comments, and we are working 

to incorporate them as we go forward. 

Mr. STIVERS. Great. 

My next question is for Mr. Gibson and Mr. Lyons. Somebody before said it is really activities of the bank, not the size, that determines the risk. And I am really worried about mis-ascribing the 

cost of risk, especially associated with mortgages and home equity 

lines of credit, especially with regard to the Qualified Mortgage, 

which has yet to be completely defined. 

Now, that has come up a little bit before, but can you talk about 

what you are going to do to make sure that we don’t mis-ascribe 

risk? Because if we do, it is going to drive up the cost of credit and 

limit credit availability. 

Mr. LYONS. Congressman, we attempted to calibrate risk based 

on the performance of those assets through the crisis. We have received comments from many, many banks and institutions that we 

need to take a look at, a second look at that, and we will as we 

go through the process. But we attempted to calibrate the risk 

based on the performance of those assets through the crisis. 

Mr. STIVERS. Is there any way that you can finalize this before 

the QM definition is defined? Because I don’t think you—if you 

really are going to do that, how can you finalize this rule before 

the QM rule is finalized? 

Mr. LYONS. That is a good point. In the proposal, there are two 

categories of mortgages, category 1 and category 2. Category 1 

closely resembles what we think will come out of QM. But we are 

working very, very aggressively to review all comments and come 

up with a final proposal. 

Mr. STIVERS. And that kind of brings me back to—and I only 

have 10 seconds—the problem with this requirement is it is so complex and granular, that it has interplay with other regulations that 

are only in proposal stage. And, it could be very problematic, very 

difficult to implement, and, in fact, contradict with or just not give 

credit to some of the other regulations that other regulators are 

spending a lot of time and effort to get right. 

So I would hope you would be mindful of that as you proceed on 

this course. 

Chairwoman CAPITO. Thank you. 

I want to thank the gentlemen. 

Mr. STIVERS. Thank you. I yield back. 

50 

Chairwoman CAPITO. Thank you. 

That concludes the first panel. 

The Chair notes that some Members may have additional questions for this panel, which they may wish to submit in writing. 

Without objection, the hearing record will remain open for 30 days 

for Members to submit written questions to these witnesses and to 

place their responses in the record. 

I would also, before I dismiss them, like to enter these statements for the record: Mid-Size Bank Coalition of America; Consumer Bankers Association; American Council of Life Insurers; 

American Insurance Association; America’s Mutual Banks; Mortgage Bankers Association; Council of Federal Home Loan Banks; 

Financial Services Roundtable; MCAM; and the National Association of Insurance Commissioners. 

Mr. PERLMUTTER. Madam Chairwoman? 

Chairwoman CAPITO. Yes. 

Mr. PERLMUTTER. I would like to enter into the record the speech 

by Tom Hoenig of September 14, 2012, that I read from. 

Chairwoman CAPITO. Without objection, the speech from Thomas 

Hoenig will be inserted into the record. 

Mr. PERLMUTTER. Thank you. 

Chairwoman CAPITO. I want to thank the gentlemen on the first 

panel. I appreciate your very forthright testimony. 

We will switch out, and I might stand up and take a little break 

myself. So we will start back in about 4 or 5 minutes. 

[recess] 

Chairwoman BIGGERT [presiding]. I think we will start. We are 

still missing one witness, but let’s get started so that—I know you 

have all been waiting a long time. That was a long time for the 

first panel. 

I am now going to introduce the second panel. First of all, we 

have Professor Anat Admati, George G.C. Parker Professor of Finance and Economics, Graduate School of Business at Stanford 

University. 

Second, we have Mr. Terrence Duffy, executive chairman and 

president, CME Group Incorporated. It is very nice to see you. Mr. 

Duffy has been one of my constituents for 14 years. And I have enjoyed working with you. 

Third, Mr. James M. Garnett, Jr., head of risk architecture at 

Citi; followed by Mr. Marc Jarsulic, chief economist, Better Markets, Inc.; Mr. William A. Loving, president and chief executive officer, Pendleton Community Bank, on behalf of the Independent 

Community Bankers of America; Mr. Daniel Poston, chief financial 

officer, Fifth Third Bancorp, on behalf of the American Bankers Association; Mr. Paul Smith, senior vice president and chief financial 

officer, State Farm Mutual Automobile Insurance Company; and 

Ms. Virginia Wilson, executive vice president and chief financial officer, TIAA–CREF. 

Thank you all for being here. 

And we will start with the first witness. Professor Admati, you 

are recognized for 5 minutes. 

51 

STATEMENT OF ANAT R. ADMATI, GEORGE G.C. PARKER PROFESSOR OF FINANCE AND ECONOMICS, GRADUATE SCHOOL 

OF BUSINESS, STANFORD UNIVERSITY 

Ms. ADMATI. Thank you. I very much appreciate being here 

today. I have spent a lot of my time thinking precisely on the issue 

of capital, and I have some materials. I have not submitted comments for this one because I was busy writing a book on the subject. 

The first thing I want to refer to is the question that was asked 

in the invitation letter, which asked about how capitalized the U.S. 

institutions are. And, specifically, it asked how their capital reserves compare to the years prior to the crisis. 

The term ‘‘capital reserve’’ leads me to stop right here, as well 

as what I have been hearing in the last 2 hours, to just make a 

very important clarification about what we are talking about. The 

use of the term ‘‘capital reserves’’ is very, very confusing, as is the 

language being used. The term ‘‘reserves’’ is like a rainy-day fund. 

It is cash set aside for some emergencies. And you could say the 

banks hold reserves. A certain fraction of their assets are actually 

in cash or in deposits with the central banks. 

But the problem is that unless reserves are, like, 100 percent or 

very, very, very high, they don’t solve the following problem. And 

the problem is, when the banks make loans, how are they going to 

be able to absorb those losses without becoming distressed? That 

is where capital comes in. So the word ‘‘capital’’ actually refers basically to unborrowed funding. It has nothing to do with what the 

banks actually hold. 

So banks actually do not hold this capital, and there is nothing 

stopping them from lending capital. Because in the rest of the 

world, in the rest of the economy, the word ‘‘capital’’ is actually not 

used in that way. The word that is used is ‘‘equity.’’ 

And down the street from me in California there is a company 

called Apple. And we do not say that Apple holds 100 percent capital. But Apple actually does not borrow, and yet it invests a lot. 

So there is nothing about capital that actually stops lending, nothing about it. Lending will happen if banks want it. 

And the only issue about lending is who bears the losses when 

that happens. Is it the safety net, or is it the banks themselves and 

their shareholders? If they lose on any investments, can they still 

function, or do they become so distressed that we see a problem? 

So the issue is the extent of borrowing that banks do. 

Banks are among the most indebted corporations in the economy. 

Nobody in the economy borrows as much. There is no healthy company in the economy that operates with a single-digit amount of 

equity. And so, banks might tell you that is their business, but that 

is false. It is not their business to be as highly leveraged. In fact, 

when they are so highly leveraged, they do worse for the economy 

because the stress or highly indebted entities do not make good investment decisions. 

The key for banking stability is the banks have sufficient funding 

with equity so they can withstand losses without getting the stress, 

and so they worry about the downside of their investments more 

than they currently do. The safety net of banking has increased 

and expanded to a degree that people forget that they are actually 

52 

corporations who can own their decisions on the upside and on the 

downside. 

We do regulate them, and we do not regulate the other companies in the economy, and yet they do not borrow as much. They 

could, but they don’t. Why do banks love so much borrowing? I 

have written extensively about this, and I won’t talk about it here. 

We do regulate the amount of borrowing because when they get 

distressed, we all suffer. So that is important. 

How much equity should they have? I side with—my benchmark 

is pre-safety-net, just like Mr. Hoenig, and it is certainly not in the 

single digits relative to total assets. That is the amount of equity 

that they should have. There is absolutely nothing at all that stops 

banks from having 20 or 25 percent equity. They will have to transition there, but that is the way they would be healthier and serve 

the economy better. There is no increase in their funding cost except for the fact that they own more of their downsides and they 

are less able to use tax subsidies and borrowing than other people 

who don’t use as much as they do. 

The Basel is risk-calibrated, and this risk calibration actually 

creates distortions in lending. Banks lend too much to mortgage, 

and now we want to correct that, but next they might lend too 

much. So municipalities which have low-risk rates in Europe, they 

lend too much to governments and they take the governments and 

themselves down. That is very unhealthy. So the risk weights can 

be highly destructive to lending. 

What we need banks to do is lend to businesses. The risk weights 

actually discourage that. Banks would lend if we give them the opportunities to lend and not expect them to do so. The current regulation is made that way, and it is greatly insufficient. 

One comment on whether it should be one-size-fits-all, definitely 

not. But the biggest institutions definitely need more capital requirements, but the one thing that all regulators should do—and 

if they are not here, I have certainly tried to say this to them. The 

one thing that must be done right away on the biggest institutions 

is to stop them from paying out to their equity holders right now 

and for the foreseeable future. There is absolutely no reason that 

a large institution should pay to its equity holders, to its shareholders, instead of lending the money, paying down their debts. 

Their debts are debts that they chose to take, overfunding with equity. When they pay out, the equity is depleted, and the economy 

is harmed. 

That is a failure of the regulation, repeating failures from before 

the crisis, where half of the amount that TARP ended up having 

to put into the banks was the amount that was paid in the years 

2007–2008 out to shareholders, disproportionately to bank managers. This industry should be brought into the world of real economic costs and benefits. 

Thank you. 

[The prepared statement of Professor Admati can be found on 

page 88 of the appendix.] 

Chairwoman BIGGERT. Thank you. 

I now recognize Mr. Terrence Duffy for 5 minutes. 

53 

STATEMENT OF TERRENCE A. DUFFY, EXECUTIVE CHAIRMAN 

AND PRESIDENT, CME GROUP INC. 

Mr. TERRENCE DUFFY. As a former trader, I actually didn’t need 

a microphone. I was going to be able to yell just fine. 

But let me thank you, Madam Chairwoman and members of the 

subcommittees, for allowing me to testify today. And, Madam 

Chairwoman, let me also thank you for all of your service to your 

district and to our district, for your service and your leadership. 

You did a wonderful job, and we are going to miss you. So thank 

you very much. 

CME Group applauds the Federal Reserve Board, the FDIC, and 

the Office of the Comptroller of the Currency for deferring the capital rules, and implementing the Basel III Interim Capital Framework. 

Both Dodd-Frank and the G-20 mandates aim to reduce systemic 

risk and increase the transparency. Our concern is that Basel III’s 

one-size-fits-all rules for capital charges based on the risk of 

cleared derivatives is at odds with these objectives. 

The Basel framework treats all cleared derivatives as if they require a margin to cover a 5-day period of risk. This means that 

highly liquid derivative contracts that trade by means of central 

limit order book that can be easily and quickly liquidated without 

substantial risk are put in the same category as cleared OTC contracts that are not usually liquidated or traded transparently. 

Clearinghouses recognize the difference between these two products. They require margin levels based on timeframes that are justified by the actual risk inherent in liquidating the positions. In the 

United States, this means 1 or 2 days for futures, and 5 days for 

less liquid cleared swaps. 

If capital charges are not based on properly measured risk, it 

could encourage the use of higher-risk instruments. This is inconsistent with both Dodd-Frank and the G-20 policy goal to reduce 

risks in derivative trading by moving from opaque markets to 

transparent markets. 

Clearinghouses properly set margins for liquid derivatives to 

cover 1-day risk. If banking regulators impose a capital charge 

based on a 5-day, banks will be burdened with unwarranted capital 

requirements. This cost will be passed down to the customers trading liquid products in the form of higher collateral or higher fees, 

once again contrary to the Dodd-Frank Act. 

This could distort customers’ product choices. Customers may 

move away from trading liquid exchange-traded derivatives. There 

is the potential that central limit order book exchange-traded products could be more expensive. The last thing we want to do is drive 

customers back into an opaque OTC market because of a one-sizefits-all margin period. 

Basel III’s one-size-fits-all margin period is also inconsistent with 

the international clearinghouse standards. These standards recognize that margin levels and risk periods should correspond to risk 

and liquidity profiles: as I said earlier, 1 to 2 days for futures; 5 

days for OTC cleared swaps; and then, of course, 10 days for 

uncleared swaps. 

Liquid derivatives traded via a central limit order book and 

cleared through a clearinghouse offer complete transparency. They 

54 

trade in deep liquid market. The turnover is 10 times more frequent than OTC swaps. Those characteristics permit rapid offset 

and liquidation in the event of an emergency. 

There is no risk management benefit to the banks or the system 

by imposing capital charges beyond the clearing level margin established by these liquid contracts. We have expressed these concerns 

in written comments to the Fed, the FDIC, and the OCC. We have 

also had discussions with the Fed staff. In addition, we have submitted two letters to the Basel Committee. 

The agencies’ capital rules should be amended to eliminate the 

addition of 4 days’ capital on top of a 1-day margin for exchangetraded derivatives. This should be replaced with an approach consistent with the current standards. These standards recognize that 

margin periods will differ based on the liquidity, transparency, and 

other risk-reducing characteristics of each product. 

I want to thank you for the opportunity to testify before you 

today. 

[The prepared statement of Mr. Terrence Duffy can be found on 

page 126 of the appendix.] 

Chairwoman BIGGERT. Thank you, Mr. Duffy. 

Mr. Garnett, you are recognized for 5 minutes. 

STATEMENT OF JAMES M. GARNETT, JR., HEAD OF RISK 

ARCHITECTURE, CITI 

Mr. GARNETT. Good afternoon, members of the subcommittees. 

My name is Jim Garnett, and I am the head of risk architecture 

for Citigroup. In that capacity, I am responsible for implementing 

the Basel III capital rules for Citi within the United States and 

throughout the 160 countries and jurisdictions where Citi does 

business around the globe. 

Citi broadly supports the goals of Basel III capital rules proposed 

by the U.S. banking regulators. As a global bank, Citi has long supported risk-based capital standards along with heightened liquidity 

standards. We recognize the importance of capital to serve as a 

buffer against changing market and economic conditions. Aligning 

capital with economic risks ensures that adequate capital exists to 

cover risks and avoid excess capital, which can unnecessarily constrain lending and investment activities that support the real economy. 

There are, however, certain features of the proposed rules that 

deserve refinement in order to avoid unintended negative consequences. 

First, cumulative capital levels will unnecessarily constrict credit 

for all but the Nation’s most creditworthy borrowers. Notably, 

small-business owners will be adversely affected in the form of 

higher credit costs and constrained credit availability, particularly 

because small businesses do not have direct access to the capital 

markets. 

To help avoid capital standards that divide consumers, we support the industry’s call for a quantitative impact study of the proposed rules. Such a study would enable Congress, the Federal 

banking regulators, and others to better understand the impact of 

the proposed rules and, if appropriate, make adjustments that 

avoid an unintended contraction in credit to customers. 

55 

Second, the elimination of the filter for the accumulated other 

comprehensive income in calculating Tier 1 common equity will 

negatively impact the ability of banking organizations to extend 

new credit, thereby reducing investments in U.S. Treasuries, agency debentures, and mortgage-backed securities. 

A better solution would be to continue to exclude unrealized 

gains and losses in Basel III Tier 1 common capital for availablefor-sale securities of only the most creditworthy and liquid issuers. 

This approach would create consistency between the regulatory 

capital treatment of securities and the regulatory capital and accounting treatment of the deposit liabilities they are largely hedging. Further, it would reduce the negative consequences caused by 

volatility in regulatory capital levels. 

Third, we are concerned about the apparent lack of uniform application of capital and other supervisory standards within the 

United States and globally. An unlevel Basel playing field across 

national jurisdictions can arise from two different sources. First, 

banking supervisors in different countries may apply different 

standards when approving internal models or approving internally 

calculated risk parameters. 

Second, if the Basel rules are adopted and implemented uniformly, a given rule can have a disparate impact across national jurisdictions because of differences in market structures and associated accounting standards across countries. Thus, U.S. international banking regulators need to ensure that the Basel III rules 

are applied consistently and uniformly. Deviations in risk-weighing 

should not be allowed. 

Finally, we believe the capital rules should be tailored to different types and sizes of banks. Community banks are justifiably 

concerned about the compliance costs imposed by Basel III, and 

Citi supports a simpler set of risk-based rules for these institutions. The Federal banking regulators should reconsider the application of Basel III through traditional community banks that do 

not have complex balance sheets and permit such institutions to 

continue to comply with Basel I or some other simplified risk-based 

capital regime. 

In closing, I would like to note that Citi today is one of the bestcapitalized banks in the world. We support strong capital requirements as one of the critical pillars of a safe, sound, and effective 

financial system. We have added over $140 billion in new capital 

to our capital base. Our capital strength is more than 5 times higher than it was during the crisis. Although the Basel III capital requirements do not fully become effective until January 2, 2019, Citi 

is well under way toward complying with them, both the baselines 

and the surcharges. We are in a position to put our financial 

strength to work for our clients during challenging and uncertain 

economic times, and we are doing so. 

Thank you again for the opportunity to discuss these important 

rules, and I am happy to answer any questions you may have. 

[The prepared statement of Mr. Garnett can be found on page 

168 of the appendix.] 

Chairwoman BIGGERT. Thank you very much. 

Mr. Jarsulic—am I pronouncing that correctly? 

Mr. JARSULIC. Yes, you are. 

56 

Chairwoman BIGGERT. You are recognized for 5 minutes. 

STATEMENT OF MARC JARSULIC, CHIEF ECONOMIST, BETTER 

MARKETS, INC. 

Mr. JARSULIC. Good afternoon, Chairwoman Biggert, Ranking 

Member Maloney, and members of the subcommittees. Thank you 

for the invitation to Better Markets to testify today. 

I will note that I am summarizing written testimony that I have 

submitted to the committee, and I will restrict my comments to two 

issues: the adequacy of proposed capital requirements generally; 

and the application of these requirements to community banks. 

Let me begin by observing that the financial crisis revealed two 

important weaknesses of the U.S. banking system. 

The first weakness is that U.S. banks use far too much debt and 

far too little equity to finance their positions. High leverage makes 

them vulnerable to asset price declines and creditor runs. This is 

very clear from the data. As detailed in my written testimony, 

highly leveraged banks such as Washington Mutual, Wachovia, 

Citigroup, and Bank of America all went through similar scenarios. 

As the crisis developed and they charged off loans and wrote down 

assets, markets doubted that they were solvent. They either lost 

access to the capital markets and failed or were rescued by the injection of government equity and other crisis support. 

Their losses, or the sum of their losses plus government equity 

injections, were between 7 and 111⁄2 percent of tangible assets. The 

failure or near failure of these and other important banks clearly 

indicate that banks require common equity of at least 20 to 25 percent of tangible assets to survive financial crises of the severity 

that we have just witnessed. They require that much equity to absorb large losses and remain viable. 

The second weakness is that the broker-dealers operated by large 

banks are highly exposed to the risk of very rapid counterparty 

runs. Broker-dealer trading is heavily reliant on repo financing, 

which can be highly unstable. In early 2008, there was a general 

run on repo as firms and asset classes became suspect even for 

overnight loans. By the end of the year, the outstanding repo held 

by primary dealers contracted from a peak value of $4.6 trillion to 

$2.4 trillion. 

It is also the case that the broker-dealers with large over-thecounter derivatives books are subject to rapid runs during which 

their counterparties novate contracts, close out contracts, or make 

margin calls. Runs of this kind materialized during the financial 

crisis at Bear Stearns and Lehman Brothers, contributing to the 

collapse of those firms. 

Let me next observe that the proposed capital rules do not adequately address either of these two weaknesses. The proposed capital rules do not require banks to use nearly enough equity finance. 

For example, the proposed rules require banks to have common equity equal to 4 percent of on-balance-sheet assets. But the evidence 

clearly indicates that banks require common equity equal to at 

least 20 to 25 percent of their tangible assets to survive financial 

crises of the sort we have just witnessed. 

In addition, the proposed rules do not require banks to self-insure against the run risk posed by over-the-counter derivatives and 

57 

repo borrowing. The proposed rules allow banks to calculate repo 

exposures net of collateral used to borrow and to calculate derivatives exposures net of counterparty exposures. These net calculations do not reflect the fact that runs on repo finance will mean a 

loss of gross repo financing or that the run on over-the-counter derivatives is related to gross exposure to the weakened dealer. Instead, equity requirements should rise as trading operations increase their gross repo borrowing or gross derivatives exposures. 

This would force banks to self-insure against runs. 

Finally, let me observe that while it may prove useful to make 

some adjustments to the proposed capital requirements for community banks, those adjustments should be restricted to a properly defined set of banks. The banking agencies have indicated that the 

capital rules may need some changes to account for issues that are 

specific to community banks. Some real changes discussed in my 

written testimony may help preserve the supply of credit to households without significantly increasing the risk to the overall financial system. 

However, these changes should be restricted to genuine community banks. Researchers often use an asset threshold of $1 billion 

as a proxy to identify community banks. If that threshold were 

raised to $10 million, it would mean, with the exception of some 

small banks and multiple bank holding companies, 98 percent of all 

individual banks would be considered community banks. Such a 

threshold would also guarantee that large, too-big-to-fail banks 

would be prevented from using changes to the capital requirements 

to unduly increase systemic risk. 

Thank you, and I would be happy to answer any questions. 

[The prepared statement of Mr. Jarsulic can be found on page 

226 of the appendix.] 

Chairwoman BIGGERT. Thank you. 

Mr. Loving, you are recognized for 5 minutes. 

STATEMENT OF WILLIAM A. LOVING, JR., PRESIDENT AND 

CHIEF EXECUTIVE OFFICER, PENDLETON COMMUNITY 

BANK, AND CHAIRMAN-ELECT, INDEPENDENT COMMUNITY 

BANKERS OF AMERICA (ICBA), ON BEHALF OF ICBA 

Mr. LOVING. Good afternoon, Chairwoman Capito, Chairwoman 

Biggert, Ranking Member Maloney, Ranking Member Gutierrez, 

and members of the subcommittees. My name is William A. Loving, 

Jr., and I am president and CEO of Pendleton Community Bank, 

a $260 million bank in Franklin, West Virginia. I am also chairman-elect of the Independent Community Bankers of America, and 

I am testifying today on behalf of its nearly 5,000 members. 

Basel III was meant to only apply to the largest internationally 

active institutions, as opposed to community banks with their simple capital structures and conservative lending. Applying the same 

capital standards in addition to the many other new far-reaching 

regulations that will soon become effective will undermine the viability of thousands of community banks. 

In numerous ways, these rules strike at the heart of the community bank competitive advantage: customized lending based on 

firsthand knowledge of the borrower and the community. We ask 

58 

you to support an exemption for banks with assets of less than $50 

billion in size. 

There are many overreaching provisions of Basel III in the 

Standardized Approach. Individually and collectively, they will fundamentally reshape the United States financial industry. I will 

begin my remarks with the impact the rules will have on residential mortgage lending. 

New risk weights on certain residential mortgages will impose 

punitive capital charges on all but standardized, plain-vanilla 

loans. Customized loans such as balloon loans, a staple of community banking, would move from their current 50 percent risk weight 

to a minimum of 100 percent and potentially 200 percent, though 

they are fully secured by real estate. 

In the rural areas I serve, many loans are ineligible for sale into 

the secondary market because they lack comparables or because 

the house sits on an irregular or mixed-used property. I am happy 

to hold such loans in my portfolio, but the only way I can protect 

my bank against interest-rate risk is to structure the transaction 

as a balloon loan, typically with a 5- to 7-year maturity. 

I and other community bankers have safely offered balloon loans 

for decades. Because I retain these and other loans in my portfolio, 

I have a vested interest in their performance. I am not aware of 

any data whatsoever that demonstrates that balloon loans are 

more risky than other types of credit. I would have to seriously reconsider making these loans with a 100 percent risk weight, let 

alone 200 percent. 

Second liens, like home equity loans and home equity lines of 

credit, would also become impossible under the new risk weights. 

Prudently underwritten second liens serve a vital role in the lives 

of homeowners: financing property improvements; sending a child 

off to college; or starting a small business. 

The new risk weights will drastically curtail residential lending 

in the rural and underserved areas that community banks serve, 

including mutual and thrift institutions. This is especially true if 

combined with new rules on Qualified Mortgages, Qualified Residential Mortgages, and other issues. 

I will note one additional provision that will undermine community bank regulatory capital. Requiring us to include unrealized 

gains and losses on certain investment securities will create volatility where stability is paramount. When interest rates rise—and 

they surely will—today’s paper gains on Treasuries and other securities will rapidly become paper losses. The sudden adverse impact 

on capital levels will be substantial, though the banks’ actual ability to absorb the losses will remain unchanged. Large banks manage these risks with interest-rate derivatives that are simply impractical for community banks. Volatile capital levels send the 

wrong signal to the public, depositors, investors, and regulators. 

Many additional provisions are nearly as troubling, and the total 

impact, as I have stated, could increase consolidation and reduce 

the number of community banks. An economy dominated by a 

small number of very large banks offering commodity products 

would not provide the same level of competitive pricing and choice 

and would definitely not be in the best interest of consumers. Small 

59 

towns in rural areas will face curtailed access to credit and economic stagnation. 

Thank you for convening this hearing and helping to raise the 

profile of a significant economic policy issue with far-reaching and 

still unappreciated applications. Your letters to the bank regulators, both in their thoughtful quality and their sheer number, 

have hopefully made a significant impression. We look forward to 

working with you in this committee to obtain a full exemption on 

Basel III and the Standardized Approach for banks with less than 

$50 billion in assets. 

[The prepared statement of Mr. Loving can be found on page 242 

of the appendix.] 

Chairwoman BIGGERT. Thank you, Mr. Loving. 

Mr. Poston, you are recognized for 5 minutes. 

STATEMENT OF DANIEL T. POSTON, CHIEF FINANCIAL OFFICER, FIFTH THIRD BANCORP, ON BEHALF OF THE AMERICAN BANKERS ASSOCIATION (ABA) 

Mr. POSTON. Chairwoman Capito, Chairwoman Biggert, and 

members of the subcommittees, my name is Dan Poston, and I am 

chief financial officer of Fifth Third Bancorp, a regional bank based 

in Cincinnati, Ohio. 

Fifth Third, like most other regional banks our size, is a traditional banking organization. We are domestically focused, serving 

our local communities by providing traditional banking services, 

primarily consumer and business loans, deposits, trust and related 

services. We are not complex or interconnected, and we do not have 

large trading or capital markets businesses. 

We strongly support standards for appropriate levels of highquality bank capital. We also support a more risk-sensitive system 

that applies broadly and treats similar risks with similar capital 

treatment. 

There are 7,000 banks in the United States, the vast majority of 

which are community-based banks. Therefore, any general risk 

weights must work for these banks or else they don’t work. We believe that such an approach would be entirely appropriate for regional banks like Fifth Third, whose risks are those of a traditional 

bank. 

U.S. bank capital levels are now at historic highs. The issue is 

not whether U.S. banks have the capital for these rules; the vast 

majority of us do. It is the complex way that the rules would operate that would be so damaging to our customers and to the United 

States economy overall. 

For example, the proposed risk weights would double the capital 

required for certain traditional mortgage products. The proposed 

rules are especially punitive to home equity lines of credit, which 

have not demonstrated the risk implied by these rules. We believe 

the rules as proposed would reduce mortgage availability, tightening credit and raising the cost of these products for borrowers 

and reducing credit to small businesses that use equity in their 

homes to start up and support the growth of their companies. 

The risk weights would also raise costs and reduce credit availability to many commercial borrowers. 

60 

We strongly recommend that the Standardized Approach be 

withdrawn. The proposed risk weights have never been studied as 

part of a capital framework. There is time for the careful study 

that is absolutely critical to ensure consistent and workable rules 

for all. This is especially the case given that this proposal goes beyond any Basel agreement and is not required by any Federal legislation. 

All banks, large and small, would benefit from an effective but 

much simpler replacement for Basel I than the one that has been 

proposed. Banks large and small have voiced very strong and remarkably consistent concerns about the complexity and burden of 

the proposed Standardized Approach. 

We very much appreciate that the banking agencies have indicated that they are carefully considering these concerns and will 

take them into account. We look forward to working with the Members of Congress, banking regulators, and others to address these 

issues for the good of all. 

I thank you for your time today and will gladly answer any questions you have. 

[The prepared statement of Mr. Poston can be found on page 304 

of the appendix.] 

Chairwoman BIGGERT. Thank you, Mr. Poston. 

Mr. Smith, you are recognized for 5 minutes. 

STATEMENT OF PAUL SMITH, CPCU, CLU, SENIOR VICE PRESIDENT AND CHIEF FINANCIAL OFFICER, STATE FARM MUTUAL AUTOMOBILE INSURANCE COMPANY 

Mr. SMITH. Chairwomen Biggert and Capito, Ranking Members 

Gutierrez and Maloney, and members of the subcommittees, thank 

you for providing State Farm this opportunity to testify on how the 

Basel proposals impact savings-and-loan holding companies, particularly those engaged in the business of insurance. 

I have a written statement for the record which I would like to 

summarize, and then I look forward to the questions at the close 

of the panel. 

State Farm is a proponent of strong capital standards, and we 

appreciate the complexity facing the Federal Reserve as they enact 

Dodd-Frank. However, applying a banking framework to companies 

predominantly engaged in the business of insurance is fundamentally flawed. It entails costly and questionable reporting requirements and favors structuring capital in a manner making insurers 

financially weaker, not stronger. 

We are also asked to spend hundreds of millions of dollars developing new accounting and reporting systems that provide little, if 

any, added benefit over current conservative accounting systems 

required by State law. Effectively, this new system would be used 

exclusively to complete a form that does not add value to the safety 

and soundness of the financial system. 

We do not believe applying the Basel framework to insurancebased savings-and-loan holding companies is required by DoddFrank and, in fact, think doing so runs counter to congressional intent, as expressed most recently by Senator Collins in a November 

26th letter to the leadership of the Federal Reserve, the FDIC, and 

the Office of the Comptroller of the Currency. Instead, the Board 

61 

should utilize longstanding and effective State-based insurance regulatory requirements in setting minimum capital standards for insurance companies. 

Finally, unless the Board is willing to accept the State-based capital rules, which it appears reluctant to do, we believe the Board 

should repropose specific governing rules for insurance-based savings-and-loan holding companies. 

I would like to share a little bit about State Farm. State Farm 

Mutual Automobile Insurance Company is a mutual company 

founded in Bloomington, Illinois, in 1922. Through a network of 

18,000 independent contractor agents and our staffs throughout 

North America and with an employee base of 68,000, we are the 

largest home and auto insurer in North America. 

These businesses—property and casualty insurance—comprise 85 

percent of our revenues. Adding in our life business, which was 

founded in 1929, brings that revenue number to 98 percent. We are 

clearly primarily in the business of insurance. 

Our thrift comprises about 2 percent of our revenues but provides important convenient service to customers in the middle market. State Farm Mutual Automobile Insurance Company, our primary automobile insurer, sits atop our holding structure. And that 

is important because, as you listen to the testimony, you have 

heard the discussion about holding companies that own insurance 

companies or banks that own insurance companies. Our holding 

company is an insurance company, and it is not recognized within 

the regulations. 

Banks and insurance are very different. Banks take deposits, 

which are liabilities on the bank’s balance sheet since depositors 

can take their money back at any time. In sharp contrast, insurers 

collect a premium to pay for fortuitous or unplanned events. 

Effective capital management of insurance companies is driven 

by matching our liabilities and our asset durations. Unfortunately, 

the banking regulatory model does not account for the nature of insurance liabilities and punishes holding longer-term assets. For a 

life insurance company, in particular, with long liability horizons, 

short-term banking regulatory preferences actually encourage 

asset-to-liability mismatches. 

Similarly, banking rules ignore the nature of property and casualty liability risks faced by the insurance industry. Ironically, 

since many lines of P&C are of shorter duration, we could envision 

satisfying minimum capital standards under banking rules at levels that would garner regulatory action at the State level. So we 

would actually be looked at as well-capitalized for banking purposes and fail regulatory capital rules on the insurance basis. 

This was recognized in a joint report with the NAIC and Federal 

Reserve staff. And I will quote from a report that was written in 

2002: ‘‘The effective regulatory capital requirements for assets, liabilities, and various business risks for insurers are not the same 

as those for banks. And effective capital charges cannot be harmonized simply by changing the nominal capital charges on individual assets.’’ As the rules have come out, that is exactly what we 

have tried to do, and it is simply not an effective regime. 

When you take the bank-oriented rules and combine them with 

the uncertainty regulators have created for insurers through the 

62 

lack of specific rulemaking on the Volcker Rule, where insurance 

thought longstanding State-regulated investment rules applied, one 

wonders if there is any meaningful regard for insurance issues 

among Federal regulators. 

My time is up, but the bottom line is that banking rules do not 

work for insurance companies and, we believe, are inconsistent 

with legislative intent. We are respectfully asking for rules that 

make sense. 

Thank you. 

[The prepared statement of Mr. Smith can be found on page 317 

of the appendix.] 

Chairwoman BIGGERT. Thank you, Mr. Smith. 

We are having a vote right now, so that is why some people have 

left. They will hopefully be back. 

Ms. Wilson, you are recognized for 5 minutes. 

STATEMENT OF GINA WILSON, EXECUTIVE VICE PRESIDENT 

AND CHIEF FINANCIAL OFFICER, TIAA–CREF 

Ms. WILSON. Thanks very much. Chairwoman Biggert, Chairwoman Capito, Ranking Members Gutierrez and Maloney, and 

members of the subcommittees, my name is Gina Wilson, and I am 

executive vice president and chief financial officer of TIAA–CREF. 

I appreciate the opportunity to testify regarding your concerns 

about the regulatory proposals to implement an enhanced capital 

regime for banking organizations. 

TIAA–CREF is an insurance company with a not-for-profit heritage and the Nation’s largest private provider of retirement benefits. Our primary goal is to ensure the lifelong financial well-being 

of our 3.7 million clients working in the academic, research, medical, and cultural fields. 

Many of our clients have lifetime relationships with TIAA–CREF 

and trust us to provide for their long-term financial success. To ensure that we are meeting our clients’ needs, we offer a comprehensive set of low-cost financial products and services, and among 

those services is a small thrift institution that allows us to offer 

our clients the option of banking with a company that they know 

and trust. 

While our thrift company is less than 2 percent of our total assets, it still brings us under the purview of the Federal Reserve, 

and therefore subjects our entire organization to the capital regime 

contemplated by the regulators. 

TIAA–CREF believes in having a set of robust capital rules governing financial institutions, and it is essential to increasing the 

safety and soundness of the financial system. We also believe the 

structure of the capital rules needs to account for the unique business models of the firms to which the rules apply. 

The Federal Reserve’s approach, however, is built solely on the 

banking business model. As a result, the proposals fail to adequately consider both the vast differences between insurance and 

banking and the potential negative consequences of applying a 

bank capital structure to an organization like TIAA–CREF that has 

a small bank but is overwhelmingly engaged in insurance. 

Let me be clear. We are not asking for an exemption from the 

proposal. We believe that imposing the proposed structure without 

63 

consideration for the existing strict capital rules to which insurers 

already adhere would negatively affect TIAA–CREF’s ability to 

offer our clients a full range of reasonably priced products and 

services. Therefore, we are asking the Federal Reserve to integrate 

the existing insurance capital rules into the proposals as they move 

forward with the final rulemaking process. 

In drafting the proposals, the Federal Reserve has taken the position that the Collins Amendment to the Dodd-Frank Act, which 

was intended to permit due consideration of insurance companies 

involved in banking, prohibits them from treating insurance assets 

differently from banking assets. We respectfully but definitively 

disagree with this interpretation. We believe that the Collins 

Amendment provides regulators with ample flexibility to integrate 

the existing insurance regulatory capital regime into their proposed 

model. 

Just this week, Senator Collins confirmed our interpretation of 

her amendment in a letter to regulators. In it, she states that she 

hopes regulators will ‘‘give further consideration to the distinctions 

between banking and insurance.’’ The Senator also goes on to note 

that Congress did not intend for Federal regulators to supplant 

prudential State-based insurance regulation with a bank-centric 

capital regime. We appreciate Senator Collins’ comments and believe that they provide the Federal Reserve with a clear path forward. 

In our written testimony and in our comment letter, we have outlined two viable alternative approaches that would allow the Federal Reserve to incorporate the existing insurance regulatory capital regime into the proposals. These alternatives would accommodate insurers who own thrifts, while still imposing a robust regulatory structure on all banking organizations. We hope regulators 

seriously consider these alternatives, especially in light of Senator 

Collins’ letter stating that it was the intent of Congress that they 

do so. We also ask the members of the subcommittees to keep these 

viable alternatives in mind as you work with and talk to the Federal Reserve about this initiative. 

Thank you for your interest in our issues. Your assistance and 

support is invaluable in complementing our own efforts to ensure 

that the final rules adequately consider the business of insurance. 

And I look forward to answering any questions you may have. 

[The prepared statement of Ms. Wilson can be found on page 326 

of the appendix.] 

Chairwoman BIGGERT. Thank you. 

We will now turn to Members to ask questions, and I will yield 

myself 5 minutes. 

While the proposed Basel III rules are intended to reduce the 

ability of banks to take excessive risks and damage the economy, 

it seems like the very nature of the business of insurance is not to 

take on excessive risk. 

Could the proposed Basel III rules unnecessarily harm insurance 

consumers, the industry, and the economy, particularly those that 

might have a holding company or a bank? 

Let’s start with you, Ms. Wilson, and then go to Mr. Smith. 

Ms. WILSON. I would say that the potential harm to our policyholders is indirect, in that the risk-weightings for longer-dated asVerDate Nov 24 2008 11:52 Apr 26, 2013 Jkt 079691 PO 00000 Frm 00071 Fmt 6633 Sfmt 6633 K:\DOCS\79691.TXT TERRI
64 

sets, which are really necessary for us to provide retirement benefits, would cause us potentially to look for less long-dated assets. 

And that would actually create risk for the organization and potentially harm the returns that we can earn in supporting those retirement benefits. 

Chairwoman BIGGERT. Okay. 

Mr. Smith? 

Mr. SMITH. Yes, I agree with Gina on that. And I would only add 

that the cost of compliance—so we use a State-based regulatory 

system for our reporting, a statutory accounting that is auditable. 

And a conversion to a GAAP statement for the State Farm organization would run a cost of somewhere in the neighborhood of $150 

million and over 4 years to implement. 

Those are costs that would go toward regulatory compliance and 

wouldn’t be available to support our policyholders. So, along with 

just the disconnect with the risk-weightings, you also have the 

issues of cost of compliance that I think are a negative impact to 

the industry. 

Chairwoman BIGGERT. Okay. 

Mr. Smith, can you envision a scenario where under the proposed 

Basel III rules, an insurance company could look solvent, but under 

State insurance regulations, the insurance company could be subject to regulatory intervention? 

Mr. SMITH. Yes, in the property and casualty world, basically the 

majority of the risk is actually carried on the liability side of the 

balance sheet. It is in the loss reserves; it is not on the asset side 

of the balance sheet. And the assets are actually very conservatively managed because we have to have liquidity for unexpected 

events. And that conservative balance sheet fares very well under 

a Basel III framework but ignores the risks to the company. 

So we have run some of our affiliates through a model that 

shows that it is actually shows the affiliates are well-capitalized at 

a time that we would—well-capitalized from a banking standpoint 

where they would be not well-capitalized or even subject to regulatory involvement at the State level. 

Chairwoman BIGGERT. Thank you. 

We are going to stand in recess for a few minutes. Mrs. Capito 

should be back, but I have to go vote. So we will be in recess. 

[recess] 

Chairwoman CAPITO [presiding]. I will call the committee back to 

order and recognize Ms. Hayworth for 5 minutes for questions. 

Dr. HAYWORTH. Thank you, Madam Chairwoman. 

I have a question for Mr. Garnett regarding your testimony. And 

of course, there is great concern about the harmonization and the 

universal application of capital standards, supervisory standards. 

At this point, how do our efforts in the United States compare 

with international efforts in terms of implementing Basel III? 

Mr. GARNETT. I think that we are probably on the same page 

with regard to the implementation of Basel III. As you may or may 

not know, we have been managing to what we think our interpretations are of Basel III for approximately a year now. 

Dr. HAYWORTH. Right. 

65 

Mr. GARNETT. We are getting new roles and drafts quite frequently. But I would say that they were certainly ahead of us with 

regard to implementing Basel II, which we did not do here. 

Dr. HAYWORTH. Right. 

Mr. GARNETT. But with regard to an all-in, if I can say that, 

Basel III, I would say that we are probably on a similar pace. 

I think the concerns with regard to the implementation of Basel 

III are similar, in the sense of we have raised in both continents, 

if I can say that, we have raised an enormous amount of capital; 

we have raised an enormous amount of liquidity; we have rightsized our organizations; we have simplified our organizations. 

And the question we have now—and I think it is the same question that the Europeans have—is, where is the right balancing spot 

between when enough is enough and when we start to impair doing 

business that we should be doing business? 

Dr. HAYWORTH. Right. 

Mr. GARNETT. And I think that is what we are both struggling 

with. I think that, obviously, some of that had to do with the delay 

that we have seen here and most certainly has a lot to do with the 

delay that we have seen in Europe. 

Dr. HAYWORTH. But presumably, you have to act in an anticipatory way because the cost of retrofitting— 

Mr. GARNETT. Yes. I can’t take the chance of nothing happening, 

nor have we. As I said, we are implementing and adhering to and 

making business decisions every day as if Basel III were with us. 

Dr. HAYWORTH. And you have rightly noted the cost, the opportunity cost, if you will, of overregulating. If you never want to fall 

off a bicycle, don’t get on; you just won’t go anywhere. 

Do you think that we risk—the further we go, do you think we 

risk tipping the balance in a way that is detrimental to our capital 

markets, to our opportunities for growth? 

Mr. GARNETT. I think there has to be a line in the sand somewhere. I am not quite sure where it is. 

Dr. HAYWORTH. But do you think it is somewhere within Basel 

III, Mr. Garnett? Do you think— 

Mr. GARNETT. I think with regard to where at least we as an institution are adhering today to Basel III and the ratios that we 

produce, we believe as in institution we are well-capitalized, in a 

very strong position of liquidity, which is also, most people forget, 

a part of Basel III. 

Dr. HAYWORTH. Right. 

Mr. GARNETT. We have simplified. We stress ourselves six different ways every month. We are complying with the CCAR requirements that put us and several other financial institutions 

through significant stress tests via the Fed. 

And it is my personal opinion, with the amount of capital that 

has been raised as a result of Basel III and other related requirements, that we are at a point now where we really need to stop 

and think, if you would, about how much more we need to go before 

we impair lending to consumers in the United States. 

Dr. HAYWORTH. Right. That is an enormous issue and one, certainly, that I hear about on the community bank level. Because I 

have had very good people come to me and say, I can’t get a loan 

66 

from my bank anymore because the regulators are leaning so heavily on them. 

Madam Chairwoman, thank you. I yield back. 

Chairwoman CAPITO. Thank you. 

Mr. Miller, do you have any questions? 

Mr. MILLER OF NORTH CAROLINA. I think Ms. McCarthy has 

more seniority, but she is being very gracious today. 

Mr. Jarsulic, I am sure you heard my questions earlier to the 

earlier panel about living wills. And I know the answer was about 

the Orderly Liquidation Authority, but the idea of the Orderly Liquidation Authority is to be guided by what is in the living wills. 

You have to know what you are going to be looking for if one of 

the systemically important institutions goes bust and what is going 

to be required. 

Are you satisfied with what New York Fed President Dudley described, I think earlier this week or last week, of the first round 

of living wills being the beginning of an iterative process, where 

now we are learning what the impediments will be? And we certainly know what a difficult time we would have; we have learned 

that. And ultimately, there may be changes to the banks as a result of the living wills. 

Before the reforms of the New Deal, the deposit insurance, the 

prudential regulation, we didn’t have financial crises every few 

generations, we had them every few years. 

Are you satisfied with the pace of the living wills process? 

Mr. JARSULIC. Let me say that I am not familiar with Mr. Dudley’s speech. But I think that, looking at the level of equity that 

banks currently hold, I am not confident that the banks are really 

far away from the fragile state that they were in prior to this crisis. And, therefore, that puts a stronger weight on the ability of 

Federal regulators and Federal agencies to respond should something go wrong with one of these very large banks. 

And I am not at all surprised that it has been very difficult for 

the banks and the regulators to converge on living wills given the 

complexity of the organizations that we are talking about. There 

was a study recently by people at the New York Fed looking at 

very large bank holding companies, and some of them have literally 

thousands of subsidiaries. 

So to construct a plan to quickly and effectively resolve an institution that complex seems on some levels very, very difficult. And, 

therefore, it seems to me that adds impetus to the need to provide 

other safeguards and not to rely on a backstop should something 

go wrong. Therefore, capital requirements, I think, are extraordinarily important. 

Mr. MILLER OF NORTH CAROLINA. I am all for more equity. And, 

obviously, the importance of having an equity cushion, a capital 

cushion if something goes wrong, makes it less likely that there 

would be a catastrophic collapse of a systemically important institution. 

But just today there is an article that the Bank of England— 

their financial policy committee said that the banks may be overstating their capital because they are understating the risks with 

different kinds of assets, not really taking losses on troubled loans. 

67 

Would the same thing be true in the United States? It is pretty 

striking that the market value of the stock of almost all of the biggest banks is well below the book value, which suggests that the 

market doesn’t quite believe their accounting. 

Professor Admati, do you want to— 

Ms. ADMATI. I commented about this in my written testimony, 

because when you ask how well-capitalized they are, the question 

is, what measures do you use for that? What measures of the equity, what measures of the assets, so that you can look at capitalization? 

It is, in fact, the case that market values are very low. And in 

a book by Mike Mayo, an analyst, he estimated in 2011 that there 

are $300 billion in unrecognized losses. Some of what we see in 

terms of mortgage renegotiations, even eminent domain debates 

and all of that, has to do with banks—with the inconvenience of 

recognizing losses. 

Of course, if you use accounting measures to measure capital, 

then you might look better than you actually are, and the market 

knows that. So I am quite concerned about the lower market values 

because those are the ones that are relevant also for raising equity. 

Unfortunately, the banks did lose, and, unfortunately, they are 

weak. 

So I think the Bank of England is right spot-on in challenging 

the banks on giving a correct picture. And even in Europe, when 

they did their special requirements, which were very helpful to the 

banks that complied with them, they made sure that they recognized more losses. 

When you have denial, as we saw in the savings and loans, as 

we saw in Japan and other places, that does not help the economy. 

Banking problems should be recognized early. We have potentially 

some zombie banks. The book claims that Bank of America and Citi 

might be insolvent, so we don’t know. 

Chairwoman CAPITO. The gentlewoman’s time has expired. 

I am going to recognize myself for 5 minutes for questions. I 

want to start with Mr. Loving. 

In your statement and in other statements, it was mentioned, the 

Qualified Mortgage issue, the rule that is still pending. You and I 

talked about this when I visited the bank several months ago. And 

I specifically asked the regulators the question, as did a lot of other 

Members because there is a lot of concern. 

Are you satisfied with the response in terms of that they are actually looking at the interplay between these two issues, very large 

issues, and how they could impact a bank of your size? 

Mr. LOVING. It is certainly encouraging to hear that they are 

looking into it, but it is still concerning if the two would come together at the same time or even separate. 

When you look at the definition of QM or QRM, if it is defined 

too narrowly, it could potentially force many institutions, community banks that provide much of the lending in rural and underserved areas, it could force them out of the mortgage market. And 

if you add to that the additional capital reserves that would be required by Basel III, it could be a big issue. 

68 

I am, as I said, encouraged that they are looking at it. I hope 

we have an answer soon on a definition of the Qualified Mortgage 

and hope it is not too narrow. 

Chairwoman CAPITO. Thank you. 

Mr. Garnett, could I ask you to educate me a little bit—I know 

you have been in risk analysis for a long time for a large institution. And we have heard a lot about risk-based assets and how they 

are going to be assessed. 

But going forward—we can predict today what maybe the risk is 

on a lot of on financial instruments, but you have to have elasticity 

enough to be able to price the risk of the financial instruments of 

the future. And I think, obviously, from 2008, some of the risk was 

not properly assessed by the institutions or the regulators. 

What advice would you have, looking forward—this is a little offtopic—but looking forward—because it is topical in terms of how 

you are going to set these regulations—that we are not pricing the 

risk-based assets today for Basel III but 5 years from now they are 

going to be insignificant because of the change in the marketplace? 

Do you have any thoughts on that? 

Mr. GARNETT. I do. And inherent in any measurement using 

models, most usually look over their shoulder to help them conclude on whatever you are asking the model to conclude. And looking over your shoulder is not always necessarily going to give you 

the clearest path forward, as you said. 

What has been done, and has been done not only by the industry 

but by the regulatory community, has introduced very rigorous 

stress testing, coming up with hypothetical scenarios to test our resolve and to test the loss-absorption capacity in our institution, 

whether that be testing liquidity or testing losses that may be absorbed by our capital or our reserves. 

The CCAR is a perfect example of where I think the industry 

over the last 3 or 4 years has begun to do a lot more forward looking, a lot more hypothetical thinking, rather than simply relying on 

the past, which unfortunately is an inherent weakness with relying 

solely on models. 

And that is one of the reasons, I think, that our regulators are 

not solely relying on Basel, they are not solely relying on recovery 

or resolution plans, they are not solely relying on new liquidity. 

But when you put the stuff together, it makes a pretty powerful 

package. 

Chairwoman CAPITO. Thank you. I think that is an important 

issue to keep before the committee as we move through these next 

several years, because you can’t anticipate—we were never able to 

really anticipate where the weaknesses were. Maybe we weren’t 

looking hard enough or looking in the right places. But you always 

hear profit-makers are always a little step ahead of you, and so we 

know that is the case. 

Mr. Poston, let me ask one last question. You heard the regulators express the fact that they were looking through the thousands of comments. How does that make you feel? Better? More relieved that they are actually taking this issue that has been 

brought to them by regional banks and others seriously? Or do you 

have any comments on anything you heard them say today that 

caused a red flag for you? 

69 

Mr. POSTON. I wouldn’t say anything raised concern relative to 

a red flag. However, there are 2,000 comment letters, there are lots 

of different views with respect to these rules. Certain elements of 

the rules—the feedback from the industry has been remarkably 

consistent. And I am hopeful and encouraged by the fact that they 

have said they are committed to reviewing those comments and 

taking those comments seriously as they finalize these rules. 

Chairwoman CAPITO. Thank you. 

My time is up. I will say the consistency that—we also heard 

that consistently across both the Republican and Democrat side 

here as we raised the concerns. 

Mrs. McCarthy? 

Mrs. MCCARTHY OF NEW YORK. Thank you. And thank you for 

having this important hearing. 

I will have to say, and I will repeat the chairwoman’s words, 

there are many of us on both sides of the aisle who are very concerned about what the rules have been. Because it certainly was 

not our intent for those who had worked on this side of the aisle, 

the Frank side. We left the language that way because many of us 

do not believe that one-size-fits-all. You have insurance companies 

here, you have regional banks here, you have community banks 

here. They all have different models. So we were hoping, in their 

wisdom, they would understand that. 

With that being said, though, I believe both sides of the aisle 

have been working. We will continue, in my opinion, to speak out 

very diligently to come up with a fair ruling. We do not—and this 

is something that Barney Frank said right in the beginning when 

we started working on the Frank bill. And it took us almost a yearand-a -half to do it. We took our time, trying to cover everything. 

Obviously, we couldn’t cover everything. But with that being said, 

I think we did a very good job on that. 

With that being said, I have a curiosity because the bottom line 

is what we are trying to do is protect our constituents. That has 

always been the bottom line for all of us. 

So, Ms. Wilson, with your line of business—because I know that 

in your company you take care of middle-income families. They are 

nurses, they are teachers, they are all along those particular kinds 

of jobs. How would the changing of the rules as they seem to be 

going with the regulators, how is that going to impact your customers, your clients? 

Ms. WILSON. Thank you very much for the question. 

We serve about 31⁄2 million participants, and we protect their retirement savings. And to the extent that these proposed rules and 

the risk-weightings for some of the longer, more diverse asset types 

in America will get a heavier risk-weighting, that might cause us 

to invest less in America for long-term construction projects, for 

long-term bonds for corporate America that are creating jobs. 

And what that does to our participants is it actually potentially 

would reduce the amount that they will get in retirement, which 

to us is really the wrong answer. We have looked at the insurance 

regulatory regime for how much capital an insurance company 

needs, and it has worked very well for decades. And it is based on 

pretty rigorous analysis where the risk exists in the insurance 

products and in the assets we carry. And if we can’t get that match 

70 

between the long assets that we buy and the long promises we are 

making, we could potentially disadvantage our customers. 

Mrs. MCCARTHY OF NEW YORK. Just a very quick, maybe a yesor-no answer: During the really rough years, did any of your clients 

lose their monthly check? 

Ms. WILSON. They did not. In fact, we probably benefited indirectly from the crisis, in that we had more people who were willing 

to trust their money with us. 

Mrs. MCCARTHY OF NEW YORK. Excellent. 

Mr. Loving, when you had given your testimony, you basically 

came up with the banks not being looked at for—you put a price 

tag on it, $50 billion. How did you come to that particular amount 

of money? 

Mr. LOVING. The $50 billion aligns itself with the limit that was 

set in the Dodd-Frank for the systemically important institutions. 

And so that is where that limit came from as a cutoff for those that 

should be exempted from the Basel III. 

Mrs. MCCARTHY OF NEW YORK. Just following up a little bit, if 

the rule goes into effect as the FRB proposed, what do you think 

will be the bottom line, Ms. Wilson, on your company? 

Ms. WILSON. We will have to see what the final rules look like 

before we have a full assessment. Right now, we are doing modeling to see what it would look like under the proposed rules. And 

we are probably going to have to make some changes to our investment philosophy, if you will. 

Mrs. MCCARTHY OF NEW YORK. I would say to all of you that this 

is one of those issues, whether the full committee agreed with 

Dodd-Frank or not, that we are working together again to try to— 

certainly, because we don’t want to stifle the economy. But the bottom line is we want to make sure our constituents are protected. 

It is all of your reputations that are on the line to do the best for 

them. Because if your reputation goes down the tubes, you are not 

going have any clients, and that is the bottom line. 

Thank you for your testimony, and thank you for your patience 

basically the whole day. 

Thank you. I yield back. 

Mr. CANSECO [presiding]. The Chair recognizes Mr. Luetkemeyer 

for 5 minutes. 

Mr. LUETKEMEYER. Thank you, Mr. Chairman. 

I will yield my spot in line to the gentleman from Ohio if I can 

pick back up after him. 

Mr. CANSECO. Certainly. 

Mr. LUETKEMEYER. He has another committee to go to. Thank 

you, sir. 

Mr. CANSECO. Okay. 

Mr. Stivers? 

Mr. STIVERS. Thank you. I appreciate the gentleman from Missouri allowing me to scoot up a little bit. 

I appreciate all the witnesses’ testimony. My first question is for 

Mr. Poston. 

You talk about in your testimony the concern about the Standardized Approach for risk-weighting. And, I was really taken by a 

point you make on page 7 about how some nonperforming loans acVerDate Nov 24 2008 11:52 Apr 26, 2013 Jkt 079691 PO 00000 Frm 00078 Fmt 6633 Sfmt 6633 K:\DOCS\79691.TXT TERRI
71 

tually are seen as less risky than home equity lines of credit and 

other mortgage products. 

Would you like to talk about that a little bit? Because that does 

seem incomprehensible, that a nonperforming loan would be less 

risky than a loan that is performing. 

Mr. POSTON. Yes, I think your question gets to a point that I 

think has been one that many in the banking industry have focused on, and that is the treatment of mortgage loans and the 

treatment of home equity loans. And the risk-weighting with respect to those categories of loans has been made excessively more 

complex than it has been under prior rules and is very punitive, 

in the view of most in the industry. 

So the example that you point out gets to the inappropriateness, 

in our view, of the risk-weightings of mortgage loans and home equity loans and what we believe will have a significant negative impact on our customers in terms of the availability of that type of 

credit as well as the cost of that type of credit. 

Mr. STIVERS. Thanks. 

And with regard to that, sort of a formulaic approach to riskbased weighting, where the regulators assume they know exactly 

what the risk of every potential problem is, seems to me like it is 

very problematic because, in my experience—I have been in the 

Army 30 years, and the generals always want to fight the last war. 

And this appears to me like we are creating a Maginot Line that 

the regulators today believe is impenetrable. And, as we all know, 

in World War II they just found another way, and we don’t always 

judge the right crisis. 

Does anyone else want to talk about the concerns of sort of the 

standardized risk-weighting? I know that in Mr. Loving’s testimony, it was something you addressed. Is there anybody else who 

has concerns about it, the formulaic approach where we pretend to 

know exactly what the risks are in some mathematical formula? 

The professor is shaking her head. Maybe she would like to address something, too. Mr. Loving first, maybe, and then the professor. 

Ms. ADMATI. Oh, sure. 

Mr. LOVING. Yes. When you look at the Standardized Approach 

and the risk weights that are applied, it does create some question 

as to the real estate marketplace and the risk weights that are 

placed on certain real estate loans versus other components, whether it be commercial loans or home equities. They all carry a different level of risk, but I am not sure that a 200 percent risk 

weight is the appropriate level on a balloon mortgage or even a 

home equity. 

Mr. STIVERS. Go ahead, Professor. 

Ms. ADMATI. Yes, it seems like they are fighting the last war in 

a very narrow way. They are not learning the really big lesson, 

which is more what you said, that it is an illusion that we can 

measure these things, that there are a lot of things, that it is sort 

of about unknowns, it is about having an actual buffer. 

Even in the stress testing, by the way, there is a lot of reliance 

on models. 

Mr. STIVERS. Right. 

72 

Ms. ADMATI. How would you predict, and do you know the contagion mechanism, and do you really know what AIG is holding, 

and do you really predict these things? 

So we should be humble about our ability to do this modeling. 

And I am saying this as a theorist in finance. 

Mr. STIVERS. Great. 

Mr. POSTON. If I could just add to that, I think— 

Mr. STIVERS. Sure. 

Mr. POSTON. —the other concern, I think, with the risk weights, 

in our view, is that those risk weights are driven off of qualitative 

factors largely about product structure and not on the elements 

that we believe drove risk and drove losses through the last crisis. 

And those are more things about how the loan is underwritten, 

what the debt-to-income ratios are, what the FICO scores are, what 

the creditworthiness of the borrower is. 

So, in our minds, being more risk-sensitive makes a lot of sense, 

but the rules seem to focus in on the wrong thing. 

Mr. STIVERS. Sure. And to follow up on that, Mr. Poston, do you 

think that capital rules should be tailored to the complexity of the 

institutions that are covered at all or— 

Mr. POSTON. Yes, we would support capital rules that are related 

to the complexity, but I think it is important to recognize that it 

is the complexity of the activities that are going on— 

Mr. STIVERS. Right. 

Mr. POSTON. —that needs to be focused on. So I think focusing 

on the complexity of derivatives activities or capital markets activities, international activities is appropriate. One thing I think that 

concerns me, concerns Fifth Third, concerns some regional banks, 

is that size is sometimes used as the only barometer of risk. 

Mr. STIVERS. The proxy. 

Mr. POSTON. And I think these rules really need to look at the 

underlying activities and make sure that for the same underlying 

activity, irrespective of the size of the bank, it gets the same capital treatment. 

Mr. STIVERS. It is what you do, not how big you are. 

Mr. POSTON. Absolutely. 

Mr. STIVERS. I yield back the nonexistent balance of my time, 

Mr. Chairman. 

Mr. CANSECO. Thank you, sir. 

The Chair now recognizes the gentlelady from New York, Mrs. 

Maloney. 

Mrs. MALONEY. Thank you all for your testimony. We have a lot 

of activity today, and the caucusing on the Floor, and many of us 

could not be here the whole time. I would like to ask Ms. Wilson 

and Mr. Smith, do you believe that the regulators have enough 

flexibility within the current law to structure the Basel rules to 

make distinctions between insurance companies and other financial 

institutions? 

Mr. SMITH. I will take a shot at that first, and Ms. Wilson will 

clean up after me. I think, clearly, if we consider the legislative intent, and as confirmed by Senator Collins in her letter early this 

week, the equivalency is the test, not the same set of rules. And 

so if you apply an equivalency standard, you can actually use the 

insurance-based model and say, what is equal to the capital 

73 

strength that would be applied within the Basel framework to a 

bank, and not necessarily formulaically apply that same set of 

rules. 

And so I believe, yes, there is flexibility within, and clearly legislative intent to deliver that flexibility that Basel III is a floor. It 

was not a formulaic approach. It was an intent to get equivalency 

of capital standards. And there are clearly a lot of strengths in the 

State-based regulatory capital system that could be looked at for 

equivalency to the Basel rules as applied to banks. 

Mrs. MALONEY. Ms. Wilson? 

Ms. WILSON. I would agree. And I think the other important 

thing that the Federal Reserve has talked about is making sure 

that there is a floor and there is absolutely no impediment to making sure that you have this no less than, and the equivalency covered, even if you respect the insurance capital regime that is already in place. 

Mrs. MALONEY. Okay. What changes, Ms. Wilson, could the regulators make that would possibly improve the situation and that will 

recognize the distinct business models of your organization, insurance, and other organizations? And also, Mr. Smith, if you would 

like to comment? 

Ms. WILSON. What we had proposed in our comment letter were 

two different ways that the Federal Reserve could adjust their approach to recognize the fact that insurance companies are already 

well-regulated by State insurance regulators: one is referred to as 

the deduction approach; and the other one is a calibration approach. We think either one is a possibility. 

If I could describe one, it is almost like looking at the two different parts of the organization separately, giving them a blended 

grade, and saying that is good enough. The other one is actually 

kind of doing an equivalency test between metric and sort of U.S. 

standards. So it is not that hard. We just think that it wasn’t really 

considered. 

Mr. SMITH. And I don’t have really anything to add to that. I 

think the way that TIAA–CREF has proposed addressing this is 

very logical in looking at the existing system and adding to that 

and making sure you have a comprehensive view of the organization, but not necessarily forcing it into the same model. 

Mrs. MALONEY. Okay, thank you. 

And, Mr. Jarsulic, we heard testimony in our offices here today 

that the smaller community banks and regional banks, where they 

have said that complying with the Basel formula will mean that 

mortgages will be harder and more expensive to obtain and there 

will be less capital out there. Are you sympathetic to that argument? 

Mr. JARSULIC. I am not sure precisely where they feel the increased cost is coming from. If the increased cost is coming from— 

Mrs. MALONEY. They are talking about the 20 percent downpayment that a lot of people don’t have. If you are a low- or moderateincome worker, you don’t have a nest egg to put it down, and it 

might limit their ability to get credit and to get mortgages and to 

move forward. 

Mr. JARSULIC. The claim seems to be that if we have to have 

greater equity backing the lending that we are doing, that is someVerDate Nov 24 2008 11:52 Apr 26, 2013 Jkt 079691 PO 00000 Frm 00081 Fmt 6633 Sfmt 6633 K:\DOCS\79691.TXT TERRI
74 

how going to increase the cost of finance to us. And I think the 

data don’t really support the notion that lower levels of leverage 

are correlated with higher costs. If you look at the historical data— 

there are some cited in my testimony—there does not appear to be 

a correlation between leverage levels and cost of finance. It doesn’t 

seem to translate. 

So while these banks may have other issues with some of the 

rules for mortgage lending under Basel III, it is not clear to me 

that there is going to be an increased cost of finance. 

Mrs. MALONEY. I would like to see if Professor Admati and Mr. 

Loving and Mr. Poston would respond, but I also want to ask for 

comment on an article I was reading last night that said that Basel 

II had no capital requirements compared to Basel III. And then the 

swing from that, Basel II never went into effect, but that was the 

article that I was saying, that there was a tremendous swing. 

And if anyone would like to comment also on community and regional banks. Of course, they are going to be regulated by DoddFrank, but should they also be required to go into Basel III even 

though they are not doing any international commerce at all? They 

are saying that it is going to really hurt them, and I would like to 

hear the panel’s response to that. 

Mr. LOVING. I will comment on that as it relates to community 

banks and being applied to Basel III. As I have said in my testimony, many of the provisions are going to create hindrances, in 

some cases, exit of the institutions from the mortgage market. 

As was mentioned earlier, the possibility of QM and QRM coming 

into existence at the same time, although in itself they created a 

problem in themselves, if they come together, it will create real 

problems, and increase cost in trying to determine if it is a fully 

docked loan or not a full doc loan, and whether it needs to be a 

category one loan, or a category two loan, and simply the cost involved to determine whether it is a category one or a category two 

loan. 

In our case, looking at previous underwriting, because we know 

our borrower, we would have to go back on a file-by-file review to 

determine if it meets the requirements of a fully documented loan, 

simply because we may not have required a verification of employment. 

In our area, we know where they work, we know where they live, 

and we know what they make. And so that creates a significant 

problem for us and many community banks across the country. 

Ms. ADMATI. I would like to comment on that. When you say 

Basel III, there are really two things there, there are the levels and 

there are the risk weights. The levels, I concur with Mr. Jarsulic’s 

comments. On the levels of equity, there is no problem there except 

for transition. We want the levels to be higher so the downside is 

where the upside is. So there is just a question of being operating 

at the safe level, and not compare it to speed limit or something. 

On the risk weights, there could be huge distortions. So I agree 

with the comments that this notion of complicating the matters 

and starting to fine-tune, exactly changing their incentives to do 

something versus another in one particular way, and then having 

the risk go some other places, what the regulations think are safer, 

75 

but are actually not safer, or becomes unsafe, that is not a good 

path. 

So I am in favor and many academics are in favor of very high, 

and cruder, simpler kinds of requirements. But we especially want 

the markets to work. We want the markets to guide investments 

and funding decisions. 

Mr. CANSECO. The gentlelady’s time has expired. 

And the Chair now recognizes the gentleman from Missouri, Mr. 

Luetkemeyer. 

Mr. LUETKEMEYER. Thank you, Mr. Chairman. 

I just want to talk with Mr. Smith for a second with regard to— 

Mr. Miller, back here behind me in the first panel, were you listening to his discussion? 

Mr. SMITH. Yes. 

Mr. LUETKEMEYER. He made some really good points with regard 

to the assessment of your securities that you invest in to offset the 

term of the investments that you make or the policies that you 

write. 

Mr. SMITH. Right. 

Mr. LUETKEMEYER. Can you give me some for instances here of 

the direct effect it would have on your business with regard to if 

they downgrade their securities so that you have to put additional 

securities in there, or you have to put more additional capital in 

there, how would you offset this situation to make sure it didn’t impact or how does it impact, I guess, your portfolio of— 

Mr. SMITH. I appreciate the question. I think we would ground 

the answer to that question in the fact that we are a very well-capitalized organization, and under any of these standards we show up 

as a well-capitalized organization. Relative to our business model, 

frankly, we wouldn’t change, because for us to change the business 

model in response to the regulatory scheme would be a shame. And 

it would be inappropriately matching the assets to the liabilities. 

If you forced the matching to be shorter term, so if you took the 

life insurance industry and put it in shorter-term duration assets, 

you effectively would be driving down the yields, or the crediting 

rates associated with the policies, and you would be hurting the 

policyholders who purchased it. The longer-term view with quality 

bonds is actually a very effective way to fund those long-term liabilities. 

Mr. LUETKEMEYER. My question is, if the regulators come in and 

say that the quality of your bonds is not as good as you think it 

is and they start arguing with you about that, how does that impact your cost for the products that you have or are you going to 

have to go out and purchase different securities to match off or how 

would you solve the problem? 

Mr. SMITH. The costs would increase if we had to move in that 

direction. Frankly, we would be faced with a decision as to whether 

we would stay in the banking business, which many of our competitors have made a decision to exit the business. It is a shame when 

the regulatory framework puts upon the industry a change that actually causes people to say, it is just not worth it because I can’t 

conform. 

And so, we are really faced with that decision at the same time 

we would face the funding decision. Given 98 percent of our revVerDate Nov 24 2008 11:52 Apr 26, 2013 Jkt 079691 PO 00000 Frm 00083 Fmt 6633 Sfmt 6633 K:\DOCS\79691.TXT TERRI
76 

enue is from insurance, it would really call into question the banking. And we feel that having a bank is actually good for the United 

States, so it is a positive thing. 

Mr. LUETKEMEYER. I am asking with regard to the insurance portion of your business. That is where I am going with my question. 

Mr. SMITH. It would raise the cost. It would raise the cost and 

it would make some products difficult to offer. 

Mr. LUETKEMEYER. Okay, thank you very much. 

Mr. Loving, with regard to all the community banks, they hold 

their securities to maturity most of the time. Very few of them 

trade their securities. So one of the things with Basel III here is 

that they want to look at every single security, and then making 

you charge off or add to your capital account the unrealized loss 

or gain from what you are doing here. And it is really difficult for 

a lot of the smaller institutions because obviously they hold them 

to maturity and it is not a big deal to them. 

What effect do you think this would have on the smaller institutions with regard to their purchase of local bonds? In other words, 

a lot of your community banks will buy the local hospital bonds, 

they will buy the local sewer bonds, the local fire department bonds 

to help their own communities be able to build or help them to 

exist, provide the services for the community. How would that affect their ability to support the community with those types of investments? 

Mr. LOVING. I believe that those particular investments will be 

looked at and will have to be looked at under additional requirements as to the value and the creditworthiness of that particular 

investment. There are some regulations coming down that guide us 

on how we value and underwrite those credits. 

So I think there will be an impact. I think it will be a negative 

impact on the ability to hold and to buy those and there may be 

an impact on the value of that institution, or of that obligation that 

you are— 

Mr. LUETKEMEYER. Do you think that you would probably cut 

back on the amount that you would invest, instead of 1 percent of 

your investments in local bond issues, maybe half a percent or 

something like that? 

Mr. LOVING. Each institution would probably evaluate it differently and specifically, but, yes, I think in general, there would 

be a deduction or a decrease in the amount purchased and held. 

Mr. LUETKEMEYER. Mr. Poston, Mr. Jarsulic made a comment 

with regard to the increased cost of mortgages, that he didn’t think 

there was an increased cost. Would you like to make a comment 

about that? 

Mr. POSTON. Yes, thank you. I think Mr. Loving addressed earlier some of the increased costs with respect to mortgage lending 

with respect the to the administrative costs, and I would certainly 

agree with those comments. The other thing I would point out is 

that perhaps in some of the discussion here of those who think that 

there is no significant increase in costs, they are not considering 

the cost of capital. 

To the extent that a tremendous amount of additional capital is 

required to be held by that loan, that loan is in fact funded not by 

customer deposits, or not by borrowings which carry a much lower 

77 

rate, particularly in this rate environment, that cost may be half 

a percent, three-quarters of a percent. If you have to fund greater 

portions of that loan with equity, the cost of equity is 12 or 13 percent, so it is multiples of 20 times the cost in terms of the funding 

costs of that loan if it is funded with equity or capital, rather than 

borrowings or deposits. 

Mr. LUETKEMEYER. Okay, thank you. 

I see my time is up. Thank you, Mr. Chairman. 

Mr. CANSECO. Thank you. 

The Chair now recognizes the gentleman from California, Mr. 

Sherman, for 5 minutes. 

Mr. SHERMAN. Thank you, Mr. Chairman. 

Mr. Garnett, you might be best for this. Basel envisions marking 

to market those securities identified as available for sale. And I 

could imagine a bank having to decide whether a particular bond 

that had declined in value is available for sale. Does management 

pretty much get to pick which ones are available for sale and which 

are not? 

Mr. GARNETT. No, they do not. 

Mr. SHERMAN. What is the definition of a security available for 

sale? 

Mr. GARNETT. It is a security that you want to have the ability 

to sell for liquidity purposes. It is not an asset you are going to 

hold to maturity, and it is not a trading account. 

Mr. SHERMAN. Okay, but I am a local bank. I buy some water 

bonds, I buy some sewer bonds, I buy some school bonds. 

Mr. GARNETT. Right. 

Mr. SHERMAN. And every year, I have to decide what is my intention. Do I want to hold these to maturity or not? 

Mr. GARNETT. At the time you purchase that security, you must 

determine. 

Mr. SHERMAN. And that is permanent for the entire—so if I 

change— 

Mr. GARNETT. That is where you start. 

Ms. SHERMAN. That is where you start. 

Mr. GARNETT. Right now. If you want to change and move a security that is held for sale into a held to maturity, it must be done 

at the current market value. So you can’t simply ignore any gain 

or loss in that transfer. 

Once you move it into held to maturity, it is there forever. 

Mr. SHERMAN. So there is no way to, if a security has declined 

and you designate it as available for sale when you purchase it, 

there is no way to delay the recognition of the unrealized loss because you either keep it as available for sale and you would have 

to recognize that, or you redesignate it and that act causes the recognition. 

Mr. GARNETT. Recognizing the loss, yes, sir. 

Mr. SHERMAN. And if it was a security that you knew was going 

to go further down in the future, if you really knew that, you would 

sell it now? 

Mr. GARNETT. That is correct. 

Mr. SHERMAN. Okay. So really do have a mark-to-market on anything that wasn’t designated as hold. What about the other direction, though? You buy a security. It goes up in value. And you had 

78 

it designated hold to maturity and now you want to make it available for sale. 

Mr. GARNETT. You cannot do that, sir. Hold to maturity, you are 

stuck. 

Mr. SHERMAN. Hold for maturity, even if you have called your 

broker and he is a minute before selling it, it is still not available 

for sale. 

Mr. GARNETT. You might be able to sell it just before you go and 

visit the FDIC before they put you into resolution. 

Mr. SHERMAN. Okay. On the other hand, if you actually sell an 

asset that was designed to be held for maturity, that is a recognition event that increases your capital if you sell at a profit. 

Mr. GARNETT. That gain would already be recognized in your 

capital because you are already marking it to market. 

Mr. SHERMAN. You are marking to market the hold to maturity 

securities? 

Mr. GARNETT. No, I thought you said the— 

Mr. SHERMAN. Okay, if you buy something and you are going to 

hold it to maturity, you put it in that account. 

Mr. GARNETT. Yes, sir. 

Mr. SHERMAN. It goes up in value a couple million bucks and you 

sell it. Have you increased your capital by a couple million bucks? 

Mr. GARNETT. You cannot go to held to maturity and sell things 

prior to maturity. 

Mr. SHERMAN. Wait a minute. I buy a 30-year bond. 

Mr. GARNETT. Yes. 

Mr. SHERMAN. I intend to hold it to maturity. For business reasons, a new business plan, after holding it for 5 years I want to 

sell it, and the banking regulators won’t let me sell the bond? 

Mr. GARNETT. In what account did you put it? 

Mr. SHERMAN. The hold to maturity when I bought it but I 

changed my mind. 

Mr. GARRETT. You cannot change your mind, sir. 

Mr. SHERMAN. That is a hell of a straitjacket. 

Mr. GARNETT. We can’t blame that on the regulators. That is a 

very clear accounting regulation. 

Mr. SHERMAN. Accountants, and I am one, account for what you 

do. We don’t tell you, you can’t do it. I have never heard of a business being told it can’t sell an asset. 

Mr. Poston, do you agree with that, that under existing bank regulations, if you buy something intending to hold it to maturity and 

after several years you decide it is in the best interest of the bank 

to sell it, you need liquidity, you are not allowed to sell it? 

Mr. POSTON. No, I would disagree with that. I think you are allowed to sell it. The challenge and the problem comes in as to what 

are the consequences of you selling that. And the consequences are 

all other securities that you are classifying as held to maturity no 

longer qualify for that classification. So it is viewed as a privilege, 

that if you are going to classify securities as held to maturity— 

Mr. SHERMAN. Wow. Let me move on to another question. Ms. 

Wilson, if the rule goes into effect as the Federal Reserve has proposed it, what is going to be the impact on your organization, 

TIAA–CREF? 

79 

Ms. WILSON. We would have to seriously consider whether we 

would make changes to our investment policy because there is a 

likelihood that longer-dated securities would be treated less favorably. One of the challenges with long-dated securities is the pricing 

varies substantially, so there is more volatility in those assets. And 

even though we intend to hold them for the duration, the volatility 

in the capital levels would be uncomfortable for us. 

Mr. SHERMAN. As I pointed out with the first panel, an insurance 

company tends to have long-term liabilities. As long as my doctor 

is right about me, that is true. And you would try to match that 

with long-term assets. I believe, speaking of long-term, that my— 

oh, no my time has not expired. 

Mr. CANSECO. It has, Mr. Sherman. 

Mr. SHERMAN. The clock is inaccurate? 

Mr. CANSECO. No, you are beyond— 

Mr. SHERMAN. Oh. 

Mr. CANSECO. That is all right. It is all right. 

Mr. SHERMAN. I yield back to the Chair. 

Mr. CANSECO. The gentleman’s time has expired. 

And the Chair will yield himself 5 minutes for some very brief 

questioning. 

Ms. Wilson, if the proposed rule goes into effect as it stands right 

now, has your company considered de-banking? 

Ms. WILSON. We have certainly looked at what other companies 

have done with respect to their depository institutions. We are 

aware that there are some other very large companies that have 

decided to get out of the banking business. We have some significant conversations ongoing with our board and within the management team. And we really would like to stay in the banking business because we think it is good for America and good for our customers, but if the rules don’t change at all we will continue to discuss that. 

Mr. CANSECO. And there is the balance of your shareholders, too. 

Ms. WILSON. We don’t really have shareholders. We are a not-forprofit, so this is all for benefit of our participants. 

Mr. CANSECO. All right. If a company such as TIAA–CREF was 

forced to de-bank, where do you think its clients would end up and 

where would they take their money? 

Ms. WILSON. Right now, they have a limited number of choices. 

In large banks that provide really diverse services. They obviously 

can take advantage of services from community banks. But when 

we are talking about some of our clients’ needs, they include things 

like trust planning and stuff of that nature that we do now, and 

we would hate to have to give that up. 

Mr. CANSECO. Thank you. 

Professor Admati, do you have concerns that the overly complex 

Basel III requirements could encourage arbitrage amongst some of 

the more sophisticated banking organizations? 

Ms. ADMATI. Arbitrage is always a problem. So arbitrage created 

the shadow banking system, and there are all kinds of ways that 

people always try to get around regulation. That is true for tax 

codes as well. 

So the key is to kind of keep track of where the risk is going, 

how the risk is being spread. Industry can do well by moving the 

80 

risk to good places, spreading it efficiently, but it can accumulate 

in various places and some of the regulation can do that. But the 

key is really to not allow people to lay risks that they take on others. So that should be the objective, and that stability as well. 

I just have to make one statement, which is that for more than 

50 years, we know that the statement was just made that because 

equity has a higher required return than debt, that funding with 

equity is more expensive. We know that is false. I would teach that 

in every basic course. The risk has to go somewhere, just because 

some security pays more than others. By this logic, Apple is being 

crazy, or Wal-Mart, or all the other companies that fund with so 

much equity even though they are not required to. So this reasoning is just false. Somehow in banking they don’t accept that reality, but the downside risk has to be borne by somebody. 

Mr. CANSECO. Thank you for that comment. 

Now, do you believe that the complex models included in the proposed rule, going back to the Basel III rule, have any kind of predictive model, or would it be more effective to rely on simpler measures such as leverage ratio? 

Ms. ADMATI. I believe the models are very limited and I believe 

people trust them too much. I think that is the big conclusion, not 

that we need to tweak it that way and the other way, but that the 

approach is flawed. 

So I think that, again, we have to watch the system, but we have 

to kind of step back and see what we are trying to do, which is 

maintain a stable system that doesn’t run into too much trouble. 

Just like speed limits. And so we don’t in speed limits go to the 

trucking companies and ask them for fancy models about, and then 

worry about whether they took account of the fog or the kid jumping in front of the truck. We have speed limits that try to maintain 

safe limits for trucks going through neighborhoods, and that is how 

we should view leverage. It is like speed. 

Leverage creates unnecessary risk. Risk is good, but leverage 

risk is unnecessary. And that is what we have to reduce. So we 

should keep our eyes on the ball, basically, and I think the details 

of the accounting and the risk weights and the models, and that 

is just letting you forget what it is about. 

Mr. CANSECO. Thank you. 

Mr. Poston, could you tell us how you think the capital standards 

included in the proposed rule will affect your customers, particularly small businesses? 

Mr. POSTON. I think the provision that will most significantly impact small businesses is one that we have talked about several 

times today already. And that is the way mortgage lending and 

home equity lending is treated by the Standardized Approach. 

Higher risk weights, particularly with respect to home equity lending, will be particularly difficult on small businesses, the owners of 

which often rely on the equity in their homes to provide the ability 

to borrow for the seed capital to start those businesses and to grow 

those businesses. 

So I think with respect to our ability to help small business owners, that particular provision would be particularly difficult. 

81 

Mr. CANSECO. Would the proposed rule ultimately make the financial system riskier by shifting activity to less regulated corners 

of the market like Dr. Admati mentioned? 

Mr. POSTON. Yes. I think in particular to the extent that rules 

start to be written that apply differently to different organizations, 

whether that is amongst different sized banks, or differences between non-banks and banks, the credit will flow to those areas 

where it is least regulated and requires the least capital. And that 

creates difficulties in terms of differential rules because then you 

start to create risk concentrations perhaps in places where they 

shouldn’t be, and the flow of capital is suboptimal for the economy 

as a whole. 

Mr. CANSECO. Thank you, Mr. Poston. 

My time has expired, but I see that—Professor Admati, did I call 

you doctor out of turn? 

Ms. ADMATI. You can call me Anat. 

Mr. CANSECO. Okay. You wanted to say something. 

Ms. ADMATI. I do want to say something because I want to make 

sure to not imply that the risk of somebody trying to evade regulation is a reason not to regulate. For robbers going into dark alleys, 

we don’t tell the police not to go to the dark alleys. 

Mr. CANSECO. No different. The speed limit being— 

Ms. ADMATI. Exactly. So we need the police to go to wherever 

they are going to drive fast. And so therefore, the shadow banking 

system just presents an enforcement problem. But any regulation 

needs enforcement. So just because we would try to evade it does 

not mean we shouldn’t try to regulate it. That is sort of an upsidedown reason not to regulate, to say somebody will evade it, because 

then we are lost. Then, it is too bad. 

Mr. CANSECO. Thank you. 

The Chair now recognizes the gentleman from Michigan, Mr. 

Huizenga. 

Mr. HUIZENGA. Thank you, Mr. Chairman. I appreciate that. 

And once again here in Congress, we are trying to defy physics. 

I am supposed to be in another hearing upstairs as well. So my 

apologies for coming in a little late, and I will be leaving here. But 

I do have a couple of questions. And I appreciated the chairman’s 

questioning. That is something I am quite concerned about as well. 

But I had a question for Mr. Poston from Fifth Third here, a little bit about underwriting standards and loan underwriting standards, and I am just curious how that standardized approach will 

impact your underwriting if finalized? 

Mr. POSTON. I think our underwriting standards are primarily 

designed for us to control and manage our risk. So, in a certain 

sense, those underwriting standards will continue because that is 

the way we manage risk. 

The difficulty, I think, will be that we are now creating a standardized approach which has a totally different view of risk and will 

greatly complicate the underwriting process because not only are 

we trying to look at the things that we truly believe drive risk, we 

are also looking at measuring, trying to capture, create systems to 

capture and track other factors and metrics that we don’t believe 

drive the risk solely for purposes of compliance with these— 

82 

Mr. HUIZENGA. So are you saying that risk on the East Coast 

versus perceived risk on the West Coast versus perceived risk in 

Cincinnati, or Grand Rapids, Michigan, may be different things? 

Mr. POSTON. Absolutely. 

Mr. HUIZENGA. Okay. I think that is part of the problem with 

this, is we may be trying to pound square pegs in round holes with 

some of this. Another quick question I have for you is, and I am 

trying to make sure I word this properly, but I think you have seen 

on both sides and from the earlier panel a lot of concern for the 

small community-based banks and the bipartisan concern there. 

I think that most of the quite large banks are either going to be 

able to hire the compliance or be able to go in and work with regulators in a way differently than a Fifth Third-sized bank, whether 

it is PNC or Huntington or a number of those types of mid-sized 

regional banks. 

And I am curious if you would comment a little bit on whether 

you are concerned that the proposed capital standards, whether 

they could impact with competitive balance between you as midsized banks and most banks really on either side of you. Is it possible that you could actually be at a competitive disadvantage? 

Mr. POSTON. Yes, we could envision a situation where we are at 

a competitive disadvantage. As you mentioned, regional banks are 

kind of caught in between the truly large banks which often do 

have differentiated risks. They are pursuing activities, such as 

trading activities derivatives, international activities, et cetera, 

that are riskier and perhaps require more complex rules. 

Our activities are largely traditional activities which are very 

similar to community banks and smaller banks. The regional banks 

are not often thought of as community banks because of their size, 

but the activities in which we engage are very similar, if not the 

same, as most community banks, carry the same risk as community banks. 

And to the extent that we end up with rules that differentiate us because we happen to be above $50 billion, or some other 

threshold, it can create competitive balances which we are very 

concerned about, both for us as well as for our customers because 

it lessens our ability to provide to our customers those credit services that they need. 

Mr. HUIZENGA. In less than about 30 seconds, does anybody else 

have anything that they want to add on that? 

Professor? 

Ms. ADMATI. Just one sentence: I am not concerned with equity 

levels. I think they can be way, way, way higher. And people misunderstand that there is really no cost to the economy for that. 

The risk measurements are problematic, and I think there we 

need to sort of try to figure out how to apply them to different institutions. The insurance companies definitely—I haven’t commented on that at all—but they do seem to have a different model. 

If you blend them, then it is not clear that everybody should do everything. So this is kind of my other comment. 

Companies in the rest of the economy, we don’t insist that all of 

them always exist. Somebody buying distressed community banks 

actually told me in private equity that he thinks there are too 

many of them, so maybe that is the case. I am sorry to have to say 

83 

that, but we do not support the existence of every single company. 

If a company has value to generate, it should be able to find funding for itself in the market. If it can’t, then there might be a question about it. 

Mr. HUIZENGA. Mr. Chairman, with your indulgence, I know I 

am over my time, but I am just curious if we could have the professor clarify a little bit on that. 

Mr. CANSECO. Go ahead. 

Mr. HUIZENGA. Thank you. 

So you do or do not believe that maybe the smaller community 

banks may operate differently than a mid-sized bank versus the 

truly large banks and whether that is okay or not? It sounded to 

me like you were saying that we need to apply the same standards 

to all of them. 

Ms. ADMATI. No, no, that is not what I was saying. The thing 

about the big banks is their ability to scale their risks to the extent 

that they do. For example, derivative trading. This is a huge concern. This is a way to hide a lot of risks, and to take a lot of risks 

and scale them up. You can take a little tiny bit of return, and 

scale it all up. 

And so, the size is just really scary for the largest banks. So 

those are kind of in a whole category of themselves, and once they 

do a lot of trading and especially the ones on derivatives, there are 

three such banks in the United States, and we are talking trillions 

of dollars of exposure. 

To the extent that the bank does traditional banking activities, 

you can sort of wrap your hands around that possibly a little bit 

better. Do they have skin in the game on their loans? Do they hold 

them? So debt can matter. I am not sure where the lines are drawn 

exactly in terms of how, it has already came up here, how you define a community bank, what does that actually mean. So we do 

have to look at the risk characteristic or nature of what they do. 

But in principle, I think the regulation should aim not to interfere as much with what people do, but to make them be making 

their decisions in light of the risk of the investments and their appropriate cost of funding for the investment that is borne by investors. 

Mr. HUIZENGA. Thank you, Mr. Chairman. 

Mr. CANSECO. Thank you. 

And on behalf of Chairwoman Capito, I want to thank all of the 

members of the panel for coming here and for your candor. 

The Chair notes that some Members may have additional questions for this panel, which they may wish to submit in writing. 

Without objection, the hearing record will remain open for 30 days 

for Members to submit written questions to these witnesses and to 

place their responses in the record. 

This hearing is now adjourned. 

[Whereupon, at 2:43 p.m., the hearing was adjourned.] 

(85) 

A P P E N D I X 

November 29, 2012 

86 


79691.001

Insurance and Housing Subcommittee and Financial Institutions 

Subcommittee Joint Hearing: 

"Examining the Impact of the Proposed Rules to Implement Basel III 

Capital Standards" 

Representative Gary Miller's Opening Statement 

November 29, 2012 

Thank you Chairwoman Biggert and Chairwoman Capito for holding this important 

hearing today to examine the Fed's proposed regulations to implement Basel III capital 

standards and Section 171 of the Dodd-Frank Act, the Collins Amendment. 

There is no question that robust capital standards, when properly applied, will help 

protect our economy. But, we must proceed with caution - such standards can actually 

be detrimental to our economy if not properly applied. 

Capital standards need to be set appropriately so that they can ensure the safety and 

soundness of financial institutions, without curtailing the creation and allocation of 

credit that our economy needs. 

There is no question that the regulations we are here to discuss today will have a 

significant effect on stability in the U.S. and global financial system, the availability of 

credit to fuel economic growth, and the ability of small banks to serve their 

communities. 

It is absolutely critical to our economy and the financial markets that the final 

regulations are appropriately designed to promote financial stability and economic 

prosperity. To achieve these objectives, capital regulations must be carefully crafted so 

as not to weaken business models or financial prudence. 

The regulations need to make sense for the business models of the industries to which 

they apply. Not all companies have the same business model and risk profile so it is not 

workable to have one uniform capital standards regulation to apply across the whole 

spectrum of financial services companies. 

For example, I am very concerned about the proposed rules' treatment of insurance 

companies that own a depository institution. The bank-centric, "one size fits all" 

approach of the proposed rules is inconsistent with safe supervision of insurance 

companies. The proposed rules could actually harm the solvency of an insurance 

company, which is exactly the opposite of what Congress intended. 

Earlier this year, Chairman Bernanke acknowledged before this Committee that 

appropriate capital standards regulations should take into account the different 

composition of assets and liabilities of insurance companies. 
87 


79691.002

Just this week, Senator Collins, the author of the language in the Dodd-Frank Act, sent a 

letter to the Fed, FDIC, and Treasury stating that "it was not Congress' intent that 

federal regulators supplant prudential state-based insurance regulation with a bankcentric capital regime." 

I am deeply concerned that the proposed rules do not take into account the different 

business model and risk profile of insurance companies. The proposed rules also do not 

take into account the state regulatory standards for insurance companies that emphasize 

long-term solvency. 

Crafting the Basel III rules is not an easy task for regulators, but we must make sure the 

regulations are appropriate to the business models of the institutions and do not hinder 

the proper allocation of capital. Getting the capital standards wrong would have a 

devastating effect on our economy and we must do what is necessary to avoid such an 

outcome. 
88 


79691.003

"Examining the Impact of the Proposed Rules to 

Implement Basel III Capital Standards" 

Testimony for hearing of 

Subcommittee on Financial Institution and 

Consumer Credit and Subcommittee on Insurance, Housing, and Community Opportunity 

November 29, 2012 

by Anat R. Admati 

George G.C. Parker Professor of Finance and Economics, 

Graduate School of Business, Stanford University 

I appreciate the opportunity to testify about the important topic of capital regulation. I 

have spent much time in the last three years studying and writing on the relevant issues. I have 

also submitted with others two separate comments related to the implementation of Sections 165 

and 166 of Dodd-Frank Act in spring 2012, one of which is attached to this document as an 

appendix. The views I will express are shared by many academics; they are briefly summarized 

in a letter signed by twenty academics, the text of which is also attached. 

Basel III is an international agreement, but it is specified as a minimum requirement. Any 

nation can go beyond the minimum. As you will hear, in my view and that of my colleagues, 

Basel III is insufficient to protect the public from risks in the financial system. The claim that we 

cannot go beyond Basel and design our own regulation because this might disadvantage our 

banks in global competition is invalid. I attach a short piece on this issue. I 

In my assessment, the banking system in the US is still weak and fragile, even if it is in 

better shape than the banking system in Europe. 

I My academic writings on the topic, as well as policy papers, presentations, opinion pieces and letters are 

available on this website http://www.gsb.stanford.edu/news/research/admati.etal.html. I have recently 

completed writing a book entitled The Bankers' New Clothes: What's Wrong with Banking and What to 

Do about It, coauthored with Martin Hellwig (forthcoming in early 2013), which explains many of the 

issues, advocates for much higher equity requirements capital regulation, and explains the flaws in past 

and proposed capital regulation. For more details. see http://bankersnewc!othes.com!. 
89 


79691.004

How well capitalized are US financial institutions? 

After posing this important question, the committee's letter proceeded to ask how 

financial institutions' "capital reserves" compare to the years prior to the financial crisis of2007-

2008.2 The blending of the terms "capital" and "reserves" calls for an important clarification, 

because it points to a pervasive confusion that muddles the debate on capital regulation. 

The term "reserves" generally refers to cash or, for banks, deposits with the central bank. 

Reserves are like is a "rainy day fund" that can be accessed immediately if necessary. One could 

say that banks, or other firms, "hold," or "sets aside" an amount or a fraction of their assets as 

reserves, for example to respond to natural fluctuations in depositors' demands. If reserves do 

not earn any interest, holding them is costly. Since interest rates are very low, banks can choose 

to hold significant reserves. Obviously, money on reserve is not used for making loans. 

Importantly, except at very high levels, reserves do not address the most critical issue related to 

financial stability, which is whether banks can absorb losses on their investments without 

becoming distressed. That's where capital comes in. 

In banking, the term "capital" refers essentially to funding that is obtained not by 

borrowing. Elsewhere, unborrowed funding is called equity, and the word "capital" is not used in 

this way. When banks are said "hold capital" or "set aside capital," or indeed when the term 

"capital reserves" is used, the impression is created that capital and reserves are the same. But 

this is false. We do not say, for example, that Apple "holds 100% capital." Apple's equity is not 

sitting idle in reserves, and it is not actually "held" by Apple. Rather, Apple's shareholders hold 

Apple stock and Apple invests and generates profits for its shareholders. The same is truc for 

bank equity or capital. Shareholders hold bank shares, banks also borrow from depositors and 

others and their shareholders are entitled to profits as long as debts are paid. Banks do not 

actually "hold" their capital. 

Capital is analogous to a down payment when buying the house, which later becomes the 

homeowner's equity. A homeowner's equity is not sitting idle in reserve; it is invested in the 

house. Similarly, the banks' capital is put into loans and investments. Having more capital does 

not prevent banks from making loans 

2 I would extend the crisis into 2009, since banks still requested support well into 2009. 

2 
90 


79691.005

Are banks well capitalized? In my view, OS financial institutions are very poorly 

capitalized. They might be in better shape relativc to many European banks, but this statement 

does not speak to where the banks should be and can bc. 

In answering this question one important issue, which indeed the regulation struggles 

with, is how we measure the capital and relative to what it should be viewed. Capital regulation 

is gcnerally based on accounting measures, but these are not always good indicators of financial 

health. Balance sheets are created in this country according to so-called Generally Accepted 

Accounting Principles or GAAP. Companies report a "book value" for thcir assets and liabilities 

or debts, and shareholder equity is the difference between them. 

Because accounting rules often use historical values and allow significant discretion, 

there is frequently a discrepancy, at times substantial, between the book value of equity and its 

market value. Market values reflect how much investors would pay for the shares, which in turn 

is based on the views investors have about the strength of the company. The market value is 

often significantly above the book value for healthy non-financial companies. For example, 

October 31, 2012, the book value of Wal-Mart cquity was about $73 billion, whereas the total 

market value of its shares was almost $253 billion, higher than the total book value of the 

company's assets. Whereas Wal-Mart has over $40 billion in long-term debt, it can obviously 

absorb significant losses without becoming distressed. 

Banks' market values are currently low relative to their book values. For example, 

JPMorgan Chase reported almost $200 billion in shareholder equity on September 30,2012, but 

the value of all its shares was only about $ I 54 billion at that time. Its total assets were reported at 

$2.32 billion. (It would be even larger if it was not allowed to net out about $1.8 trillion in 

derivatives, as GAAP allows but accounting standards in Europe do not.) Bank of America 

reported over $238 billion in shareholder equity, but thc market value of all its shares at that time 

was barely over $95 billion, significantly less than a half of the book value.3 The total assets of 

3 An important issue is how accounting standards treat derivatives and what they allow to be left "off 

balance sheet." With respect to derivatives, there is a controversy over whether to allow "netting" of 

derivatives. The International Financial Reporting Standard that is used in Europe does not allow as much 

netting as is allowed in the US. The impact is dramatic for the banks involved with derivative trading, 

such as JPMorgan Chase, Citigroup and Bank of America, increasing their assets and liabilities by more 

than $1.5 trillinn in the case of JPMorgan Chase. See lSDA (International Swaps and Derivatives 

Association) "Netting and Offsetting: Reporting Derivatives under GAAP and under IFRS." 

http://www2.isda.orgifunctional-areas/accounting-and-taxlgaap-us/. 

3 
91 


79691.006

the bank were reported as $2.26 trillion. and would again be much larger by international 

accounting standards. 

Banks were considered to be in good shape before the crisis. Even Bear Stearns was 

considered strong months before it collapsed. As it turned out, an enormous amount of risk built 

up in the system. Investors and regulators did not realize it or did not want to recognize it. The 

consequences were disastrous. In the crisis, market values plunged, credit froze, and the 

government and Fed intervened massively to support the banks and the system. Yet, throughout 

the crisis, banks' accounting-based capital ratios did not change very much. You would not know 

there was a crisis looking at them. The market values told a different story, being high prior to 

the crisis and then plunging. 

The low valuations of banks reflect the simple fact that banks lost a lot of money on 

mortgages and other investments, and they face a lot more losses, as well as various legal costs. 

Investors know it but the balance sheets do not reveal the full situation, instead painting a rosier 

picture. Mike Mayo, a bank analyst, estimated in 20 II that there are about $300 billion in losses 

that are not recognized on the balance sheets ofthe banks because accounting rules have so much 

discretion. 

The low valuation of Bank of America raises serious doubts about the health of the bank. 

A recent book called Zombie Banks by Yalman Onaran claimed that both Citigroup and Bank of 

America are insolvent, along with banks in Spain, Germany, Ireland and elsewhere. This means 

that if one actually were to recognize all their losses, their equity would be wiped out. Why do 

they still survive? Because there are ways in which they can muddle along and try to recover. 

They can borrow at extremely low rates, be paid significantly more by some borrowers, avoiding 

foreclosures or loan restructuring so as to avoid recognizing losses and deny their borrowers the 

opportunity to enjoy the low interest rates. Moreover, the banks' equity values are low even 

though they benefit from substantial implicit guarantees. 

When there is little equity, a small loss can lead a homeowner to beeome underwater, as 

many have found in recent years. Distressed or underwater homeowners do not invest in their 

houses as much and might default or walk away if they can. The same happens to distressed 

companies: they do not make efficient investments, either avoiding good ones, or taking too 

much risk or even looting the property if default is imminent. 

4 
92 


79691.007

When banks or financial institutions become distressed, this can interfere with their 

willingness to make loans through an effect called debt overhang. This is the same effect that 

leads homeowners with little equity to underinvest in their home harms. Debt overhang leads 

some investments to seem unattractive to a borrower, because they benefit creditors at the 

borrower's expense. Distressed banks make very poor lending decisions, either being too 

conservative or too reckless. The experience of Japan and our own S&L crisis of the late 1980s 

show that it is much better to face problems in banking early and it can be much more costly to 

wait. 

The distress or "failure" (even through the best resolution mechanism) of large, global 

banks that are highly interconnected or "systemic" can cause even more harm, because it can 

affect the entire financial system through various contagion mechanisms that we have seen play 

out in the crisis. These including effects on counterparties through contractual connections, 

information contagion, and the possibility of distressed sale leading to price declines and thus 

further weakening the system. 

Maintaining a stable financial system should be the key focus of financial regulation, and 

it should strive to reduce the dependence of banks on the vast and highly distortive safety net. 

This safety net has grown unnecessarily. Instead, we must strive to move to a system in which 

losses are borne in the private markets, and where that those who take risks and benefit from the 

upside do not impose the downside on others, particularly not on the public. Financial stability 

should not require taxpayers to bear losses. 

Banks can be safer bear more of their losses through the private markets. Basel III aims 

to move in this direction by requiring more equity, but the levels are still very low without 

justification. The claims that there is a tradeoff between having a safe financial system and 

lending or economic growth are false. So are the claims that there is a relevant cost to society of 

transitioning to a system where banks have much more equity than Basel III allows. 

The transition 

The prevailing view, even within the regulators, is that the banking system needs 

significant time to adjust to higher capital requirements. But this view is not justified. For 

example, it makes no sense to allow banks to make payouts such as dividends before satisfying 

Basel III. If banks used the same funds to make loans or repay some oftheir inessential debts, the 

5 
93 


79691.008

economy will only benefit. If Basel !II is viewed as the target, why allow banks to move away 

from it? 

Instead, the transition can be managed even more forcefully. Any viable bank, 

particularly those whose equity is traded in the stock markets, can raise equity at appropriate 

prices. Banks that cannot raise equity may not actually be viable and regulators should make sllre 

they are not inso lvent. 

How much capital? 

Banks do not need to borrow as much as they do. No healthy corporation in the economy 

has anywhere near the level of indebtedness that banks maintain, even though we do not regulate 

how much most companies borrow. Nothing that banks do necessitate that they are so highly 

indebted. Banks can do everything better if they had more equity. 

Yet, banks fight to continue to live on the edge. Regulators and others seem to accept that 

thc equity levels that we have gotten used to are somehow appropriate or that there is a cost to 

increasing them significantly. Basel II! requires 4.5% equity to so-called "risk weighted assets," 

(plus 2.5% "conservation buffer," also relative to these risk weighted assets). Only some banks 

are subject to a simple leverage ratio requirement and that is set at somewhere between 3% and 

4% depending on what is included in the denominator. I command the Fed for including in one 

of these measurements off balance sheet entities. However, I still find the levels outrageously 

low. There is actually no scientific basis for these numbers, and there is no relevant cost to 

society from increasing them dramatically. 

Instead of taking clue from recent history, let's go further in time. In the middle of the 

19th century, banks had 40% or 50% equity; back at the start of the 20th century, banks routinely 

had 25% equity, without any regulation. This did not necessarily make them safe, but the reasons 

were different. The increased reliance on borrowing matches the expansion of safety nets for the 

banking system, such as the creation of the Federal Reserve, and deposit insurance. 

If anything, banks today have more access to investors who might provide them with 

equity funding than in the past. If they have profitable investments, they should be able to fund 

them with equity like other companies do, even at levels of 15% or 20% or even 25% of assets. 

Why do banks hate equity so much and claim such regulations are so costly for them? 

There are four reasons. 

6 
94 


79691.009

I. Debt overhang because banks are already indebted, they (meaning their managers and 

shareholders) prefer debt over equity as a fonn of funding. This phenomenon is true for 

every borrower. In a sense, borrowing can be "addictive.,,4 

2. The tax code encourages borrowing because of the tax deductibility of interest 

payments.s 

3. Flawed fixation on return-on-equity (ROE) or similar measures for compensation. Such 

compensation encourages excessive risk taking, which does not create value unless 

someone elsc bears the downside.6 

4. The government safety net - implicit and explicit guarantees - makes it possible and 

attractive to borrow at subsidized rates.7 

Importantly, none of these reasons represents a cost to society of imposing high equity 

requirements given that high indebtedness hanns the public. The main beneficiaries from 

excessive borrowing and risk are actually the bankers. Diversified shareholders likely lose. 

If banks benefit from subsidies when they borrow, those subsidies come at the expense of 

taxpayers. Reducing tbe subsidies with more equity makes the system better for the public, 

remove distortions that give banks, particularly the largest ones, advantage over smaller banks 

and other firms in the economy, and saves on the expense of the subsidies. It is perverse to 

subsidize and encourage banks to take actions that hann us just as it would be to encourage 

pollution or reckless driving. 

4 See the paper "Debt overhang and Capital Regulation," whose executive summary is included within the 

appendix. As we explain, other companies might not be able to continue borrowing, because previous 

creditors would not allow it, yet banks' creditors feel secure enough because they might be insured, or 

have collateral, or trust the safety net. This paper discusses adjustments issues. 

5 See Section 4.1 of "Fallacies, Irrelevant Facts and Myths in the Discussion of Capital Regulation: Why 

Bank Equity is Not Expensive," whose executive summary is attached to this document. 

6 See Anat Admati "Beware of Banks' flawed focus on Return on Equity," New York Times, July 25, 

2011, and Section 3.2 "Fallacies, Irrelevant Facts and Myths in the Discussion of Capital Regulation: 

Why Bank Equity is Not Expensive," whose executive summary is attached to this document. 

7 Credit rating agencies give uplifts to some banks; research has shown that the value of the guarantees is 

very large. See Davies, Richard, and Belinda Tracey, "Too Big to Be Efficient? The Impact of Implicit 

Funding Subsidies on Scale Economies in Banking," Working paper, Bank of England, 2012. Brian 

Kelly, Hanno Lustig and Stijn Van Nieuwerburgh, "Too-Systemic-to-Fail: What Option Markets Imply 

about Sector-Wide Government Guarantees." NBER Working Paper 17615. National Bureau of 

Economic Research, Cambridge, MA, and Andrew Haldane,"Control Rights (and Wrongs)," Wincotl 

Annual Memorial Lecture, Westminster, London, October 24, 2011. 

7 
95 


79691.010

Risk calibration 

Basel III continues the quest to find proper "scientific" risk calibration. It tries to address 

some of the obvious weaknesses that were seen in the crisis. What it fails to recognize is that the 

entire approach of risk weights is highly problematic. The attempt to fix the regulation with ever 

more complex rules is based on the illusion that this can be done properly. Regulators should 

realize the limitations of models and data to capture complex systems. 

In fact, while the approach tries hard to be "scientific" in measuring some risks, it 

entirely ignores some. For example, it does not quite takc into account interest rate risk. And 

there is no way that the models will be based on enough information about the counterparties to 

be able to predict the dynamics of liquidity breakdowns or what the next crisis might bring. 

Banks continue to be allowed to use their risk models, and regulators are burdened with having 

to approve these models, all of which does not quite give confidence that the system can be 

trusted to protect us. The approach neglects "black swans" or "unknown unknowns." 

The risk weights of Basel II actually allowed banks to "innovate" to hide risks from 

investors and regulators and they made the system more interconnected and more fragile. 8 

Concentrating enormous credit risk on AIG did not make the risk go away; it only transfers it to 

AIG. When the govcrnment bailed ATG out, banks did not fact the risk they took by counting on 

ATG to be able to pay them. Regulators, meanwhile, also ignored the risks building up at AIG. 

Basel III uses narrow lessons from thc previous crisis by changing some of the ways risk 

weights are calculated but it continues to trust the models and the approach and it continues to 

ignore or be unable to treat some risks. If credit rating agencies are not used, do we know that the 

alternative models would perform better? 

A good analogy for capital regulation is speed limits. Think of banks as trucks with 

different amounts of dangerous cargo. (The most systemic banks are like trucks carrying 

explosives.) The truck companies might say that there should be no tight speed limit because 

they have good drivers and fancy risk models. They might argue that low speed limit, or 

mandated rest breaks, would increase their costs and increase prices for delivery and thus harm 

the economy. Would we allow them to drive at 80 miles per hours on the basis of their models 

and assertions? If we try, there will be much outcry after the first major disaster. 

8 See, for example, Martin F. Hellwig, "Capital Regulation after the Crisis: Business as Usual?" Max 

Planck Institute for Research on Collective Goods, Bonn, 2010, Preprint 2010-31. Many have criticized 

the risk weight approach, including Sheila Bair and Tom Hoenig. 

8 
96 


79691.011

The financial system was allowed to operate with excessive leverage and a major disaster 

did occur. Striving for a fancy model should not detract us from the objective of a safe system, 

particularly when safety can be achieved at little relevant cost. The equivalent of driving at 35 

mph and taking reasonable rest break is that banks do not takc excessive debt-fueled gambles 

that endanger the economy. There is absolutely no cost associated with that for society, only 

benefits. 

Lending and capital requirements 

It is ironic that the concerns about enhanced capital standards center on their potentially 

negative impact on lending. Let us not forget that the biggest credit crunch in reccnt years, a 

freeze that led to massive intervention by the govcrnment and by the Fed, occurred not because 

banks had too much capital but because they had too little. It is distress and insolvency that leads 

credit to be constrained. The key to healthy credit markets is well capitalized banks and fewer 

distortions. The challenge is to get the banks to this point and to maintain the system, preventing 

the buildup of risks that led to the recent financial crisis. 

Whether banks make loans or not depends on their own preferences. Capital regulation 

does not restrict lending, but distressed banks may avoid making some good loans or make 

excessively risky investments. 

Importantly, the risk weights encourage certain investments and discourage others. They 

particularly tend to bias against business lending, and they encourage banks to lend to 

governments and government-related entities such as municipalities, because they assign such 

low risk weights to such investments. Whenever regulation views investments as less risky than 

they really are, banks might over invest. Such was the case for mortgage related securities and 

for Greek debt held by EU banks. The next crisis in US might well come from excessive loans to 

highly indebted municipalities. 

Regulation should strive to put banks in the best position to make the best loans for the 

economy. It is in making loans to businesses that banks are particularly beneficial to the 

economy, but that is not always what they find most attractive. Allowing banks to make payouts 

to their shareholders does not help lending. Regulators can take a more proactive role, 

particularly in the transition, to encourage responsible lending. 

Do different banks and institutions need different regulation? 

9 
97 


79691.012

Quite clearly, the largcst and most complex global institutions, those megabanks that are 

considered too big to fail require particular attention and the strongest rcgulation. These 

institutions are truly dangerous for the economy. In my view it is critical that they be 

immediately banned from making any payouts to their shareholders until a way is found to 

contain the risk they impose on the rest of the economy and the distortions they create. 

The most systcmic institutions should have much higher capital requiremcnts, 

particularly if nothing else is done to control their risk and complexity. Their equity levels should 

be maintained between 20%-30% equity to total assets. If they are unable to reach these levels in 

a managed transition, their solvency and viability should bc callcd into question. Note that this 

does not mean that they should stay at this size. Their current size may wcll be incfficiently 

large, and if subsidies are reduced, they might shrink naturally. 

It appears that the rcgulation actually goes to some length to make distinctions between 

banks of different types. Regulations should be cost effective, and I share the concern about 

complexity. Among the advantages of very high and relatively crude rules is that they are 

simpler. They would require vigilance on the part of the regulators, but more on the bigger 

picture than on numbingly complicated models that cannot quite be trusted. 

I do not, however, share the view that the equity requirements are too high for small 

banks. I find them too low for these banks as well. More than 450 small banks failed since 2008. 

The deposit insurance system is useful and handled these failures, but banks should still strive to 

be more on their own and absorb more of their own losses without becoming distrcssed or 

failing. The costs of funding and investments should be determined in undistorted markets even 

in the case of the banking industry. Only then would we know what the efficient size and scope 

of this important industry is, and only then would it truly serve the economy. 

10 
98 


79691.013

Healthy Banking System in the Goal, Not Profitable Banks 

Letter from Banking and Finance Academics 

Published in Financial Times 

November 9, 2010 

The Basel III bank-regulation proposals that G20 leaders will discuss fail to eliminate key 

structural flaws in the current system. Banks' high leverage, and the resulting fragility and 

systemic risk, contributed to the near collapse of the financial system. Basel III is far from 

sufficient to protect the system from recurring crises. If a much larger fraction, at least 15%, of 

banks' total, non-risk-weighted, assets were funded by equity, the social benefits would be 

substantial. And the social costs would be minimal, if any. 

Some claim that requiring more equity lowers the banks' return on equity and increases their 

overall funding costs. This claim reflects a basic fallacy. Using more equity changes how risk 

and reward are divided between equity holders and debt holders, but does not by itself affect 

funding costs. 

Tax codes that provide advantages to debt financing over equity encourage banks to borrow too 

much. It is paradoxical to subsidize debt that generates systemic risk and then regulate to try to 

limit debt. Debt and equity should at least compete on even tenns. 

Proposals to impose a bank tax to pay for guarantees are problematic. High leverage encourages 

excessive risk taking and any guarantees exacerbate this problem. If banks use significantly more 

equity funding, there will be less risk taking at the expense of creditors or governments. 

Debt that converts to equity, so-called "contingent capital," is complex to design and tricky to 

implement. Increasing equity requirements is simpler and more effective. 

The Basel Accords determine required equity levels through a system of risk weights. This 

system encourages "innovations" to economize on equity, which Wldennine capital regulation 

and often add to systemic risk. The proliferation of synthetic AAA securities before the crisis is 

an example. 

Bankers warn that increased equity requirements would restrict lending and impede growth. 

These warnings are misplaced. First, it is easier for better-capitalized banks, with fewer prior 

debt commitments hanging over them, to raise funds for new loans. Second, removing biases 

created by the current risk-weighting system that favor marketable securities would increase 

banks' incentives to fund traditional loans. Third, the recent subprime-mortgage experience 

shows that some lending can be bad for welfare and growth. Lending decisions would be 

improved by higher and more appropriate equity requirements. 

If handled properly, the transition to much higher equity requirements can be implemented 

quickly and would not have adverse effects on the economy. Temporarily restricting bank 

dividends is an obvious place to start. 
99 


79691.014

Many bankers oppose increased equity requirements, possibly because of a vested interest in the 

current systems of subsidies and compensation. But the policy goal must be a healthier banking 

system, rather than high retUll1S for banks' shareholders and managers, with taxpayers picking up 

losses and economies suffering the fallout. 

Ensuring that banks are funded with significantly more equity should be a key element of 

effective bank regulatory reform. Much more equity funding would permit banks to perform all 

their useful functions and support growth without endangering the financial system by systemic 

fragility. It would give banks incentives to take better account of risks they take and reduce their 

incentives to game the system. And it would sharply reduce the likelihood of crises. 

Anat R. Admati 

George C. Parker Professor of Finance and Economics 

Stanford Graduate School of Business 

Franklin Allen 

Nippon Life Professor of Finance; Professor of Economics 

Co-Director, Financial Institutions Center 

The Wharton School, University of Pennsylvania 

Richard Brealey 

Emeritus Professor of Finance 

London Business School 

Michael Brennan 

Professor Emeritus, Finance 

Anderson School of Management, UCLA 

Markus K. Brunnermeier 

Edwards S. Sanford Professor of Economics 

Princeton University 

Arnoud Boot 

Professor and Director, Amsterdam Center for Law & Economics 

University of Amsterdam 

John H. Cochrane 

AQR Capital Management Professor of Finance 

University of Chicago Booth School of Business 

Peter M. DeMarzo 

Mizuho Financial Group Professor of Finance 

Stanford Graduate School of Business 

Eugene F. Fama 

Roger R. McCormick Distinguished Service Professor of Finance 

University of Chicago Booth School of Business 
100 


79691.015

Michael Fishman 

Nonnan Strunk Professor of Financial Institutions 

Kellogg School of Management, Northwestern University 

Charles Goodhart 

Professor, Financial Markets Group 

London School of Economics 

Martin F. Hellwig 

Director, Max Planck Institute for Research on Collective Goods, Bonn 

Hayne Leland 

Professor of the Graduate School, Haas Finance Group 

Haas School of Business, UC Berkeley 

Stewart C. Myers 

Robert C. Merton Professor of Financial Economics 

Sloan School of Management, MIT 

Paul Pfleiderer 

C.D.G. Miller Distinguished Professor of Finance 

Stanford Graduate School of Business 

Jean Charles Rochet 

SFI Professor of Banking 

Swiss Banking Institute, University of Zurich 

Stephen A. Ross 

Franco Modigliani Professor of Financial Economics 

Sloan School of Management, MIT 

William F. Sharpe 

The STANCO 25 Professor of Finance, Emeritus 

Stanford Graduate School of Business (Nobel Laureate, 1990) 

Chester S. Spat! 

Pamela R. and Kenneth B. Dunn Professor of Finance; Director, Center for Financial Markets 

Tepper School of Business, Carnegie Mellon University 

Anjan Thakor 

John E. Simon Professor of Finance 

Olin School of Business, Washington University 
101 


79691.016

Global "Level Playing Field" Arguments are Invalid 

Anat Admati and Martin Hellwigl 

Bankers on both sides of the Atlantic are lobbying furiously against stronger regulation. 

Authorities in different countries are reluctant to strengthen banking regulation as if the crisis 

never happened. The European Commission even hesitates to fully implement Basel III. 

In this debate, many argue that global competition requires a "level playing field." Following this 

argument, and concerned about the City's competitiveness, the Interim Report of the UK's 

Independent Commission on Banking avoids proposing tougher regulation for investment banks. 

These "level playing field" arguments arc invalid. Ifbanks impose costs and risks on a country's 

economy, the country is better off with regulations that limit those risks and costs even if others 

are not doing the same. 

In the seventies, environmental regulation and reductions in government support for coal and 

steel required painful adjustments. But overall welfare has been improved by having cleaner 

rivers, clearer skies and less waste of taxpayer money. The financial industry does not pollute 

rivers or skies, but in the crisis it caused damage on the order of trillions of dollars, euros and 

pounds. Public support was needed to avoid even worse. Using taxpayer money to bailout banks 

is no better than using it to support the coal industry after excessive wage settlements. 

The global economy is not a sporting event where a country's athletes are expected to win as 

many medals as possible, but a system for the exchange of goods and services. In this system, the 

competitive successes of banks and the competitive failures of firms in other industries are two 

sides ofthe same coin as a country exports financial services and imports other products 

according to its comparative advantage. 

In the UK, the rise of the financial sector over the past three decades was accompanied by a 

decline in manufacturing. This is not a coincidence. Banks are not just in competition in financial 

services markets. They are also in competition in markets for inputs, most importantly for scarce 

talent. The highly talented people that they have drawn into the financial sector have not been 

available to other industries. 

F or the economy as a whole, the question is not whether banks are successful but where its 

resources are most usefully employed. Perhaps those sharp minds in investment banking might 

have become even more productive in innovative biotechnology? 

1 An edited version 0 appeared as an op-ed in Financial Times, June 3, 2011. Full text version appeared 

online in "Martin Wolfs Economists' Forum," FT.eom, June 6, 2011. 
102 


79691.017

The best uses of scarce resources are found through an undistorted market system. Without 

distortions, a firm's success in the competition for inputs is prima facie evidence that its use of 

these resources is economically desirable. 

However, with externalities such as health effects of pollution, job and income losses from the 

fallout of the financial crisis, or costs of government subsidies, market functioning is distorted. It 

is important to correct such distortions by suitable regulation. The elimination of distortions 

favoring banks will improve the functioning of the market system and enhance economic 

welfare. 

The severity of the crisis was at least partly due to the fact that major financial institutions 

operated with only 1-3 per cent equity relative to total assets. With such high leverage, solvency 

concerns arose quickly and impaired refinancing. Had banks been funded with much more 

equity, the crisis would have been much less severe. 

Basel III allows the total equity of banks to be as low as 3% of their total assets, which is 

dangerously low. A system where banks, including investment banks, are funded with 

significantly more equity is not only less fragile, but it is healthier, with fewer incentives for 

excessive risk taking and a lower likelihood of a credit crunch due to overhanging debt. Banks 

funded with more equity can better generate economically appropriate value .and profits by 

making loans and providing liquidity, while subjecting the economy to fewer unnecessary risks 

and costs. Arguments based on banks' return-on-equity are fallacious and irrelevant, as are dire 

predictions for national competitiveness, lending and growth. None of these should enter the 

debate. 

Some argue that stricter regulation would drive banking into the unregulated shadows. By the 

same argument, we might give up on taxation because we are afraid ofthe use of tax loopholes. 

Enforcing financial regulation is a challenge, but this challenge can be met. In the crisis, the most 

problematic shadow banking activities had actually been sponsored by regulated banks, and 

would have been within regulatory reach. If national supervisors were willing to use their 

enforcement powers over activities in their territory, the threat from shadow banking anywhere 

would be much reduced. This requires political will and determination. 
103 


79691.018

Comments on 

Enhanced prudential standards under section 165, 

and early remediation requirements under section 166 

of the Dodd-Frank Act 

Anat R. Admati 

George G.c. Parker Professor of 

Finance and Economics 

Graduate School of Business, 

Stanford University 

admati@stanford.edu 

Peter M. DeMarzo 

Mizuho Financial Group 

Professor of Finance 

Graduate School of Business, 

Stanford University 

demarzo ~eter@gsb.stanford.edu 

Martin F. Hellwig 

Director, 

Max Planck Institute for Research on 

April 30, 2012 

Collective Goods, Bonn 

hellwig@coll.mpg.de 

Paul Pfleiderer 

c. O. G. Miller Distinguished 

Professor of Finance 

Graduate School of Business, 

Stanford University 

pflcider@stanford.edu 
104 


79691.019

Introduction 

Our comments will focus primarily on capital requirements. While we believe that 

liquidity issues are a legitimate concern, liquidity problems often arise, and are most severe and 

costly, in distress situations when there are concerns about the solvency of a bank or financial 

entity. Solvency concerns, in turn, are best addressed by reducing excessive leverage and risk in 

thc system. For a variety of reasons discussed below and in attached research, private actors in 

the banking system have strong incentives to choose excessive leverage that is not only 

unnecessary, but is hannful to the ability of the system to serve the economy. Since addressing 

the problem of excessive leverage is in our view the most important and critical concern, we 

begin by discussing capital requirements and related issues. 

Measures of regulatory capital based on accounting numbers, and the use of risk weights 

to calculate capital ratios, can both mask important systemic risks. Regulatory capital ratios were 

not infonnative during the crisis. What matters is meaningful loss absorbency. It is also 

important to note that critical sources of systemic risk that cannot be easily seen from balance 

sheets and from regulatory capital ratios are those associated with the interconnectedness of the 

system and, more specifically, with counterparty risks. We encourage the Fed to pay close 

attention to this in stress testing, and we view single party exposure limits as potentially useful 

tools. 

After focusing primarily on capital requirements, we will offer at the end of this note 

some comments on liquidity, stress tests, and position limits. We also attach excerpts from two 

papers we have written on the subject of capital regulation. These papers, and additional 

materials, including academic and policy papers and commentary, can be found at 

http://www .gsb.stanford.edu/news/researchl Admati.etal.html . 

The critical role of capital regulation, and relevant costs and benefits 

Our financial system has become global and greatly interconnected. This means that the 

distress and even worse the actual default or "failure" of one institution can have severe negative 

effects on many others through various contagion mechanisms. Some of these are direct effects, 

which are transmitted through contractual claims to counterparties. Others are less direct but can 

be just as significant, if not more so. For example, because institutions often make similar 

2 
105 


79691.020

investments, a type of "information contagion" can occur when observed distress in one 

institution leads to concerns about the decline of asset values in others, and to possible runs and 

liquidity problems. At the same time "fire sales" can occur in distressed situations when 

deleveraging multiples are high. This can create downward pressure on prices, and these 

externalities in asset markets can result in a "deleveraging spiral." All of these systemic risks 

harm financial stability and can ultimately interfere with the ability of the financial system to 

support the economy. The biggest credit crunch in recent memory was due to the chain rcactions 

that followed the Lehman bankruptcy in fall 2008. We have seen that these risks are not 

hypothetical and their consequences can be devastating. 

The key to reducing fragility in the financial system is to reduce the likelihood of distress, 

and the risk of insolvency and default of systemically important financial institutions. lIigh 

levels of leverage are fundamental to all the mechanisms mentioned above that create fragility. 

The capital regulations in place before the crisis, which were based on Basel II, allowed the 

system to become highly leverage and very fragile and proved to be flawed and insufficicnt. Part 

of the failure stemmed from requirements not being enforced effectively throughout the system, 

which allowed leverage and risk to "hide" in off-balancc-sheet entities, such as conduits and 

SIVs. Entities outside the banking system (such as AI G) were used to push risks off the regulated 

institutions' balance sheets - only to come back in the form of counterparty credit risk that was 

correlated with the underlying risks that were being "insured." Another significant problem 

stemmed from unrecognized "tail risk" that led to AAA securities being treated as totally safe 

when in fact they were not. 

The system that was in place to make sure there was sufficient loss-absorbing capacity 

clearly failed to protect the system and massive intervention was necessary. The models that 

were used to assess value at risk wcre fundamentally flawed. In addition, the models that had 

been used by regulators to justify any of the specific numbers in the regulations were shown to 

be ill suited for the purpose. Regulatory Tier I and Tier II capital buffers that were not equity did 

not absorb any losses and proved ineffective. 

Basel III recommends a modest increase in capital requirements. While strengthening 

some definitions and rules, Basel III retains the approach of calibrating capital requirements to 

risk-weighted assets, with 4.5 % of risk-weighted assets (plus a 2.5% capital buffer) for common 

equity, 6% for Tier 1 capital and 10% for Tier I plus Tier 2 capital. 

3 
106 


79691.021

Bankers claim that the proposed increases in capital requirements are very substantial or 

even harsh, presenting them in terms of multiples of previous requirements, and arguing that 

anything higher would have negative consequences. However, 4.5% or even 7% of risk-weighted 

assets is still very small. The fact that this is a twice or three times the previous requirement for 

common equity just indicates how low the previous requirement was. As a percentage of total 

assets, the numbers are even lower. The problem with risk weights should be abundantly clear by 

now. Tn the crisis, and even since, the realization of many risks that had been given zero weight 

in assessing risk weighted assets caused considerable distress and insolvencies. 

The new leverage ratio that is introduced in Basel III seeks to reduee reliance on risk 

weights that are misleading measures of the true risks and that can be manipulated. It requires 

lhat equity be at least 3% of total assets. This is extremely low, allowing assets to be more than 

30 times the book value of equity. For banks such as UBS, with equity equal to 2.5% of total 

assets, this leverage ratio would not make much of a difference, and we have seen that this 2.5% 

of total assets did not provide adequate protection in the crisis. 

The fact that Basel TIl only makes relatively small changes to Basel II and maintains the 

same approach is of great concern, since systemic risks and system fragility have not been 

reduced significantly through any other means. We still have several institutions whose failure 

would be too damaging to be imaginable (the so-called "too big to fail" or "too interconnected to 

fail" institutions, now called Systemically Important Financial Institutions). If anything, the toobig-to-fail problem seems to have become more severe with the consolidation of some of the 

large banking institutions that occurred during the crisis. The implicit subsidies created by the 

implicit, too-big-to-fail guarantees are still present and still lead to enormous moral hazard 

problems. They distort pricing and incentives and increase the risk to the system. All of this has 

serious adverse consequences for the entire economy. 

Clearly, the issue of what capital requirements are appropriate depends on an 

understanding of the social costs and benefits of reducing leverage, which includes 

understanding adjustment costs and implementation issues. 

We have carefully examined claims that have been made that there are costs to significant 

increases in capital requirements. In two papers that are attached, we show that the arguments 

made that equity is expensive are either flawed or based on confusions between private and 

social costs. This means that the view that we must "economize" on bank equity and accept a 

4 
107 


79691.022

fragile system is entirely false. When systemic risks and implicit government subsidies create 

externalities and distortions, it is actually the excessive leverage of financial institutions that is 

"expensive" for the economy, even if debt seems "cheap" and equity seems "expensive" to 

decision makers in banks. Reducing the leverage of systemic institutions from levels currently 

discussed to significantly lower levels, involving even 20% or more equity as fraction of total 

assets, will produce significant social benefits at little (if any) social cost. We have seen no wellgrounded model or empirical evidence that argues against this. 

In the paper "Fallacies, Irrelevant Facts and Myths m the Discussion of Capital 

Regulation: Why Bank Equity is Not Expensive," (last draft March, 2011), we havc undertaken 

an extensive examination of the various arguments that are made to justify the view that equity is 

"expensive" in any relevant sense in the context of the regulation. We show that the only reason 

that the funding costs of systemic institutions might increase with higher capital requirements is 

the loss of subsidies, which would indicate that current funding costs are artificially low and 

distorted by subsidies, particularly implicit guarantees but also including the tax subsidies to debt 

funding. 

In "Debt Overhang and Capital Regulation," we consider more closely claims that 

shareholders would be "diluted" if forced to reduce leverage. We show that while there can be a 

dilution effect as leverage is reduced, it is critically important to understand its source. The 

source is due to what has come to be called "debt-overhang." As a result of debt overhang, 

leverage becomes "addictive" through a ratchet effect. Significant inefficiencies can result, 

particularly in the context of the systemic risk externalities associated with high leverage. 

Regulation is essential. 

The debt overhang effect comes about because, in a highly-leveraged financial 

institution, much of the downside risk is borne by institution's creditors and by the FDIC and 

taxpayers, in those cases where creditors are explicitly or implicitly insured. While other parties 

are exposed to substantial downside risks, the shareholders and managers of the financial 

institution retain all the benefits of the upside. The dilution of the shareholders' and managers' 

interests that occurs when leverage is reduced is the direct result of transferring some of the 

downside risk away from creditors - especially government and the taxpayers where is does not 

belong - and onto the shareholders and managers where it more properly belongs. In other 

words, any dilution of existing equity when leverage is reduced comes about because the 

5 
108 


79691.023

financial institutions have already placed excessive risk on creditors and taxpayers. Although it 

is in managers' narrow interest to resist leverage reduction, making sure that adequate equity 

buffers are established is essential for the system. This is true even though it is not something 

that incumbent managers would choose to do on their own and will in fact actively resist. The 

debt overhang effect creates significant social inefficiencies that must be corrected through 

regulation. 

This effect holds even without any subsidies given to debt funding, but it is greatly 

exacerbated by their presence. Indeed, the cost of borrowing for any highly leveraged 

corporation would rise or restrictive covenants would be put in place if creditors had to bear the 

costs and inefficiencies of distress and bankruptcy. This does not seem to be the case for banks, 

and it is regulators that are charged with making sure that the puhlic is protected from the costs 

and inefficiencies of high leverage. 

In both papers we emphasize that the easiest way to build up capital is by retention of 

earnings. We consider the recent decision by the Federal Reserve to allow most large U.S. banks 

to make payouts to shareholders to be misguided and a move in the wrong direction. In our paper 

on debt overhang we discuss ways in which institutions might choose to reduce leverage. Based 

on our analysis and considering the current situation, we conclude that preventing cash payouts 

to shareholders and managers is one of the best ways to facilitate efficient transitions to a much 

less fragile system. 

We will not comment in detail on liquidity regulation except to note that the likelihood of 

institutions running into liquidity problems would be greatly reduced with more equity funding. 

It is concern with insolvency and default that creates or exacerbates liquidity problems, and it is 

insolvency (or suspected insolvency) that makes those problems harder and costlier to solve. The 

lender-of-Iast-resort function of central banks was specifically designed to help alleviate pure 

liquidity problems in the absence of solvency concerns. 

Chairman Bernanke told the Financial Crisis Inquiry Committee that "If the crisis has a 

single lesson, it is that the too-big-to-fail problem must be solved." He also emphasized in a 

recent speech that the vulnerabilities in the system, including high leverage and a lack of 

effective supervision of shadow market institutions, were critical reasons for the crisis.! It is clear 

I See speech before Russel Sage Foundation and the Century Foundation, April 16, 2012, available at 

http://www.federalreserve.gov/newsevents/speech/bernanke20120413a.htm 

6 
109 


79691.024

that, despite the resolution authority given FDIC under Title II of Dodd Frank Act, financial 

markets do not view current regulatory effort as reducing significantly the "too big to fail" 

problem. Capital requirements can playa critical role in reducing this problem. 

It is also critical that capital requirements be designed to give the FDIC the best chance of 

meeting its mandate to resolve systemically important financial institutions without using 

taxpayer money. To this end, there must be sufficient loss-absorbing funding for these 

institutions. Equity is the best source of such funding. In addition to earnings retention, publicly 

held banks have access to markets where they can issue new shares. 

What is the "optimal" level of req uired capital? 

The discussion above suggests that there are large social benefits to greatly reducing the 

leverage of important financial institutions. We have not seen any valid arguments or compelling 

evidence suggesting that there are social costs to offset thc gains that come with significant 

increases in capital requirements relative to existing or proposed levels. 

We are aware of the models that were used to justify the Basel III "numbers," but we find 

that these are weak and inadequate. For example, they do not capture properly the negative 

externalities and the distortions created by high leverage. At the same time they make 

assumptions that clearly exaggerate the social costs of reducing leverage. For example, one of 

the models that have been used is based on the assumption that higher capital requirements lower 

the ability of banks to provide deposit-type liabilities to the household sector? Since in this 

model deposits enter directly into the utility function of households, this creates a purported 

social cost of higher requirements. However, since deposits are only a fraction of bank liabilities 

and there are many ways banks could meet higher capital requirements without changing 

outstanding deposits, this assumption, which is critical to the model, is dubious at best. At the 

same time, this model assumes that there are no systemic risks and no costs to thc economy 

created by fragility in the financial sector, costs of the sort we witnessed in the last crisis. 

2 See Skander J. Van den Heuve!, The Welfare Cost of Bank Capital Requirements, Journal oj Monetary 

Economics, march, 2008 

7 
110 


79691.025

One of the studies attempting to calibrate the precise Basel III requirements states:3 "The 

regulatory minimum is the amount of capital needed to be regarded as a viable going concern by 

creditors and counterparties." By this criterion, capital regulation would not be necessary: A 

bank that fails this criterion would not be viable because creditors and counterparties would 

refuse to deal with it. Good regulation should focus on the negative impact that undercapitalized 

banks impose on the rest of the financial system and on society when they are distressed. It is 

this extcrnal or "polluting" impact that the regulation should seek to limit. 

The challenges involved in developing models to assess the costs and benefits of capital 

requirements lie in the extraordinary complexity of the financial system and the many ways it 

can adversely affect the rest of the economy. By necessity models must be simplifications, but a 

good model must have at least the following two characteristics: 

• It must capture those risks and other effects that are of first order importance. 

It should not be driven by assumptions that are not at all in accord with the actual 

world in which we live and do not pass the common sense "smell test." 

The models that are used to support the high leverage levels that are pennitted under Basel III 

fail to meet one or both of these criteria. 

Basel specifies only minimum requircments. If these numbers are deemed too low, any 

national regulator can choose to set higher requirements. While banks often bring up "level 

playing field" arguments, and while it is desirable for all regulators to set the same (high) 

requirements, the failure of others to implement the regulation or to go beyond the Basel 

minimum should not alter the objective of regulators in the US. It is not a national priority that 

US' banks are succes.~ful in global competition if/his exposes US taxpayers to excessive risks and 

costS.4 Regulators in UK, Sweden, Switzerland and Spain, and elsewhere might in fact follow the 

US lead if it sets higher and better designed capital requirements. 

3 Basel Committee on Banking Supervision, (2010), "Calibrating regulatory mInimum capital 

requirements and capital buffers: a top-down approach," Discussion Paper 180, 

http://www.bis.org/publ/bcbsI80.pdf 

4 See "Global Level Playing Field Arguments are Invalid" by Anat Admati and Martin Hellwig, Financial 

Times, June 3, 20 11, available here http://www.gsb.stanford.edulnews/research/admati-battle-begun.html 

8 
111 


79691.026

Risk calibration and the flaws in the risk weights approach 

Basing capital requirements on risk weights might seem like a sensible way to calibrate 

requirements to the risk that different investments bring to the banks' balance sheet. However, 

the risk weight system as implemented in Basel II, and which is essentially maintained as an 

approach in Basel 1Il, is inherently flawed. It creates distortions, it can exacerbate systemic risk, 

and it is far too easily manipulated.s 

We briefly summarize the problems. First, when regulation is based on risk weights, 

banks often attempt to move some of the major risks off their books. Interest rate swaps, 

currency swaps, credit default swaps all can be used to shift the risks from certain positions to 

third parties. Such developments increase the interconnectedness of the system and raise the 

danger of contagion effects. The effectiveness of the hedges depends on the counterparties' 

ability to pay. It: following a shock, the counterparties' ability to pay is impaired, the risk may 

come right back, now in the form of a counterparty credit risk whose incidence is driven by the 

very risk that was to be hedged.6 Prior to the recent crisis, banks tried to hedge the credit risk of 

mortgage-backed securities through credit default swaps with AIG or with monoline insurers. 

The bailout of AIG ended up covering for the downside counterparty risk that banks took in 

those transactions. 

Second, the risk weighting system gives incentives to banks to hide both risk and 

leverage by heavily favoring investments that have relatively low risk weights but are actually 

exposed to underlying risks that create a risk premium and "enhance" yield and return. A clear 

recent example can be seen in investments made in AAA securities or in sovereign debt. Many 

banks ran into trouble in the crisis, and more recently Dexia had to be bailed out even while 

presenting high regulatory capital. This is because many of the supposedly "safe" but 

"enhanced" return assets ended up leading to significant losses. 

5 For a more detailed discussion on the issues see the paper "Capital Regulation after the Crisis: Business 

as Usual?" by Martin Hellwig, available at 

http://www.ucl.ac. ukleconomics/seminarpapers/n ovem ber I O/dept03 nov 1 O. pdf 

6 An example is provided by Thailand in the crisis of 1997. In the run-up to the crisis, much lending, from 

foreign banks to Thai banks and from Thai banks to Thai finns, had taken place in dollar tenns in order to 

eliminate exchange rate risks for lenders. After the devaluation of the Baht, however, Thai finns could not 

pay their dollar debts to Thai banks, and, with their debtors in default, Thai banks could not pay their 

dollar debts to foreign banks. 

9 
112 


79691.027

Third, the system of risk weights can lead to distortions. We have seen, both before the 

financial crisis and currently in Europe, that banks may find traditional business lending less 

attractive than trading securities and other types of investments. To the extent that this is driven 

by the rather arbitrary risk weights assigned to various investments and does not reflect the 

underlying economic and social value associated with them, this results in a clear distortion and 

social loss. 

Conflicted incentives and the gap between private and social considerations 

Bank managers have incentives to increase leverage and risks because debt funding is 

subsidized relative to equity, and because their compensation, which is either directly or 

indirectly tie to ROE (return on equity), often encourages leverage and risk. Their perspectivc 

with respect to leverage and risk is also colored by debt overhang, as explained above. Since the 

choices made by market participants do not fully account for the systemic effects of their actions, 

these choices can be socially inefficient. Capital regulation is of critical importance in correcting 

the resulting distortions. 

Quite unfortunately, the tax code also encourages the use of debt funding over equity. 

Since leverage exacerbates systemic risk and thus creates a negative externality, this is a perverse 

effect. The tax treatment of debt relative to equity creates a strong divergence between banks' 

preferences regarding their funding and what is good for the public. This presents even more of a 

challenge for banking regulation and supervision. It would be highly desirable that tax codes 

change to equalize the treatment of equity relative to debt funding. 

We realize that tax policy is not controlled by the Federal Reserve. However, it would be 

useful for the Fed to clarify this issue and to call on policy makers to change the distortion 

associated with subsidizing debt funding through tax policy. This issue is broader than banking, 

but because leverage is so high and so damaging in banking, this tax distortion is particularly 

severe in this sector. It is, however, critical to recognize that, other than the distortions that they 

create, taxes are not per se a social cost. Thus, if even banks were to pay more taxes as a result of 

increased capital requirements, this does not constitute a social cost of the requirement. 

As suggested above, compensation structures in banking, which often depend on shortterm performance and on measures that encourage risk taking, are an issue. The incentives that 

such compensation structures create can exacerbate systemic risk. It would be desirable that at 

10 
113 


79691.028

least some cash payments in banking are deferred and can be clawed back if losses that harm the 

bank and the economy occur. 

Comments on stress testing 

The Fed relies on periodic stress tests to determine whether banks are sufficiently well 

capitalized and whether they should be authorized to make distributions to shareholders in the 

form of dividends and share buybacks. While stress tests can provide useful information, we urge 

extreme eaution in trusting the results and in allowing payouts to equity in the near future. 

Projections of credit risks and future losses under certain scenarios invariably involve the use of 

models and assumptions. We have seen very clearly the limitations of models and the possibility 

that assumptions prove wrong when it is too late. The regulatory capital of many institutions 

seemed adequate around the time of the financial crisis. As mentioned above, even Dexia, 

shortly before it had to be bailed out and nationalized last summer, seemed to have had 

substantial regulatory capital. 

We would also like to flag the differences between netting conventions under GAAP in 

the US and under Internatiomil Financial Reporting Standards (IFRS). Stress testing and single 

counterparty regulation might be useful in addressing the critical issue of counterparty risk. It is 

important that any scenario analysis or stress test take seriously the actual exposure to 

counterparty risks. Even if netting is allowed under GAAP, if a counterparty default does not 

void a liability for a covered entity, this can increase the risk to the entity and to the system. 

As argued above, there are no social costs associated with additional bank equity that are 

anywhere near in magnitude to the social benefits of significantly reducing leverage. It is 

therefore ill advised to deplete capital on the basis of stress tests at a time when so much 

uncertainty looms in Europe and when many uncertainties remain with respect to existing loans 

and other assets held by financial institutions. The risk and cost to financial stability is 

significant, and there is no social benefit associated with the depletion of capital, only costs. 

Instead of making equity payouts, banks could either make prudent investments with the 

earnings or reduce their debt. 

11 
114 


79691.029

Comments on single counterparty exposure limits 

The dangerous interconnectedness in the financial system manifests itself in so-called 

counlerparty risks, which leads to the contagion that causes cascading effects from the distress or 

default of one entity to the entire system. It would be alarming if the default of any counterparty 

could wipe out 10% of the loss absorbing capital of a systemically important financial institution. 

This is particularly so if such a default might be correlated with the distress of others in the 

system, such as in a financial crisis. 

We note that the exposure limit is specified as a ratio of total exposure relative to 

regulatory capital. If covered companies had more equity, and thus more regulatory capital, this 

requirement would be less onerous. Even at current levels of capital, however, it is hard to 

imagine a legitimate reason, from a regulatory perspective, for a systemically important 

institution to have such exposure to unaffiliated entities that 10% of its capital would be pul at 

risk. This exposes the entity and the system to unnecessary risk. To the extent that banks find the 

single counterparty position limit onerous, this should only alarm us with respect to the great 

interconnectedness of the system.7 

Comments on liquidity requirements 

With respect to liquidity regulation, we wish to offer the following comments. First 

"liquidity" is a property that pertains to certain asset markets and to certain assets at certain 

times. 8 It is not a fixed property and it may change quickly. As we saw in August 2007, certain 

markets and assets can be highly liquid one day and highly illiquid the next. This variability over 

time poses a challenge for any system of liquidity management, whether from the perspective of 

the bank or from the perspective of the regulator. 

Some assets are liquid even though they have long economic lifetimes, because there is a 

well functioning market for them. This would typically be true of a Treasury bond or many of the 

stocks traded on exchanges. As for private debt, we have seen that, for some debt-like securities, 

markets can tum from being highly liquid to being completely illiquid in a matter of days if not 

hours. Similar issues arise with respect to short-term debt, including repo and asset-backed 

7 The comment Jetter by the Clearing House submitted for this regulation on April 27, 2012 actually provides 

evidence of dangerously large exposures that should be a concern. 

g Hicks (1935): An asset is liquid ifthere is little uncertainty as to its being realizable at short notice without loss. 

12 
115 


79691.030

securities. The debtor's ability to repay this debt may change from one day to the next, due to a 

run by (other) creditors or to a freeze in the markets for the assets that the debtor holds. 

Given the fluidity of "liquidity" as a property of assets, any attempt to regulate liquidity 

coverage is fraught with a risk that liquidity may disappear precisely when it is needed. This 

could be avoided if the regulation restricted banks to holding cash and short-term treasuries only 

for liquidity coverage.9 

Whereas liquidity requirements can affect the assets the banks hold, capital requirements 

do not. They only affect the way in which banks fund their investments. If banks are required to 

fund with more equity, they have better loss absorbency and better incentives to avoid 

unconscionable risks. If banks have more funding by equity, market participants will also be less 

worried about the possibility of insolvency and will be more willing to provide banks with 

liquidity if needed. In a very real sense, therefore, effective capital requirements contribute to 

improving the banks' liquidity. 

In summary, effective, well designed capital requirements provide a powerful tool, and 

are the most cost-effective approach, for creating a healthier, safer, and less distorted banking 

system. 

9 Holding these assets could be costly to extent that the amount paid for the liquidity provided by these assets is 

excessive to the need. 

J3 
116 


79691.031

Fallacies, Irrelevant Facts, and Myths 

in the Discussion of Capital Regulation: 

Why Bank Equity is Not Expensive 

Anat R. Admati 

Peter M. DeMarzo 

Martin F. Hellwig 

Paul Pfleiderer" 

First Draft August 27, 2010 

This draft March 23, 2011 

Full paper available at 

http://www.gsb.stanford.eduinews/researchiAdmati.etal.html 

'Admati, DeMarzo and Pfleiderer are from the Graduate School of Business, Stanford University; Hellwig is from 

(he Max Planck Institute for Research on Collective Goods, Bonn. We are grateful to Viral Acharya, Tobias Adrian, 

Jiirg Blum, Patrick Bolton, Arnaud Boot, Michael Boskin, Christina BUchmann, Darrell Duffie, Bob Hall, Bengt 

Holmstrom, Christoph Engel, Charles Goodhart, Andy Haldane, Hanjo Hamann, Ed Kane, Arthur Korteweg, Ed 

Lazear, Hamid Mehran, David Miles, Stefan Nagel, Francisco Perez-Gonzales, Joe Rizzi, Steve Ross, Til 

Schuermann, Isabel Schnabel, Hyun Shin, Chester Spat!, llya Strebulaev, Anjan Thakor, Jean Tirole, Jim Van 

Horne, and Thea Vermaelen for useful discussions and comments. Contact information: admati@stanford.edu; 

demarzo __ peter@gsb.stanford.edu; hellwig@coll.mpg.de; pfleider@stanford.edu. 
117 


79691.032

Fallacies, Irrelevant Facts, and Myths 

in the Discussion of Capital Regulation: 

Why Bank Equity is Not Expensive 

Anat R. Admati, Peter M. DeMarzo, Martin F. Hellwig, and Paul Pfleiderer 

Abstract 

We examine the pervasive view that "equity is expensive," which leads to claims that high 

capital requirements are costly and would affect credit markets adversely. We find that 

arguments made to support this view are either fallacious, irrelevant, or very weak. For example, 

the return on equity contains a risk premium that must go down if banks have more equity. It is 

thus incorrect to assume that the required return on equity remains fixed as capital requirements 

increase. It is also incorrect to translate higher taxes paid by banks to a social cost. Policies that 

subsidize debt and indirectly penalize equity through taxes and implicit guarantees are distortive. 

Any desirable public subsidies to banks' activities should be given directly and not in ways that 

encourage leverage. And while debt's informational insensitivity may provide valuable liquidity, 

increased capital (and reduced leverage) can enhance this benefit. Finally, suggestions that high 

leverage serves a necessary disciplining role are based on inadequate theory lacking empirical 

support. 

We conclude that bank equity is not socially expensive, and that high leverage is not 

necessary for banks to perform all their socially valuable functions, including lending, deposittaking and issuing money-like securities. To the contrary, better capitalized banks suffer fewer 

distortions in lending decisions and would perform better. The fact that banks choose high 

leverage does not imply that this is socially optimal, and, except for government subsidies and 

viewed from an ex ante perspective, high leverage may not even be privately optimal for banks. 

Setting equity requirements significantly higher than the levels currently proposed would 

entail large social benefits and minimal, if any, social costs. Approaches based on equity 

dominate alternatives, including contingent capital. To achieve better capitalization quickly and 

efficiently and prevent disruption to lending, regulators must actively control equity payouts and 

issuance. If remaining challenges arc addressed, capital regulation can be a powerful tool for 

enhancing the role of banks in the economy. 

Keywords: capital regulation, financial institutions, capital structure, "too big to fail," systemic 

risk, bank equity, contingent capital, Basel, market discipline. 

JEL classifications: G21, G28, G32, G38, H81, K23. 
118 


79691.033

Executive Summary 

There is a pervasive sense in discussions of bank capital regulation that "equity is expensive" 

and that higher equity requirements, while beneficial, also entail a significant cost. The 

arguments we examine, which represent those most often made in this context, are fallacious, 

irrelevant, or very weak. Our analysis leads us to conclude that requiring that banking institutions 

are funded with significantly more equity entails large social benefits and minimal, if any, social 

costs. We list below some of the arguments made against high equity requirements and explain 

why they are either incorrect or unsupported. 

Some common arguments made against significantly increasing equity requirements: 

Increased equity requirements would force banks to "set aside" or "hold in reserve" funds 

that can otherwise be used for lending. This argument confuses capital requirements with 

liquidity or reserve requirements. Capital requirements refer to how banks are funded and in 

particular the mix between debt and equity on the balance sheet of the banks. There is no 

sense in which capital is "set aside." Liquidity or reserve requirements relate to the type of 

assets and' asset mix banks must hold. Since they address different sides of the balance sheet, 

there is no immediate relation between liquidity requirements and capital requirements. 

Increased equity requirements would increase banks' funding costs because equity requires a 

higher return than debt. This argument is fallacious, because the required return on equity, 

which includes a risk premium, must decline when more equity is used. Any argument or 

analysis that holds fixed the required return on equity when evaluating changes in equity 

capital requirements is fundamentally flawed. 

Increased equity requirements would lower the bank5' Return on Equity (ROE), and this 

means a loss in value, This argument is also fallacious. The expected ROE of a bank 

increases with leverage and would thus indeed decline if leverage is reduced. This change 

only compensates for the change in the risk borne by equity holders and does not mean that 

shareholder value is lost or gained, except possibly if increased leverage brings more 

government subsidies. 

Increased equity requirements would increase banks 'funding costs because banks would not 

be able to borrow at the favorable rates created by tax shields and other subsidies. It is true 

that, through taxes and underpriced explicit or implicit guarantees, debt financing is 

subsidized and equity financing is effectively penalized. Policies that encourage high 

leverage are distorting and paradoxical, because high leverage is a source of systemic risk. 

The subsidies come from public funds. If some activities performed by banks are worthy of 

public support, subsidies should be given in ways that do not lead to excessive leverage. 

• Increased equity requirements would be costly since debt is necessary for providing "market 

discipline" to bank managers. While there are theoretical models that show that debt can 

sometimes playa disciplining role. arguments against increasing equity requirements that are 
119 


79691.034

based on this notion are very weak. First, high leverage actually creates many frictions. In 

particular, it creates incentives for banks to take excessive risk. Any purported benefits 

produced by debt in disciplining managers must be measured against frictions created by 

debt. Second, the notion that dcbt plays a disciplining role is contradicted by the events of the 

last decade, which include both a dramatic increase in bank leverage (and risk) and the 

financial crisis itself. There is little or no evidence that banks' debt holders provided any 

significant discipline during this period. Third, many models that are dcsigned to attribute to 

debt a positive disciplining role completely ignore the potential disciplining role that can be 

played by equity or through alternative governance mechanisms. Fourth, the supposed 

discipline provided by debt generally relies upon a fragile capital structure funded by short 

term debt that must be frequently renewed. Whereas capital regulation is intended to reduce 

fragility, fragility is a necessary by-product of the purported disciplining mechanism. Finally, 

one must ask if there are no less costly ways to solve governance problems. 

Increased equity requirements would force or cause banks to cut back on lending and/or 

other socially valuable activities. First, higher equity capital requirements do not 

mechanically limit banks' activities, including lending, deposits taking and the issuance of 

liquid money-like, informationally-insensitive securities. Banks can maintain all their 

existing assets and liabilities and reduce leverage through equity issuance and the expansion 

of their balance sheets. To the extent that equity issuance improves the position of existing 

creditors and/or it may be interpreted as a negative signal on the bank's health, banks might 

privately prefer to pass up lending opportunities if they must fund them with equity. The 

"debt overhang" problem can be alleviated if regulators require undercapitalized banks to 

recapitalize quickly by restricting equity payouts and mandating new equity issuance. Once 

better capitalized, banks would make better lending and investment decisions and issuance 

costs would be reduced. 

The fact that banks tend to fund themselves primarily with debt and have high levels of 

leverage implies that this is the optimal way to fund bank activities. It does not follow that 

just because financial institutions choose high leverage, this form of financing is privately or 

socially optimal. Instead, this observed behavior is the result of factors unrelated to social 

concerns, such as tax incentives and other subsidies, and to frictions associated with conflicts 

of interests and inability to commit in advance to certain investment and financing decisions. 

High equity requirements will drive banking activities ji'om regulated to unregulated sectors 

and would thus be ineffictive or even harmful. First, in the run-up to the crisis, many 

activities and entities in the so-called "shadow banking system" relied on credit backstops 

and other commitments made by regulated entities. Thus, these activities and entities were, 

and continue to be, within regulators' reach. Second, defining on a continual basis the entities 

and activities that should be regulated will always be a challenge. It is far from elear that, 

given the tools already, and potentially, available to lawmakers and regulators, the challenge 

of effective capital regulation cannot be met. 

ii 
120 


79691.035

Recommendations 

Since, as we have argued, bank equity is not expensive, regulators should use equity 

requirements as a powerful, effective, andflexible tool with which to maintain the health and 

.lIability of the financial system. High leverage is not required in order for banks to perform 

all their socially valuable functions, such as providing credit and creating liquid securities. 

Not only does high leverage create fragility and systemic risk, it is in fact leads to distorted 

lending decisions. 

Regulators should use restrictions on equity payouts and mandate equity issuance to help 

banks, and to assure that they maintain adequate and high equity capitalization. If this 

presents a governance problem, such problems can be solved with the help of regulators. 

Prohibiting, for a period of time and for all banks, any dividends and other equity payouts, 

and possibly imposing equity issuance on a pre-specified schedule, is an efficient way to help 

banks build their equity capital quickly and efficiently without lcading to the contraction of 

credit. [f done under the force of regulation, withholding payouts or issuing additional equity 

wou Id not lead to negative inferences about the health of any particular bank. It would also 

alleviate the debt overhang distortion that might lead banks to reduce lending. 

If certain activities of the banking sec/or are deemed to require subsidies, then subsidies 

should be given in ways that alleviate market frictions and not through a system that 

encourages high leverage. Tax shields and implicit government guarantees subsidize debt 

financc and thus crcate a wedge betwecn the private incentives of the banks and social 

concerns. This policy is undesirable given the systemic risk and additional frictions brought 

about by high leverage. 

Better resolution procedures for distressedfinancial institutions, while necessmy, should not 

be viewed as alternatives to having significantly better capitalized banks. Since such 

procedures are not likely to eliminate the cost of financial distress, reducing the likelihood 

that a resolution procedure is needed is clearly important, and higher equity requirements are 

the most effective way to do so. 

Higher equity requirements are superior to attempts to fond bailouts through a "bailout 

fund" supported by bank taxes. While charging banks upfront could potentially remove the 

subsidy associated with bailouts, failure to properly adjust the tax to the risk of individual 

banks could create significant distortions, particularly excessive risk taking. Equity 

requirements, as a form of self-insurance where the bank backs up its liabilities more 

directly, would be priced by financial markets and be more effcctive in reducing the need for 

government intervention. 

• Approaches based on equity are superior to those that rely on non-equity securities such as 

long term debt or contingent capital to be considered part of capital regulation. Contingent 

capital, and related "bail-in" proposals, where debt is converted to equity when a trigger 

event occurs, are complicated to design and present many implementation issues. There is no 

compelling reason that the "debt-like" feature of contingent capital has social value. Simple 

approaches based on cquity are more effective and would provide more reliable cushions. 

iii 

79691.036

Table 2: Summary of Reasons and Critiques 

\Vould this "reason" Would this "reason" give 

"Reasons" given for why increased give incentives to bank incentives to bank From a public (!olicl:: [!ers[!cctive

equity capital requirements would be Is the statement true? managers to object to shareholders to object to legitimate reason for not signif

costly increased capital increased capital increasing capital requireme

requirements? requirements? 

Increased equity requirements would 

No. Equity can be added to 

the balance sheet without It should not, because it is 1t should not, because it is prevent banks from operating at the changing the bank's core false. false. No! It is talse. optimal scale. business. 

Increased equity requirements reduce the Yes if compensation It should not, because risk 

average ROE (Return on Equity) for Generally Yes. depends on ROE. is reduced and the value of No! This is irrelevant to value c

banks. equity would not change. 

Increased equity requirements would No. Changing the capital increase banks' total funding costs, 

because banks would be forced to use 

structure changes how risk It should not, because it is It should not, because it is No! It is false! 

more equity, which has a higher required 

is distributed but not the false. talse. 

rate of return. 

overall cost offunding. 

Increased equity requirements would Perhaps, but this depends No! Tax shields subsidize the use 

Yes, because shareholders but it makes no sense to encourag

decrease the size of the interest tax shields Yes. on their compensation beneflt from subsidies. since it generates negative externa

banks Can obtain through debt flnancing. and preferences. distortions. 

Increased equity requirements reduce No! Guarantees subsidize the use 

banks' ability to use cheap debt flnancing Yes. Yes if compensation is Yes\ because shareholders but it makes no sense to encourage 

that is subsidized by implicit government related to equity value. beneflt from subsidies. since it generates negative externa

guarantees. distortions. 

Increased equity requirements would 

It should not, because No! Claims that debt disciplines m

there are alternative ways reduce managerial discipline and thus Very unlikely to be true. No. to create effective are not supported by adequate theo

interfere with effective governance, empirical evidence. 

governance, 

No! Better capitalized banks hav

Increased equity requirements would lead retained earnings for lending; any 

banks to restrict lending if they perceive Possibly true. Perhaps. Perhaps. impact of equity issuance or p

their equity to be under-valued. restrictions can be mitigated by r

discretion, 
122 


79691.037

Debt Overhang and Capital Regulation 

Anat R. Admati 

Peter M. DeMarzo 

Martin F. Hellwig 

Paul Pfleiderer * 

March 23, 2012 

• Admati, DeMarzo and Pfleiderer are from the Graduate School of Business, Stanford University; Hellwig is from 

the Max Planck Institute for Research on Collective Goods, Bonn. We are grateful to Mary Barth, Rebel Cole, 

Hamid Mehran, Steve Ross, Chester Spat!, and Jeff Zwiebel for useful discussions and comments. 

Contact information: 

admati@stanford.edu; demarzo peter(a)gsb.stanford.edu; hellwig@coll.mpg.de; pfleider@stanford.edu. 
123 


79691.038

Debt Overhang and Capital Regulation 

Anat R. Admati, Peter M. DeMarzo, Martin F. Hellwig, and Paul Pfleiderer 

Abstract 

We analyze shareholders' incentives to change the leverage of a firm that has already 

borrowed substantially. As a result of debt overhang, shareholders have incentives to resist 

reductions in leverage that make the remaining debt safer. This resistance is present even without 

any government subsidies of debt, but it is exacerbated by such subsidies. 

Our analysis is relevant to the debate on bank capital regulation, and complements 

Admati et al. (2010). In that paper we argued that subsidies that favor debt over equity are the 

key reason that banks funding costs would be lower if they "economize" on equity. Subsidies 

come from public funds, and reducing them does not represent a social cost. It is thus irrelevant 

for assessing regulation. Other arguments made to support claims that "equity is expensive" are 

flawed. 

Like reduction in subsidies, the effects of leverage reduction on bank managers or 

shareholders do not represent a social cost. In fact, we show that debt overhang creates 

inefficiency, since shareholders would resist recapitalization even when this would increase the 

combined value of the firm to shareholders and creditors. Moreover, debt overhang creates an 

"addiction" to leverage through a ratchet effect. In the presence of government guarantees, the 

inefficiencies of excessive leverage are not fully reflected in banks' borrowing costs. 

Since banks' high leverage is a source of systemic risks and imposes costs on the public, 

resistance to leverage reduction leads to social inefficiencies. The main beneficiaries from high 

leverage may be bank managers. The majority of the banks' shareholders, who hold diversified 

portfolios and who are part of the public, are likely to be net losers. Our analysis highlights the 

critical importance of effective capital regulation and high equity requirements, especially for 

large and "systemic" financial institutions. 

We analyze shareholders' preferences when choosing among various ways leverage can 

be reduced. We show that, with homogeneous assets, if the firm's security and asset trades have 

zero NPV, and the firm has a single class of debt outstanding, then shareholders find it equally 

undesirable to deleverage through asset sales, pure recapitalization, or asset expansion with new 

equity. When these conditions are not met, shareholders can have strong preferences for one 

approach over another. For example, if the firm can buy back junior debt, asset sales are the 

preferred way to reduce leverage. This preference for asset sales, or "deleveraging," can persist 

even if such sales are inefficient and reduce the total value of the firm. 

Keywords: capital regulation, financial institutions, capital structure, "too big to fail," systemic 

risk, bank equity, debt overhang, underinvestment, recapitalization, deleveraging, bankruptcy 

costs, Basel. 

JEL classifications: 021, 028, 032, 038, H81, K23. 
124 


79691.039

A Non-Technical Summary of ResuIts and Policy Implications 

In a previous paper entitled "Fallacies, Irrelevant Facts and Myths in the Discussion of Capital 

Regulation: Why Bank Equity is Not Expensive," we reviewed arguments elaiming that substantial 

increases in capital requirements would be costly for the economy. I In the context that is relevant to 

regulation, we showed that these arguments are invalid. Some of them rest on confusions about how debt 

and equity are priced in financial markets. Others involve confusing the bank's private costs, which are 

distorted by government subsidies to debt, with the true economic costs that are relevant for the economy. 

The high leverage of large financial institutions imposes significant negative externalities by 

increasing the fragility of the financial system. However, given subsidies to debt funding, and a (flawed) 

focus on raw return on equity, banks have incentives to maintain excessive leverage. 

Summwy ()fResulls 

In this paper we show that, due to the effect of debt overhang, shareholders and managers of 

highly leveraged banks would not find it in their interest to reduce leverage. Leverage reduction benefits 

existing creditors and anyone providing guarantees to the debt. Resistance to leverage reduction can 

persist even if the total value of the bank might increase, thus creating an inefficiency. This inefficiency 

does not depend on the presence of debt subsidies. Rather, it involves a fundamental conflict of interests 

between incumbent shareholders on the one hand and debt holders and possibly taxpayers on the other. 

When high leverage imposes negative externalities on third parties, the resistance to leverage 

reduction creates social inefficiencies. In the banking regulation context, in fact, the main beneficiaries 

may bc bank managers. The majority of the banks' shareholders, who hold diversified portfolios and who 

are taxpayers and part of the public, are likely to be net losers. 

For all firms, debt overhang effect creates an "addiction" to leverage through a ratchet effect. In 

the presence of debt overhang, shareholders would not voluntarily reduce leverage even when this would 

increase the total value of the firm. By contrast, shareholders may choose to increase leverage if they can 

legally do so. In the absence of government guarantees, these inefficient distortions and contlicts might be 

mitigated through covenants in debt contracts. Inefficiencies that could not be addressed in this way 

would be reflected in the cost of borrowing. With government guarantees, however, debt holders have 

fewer incentives to address these problems through covenants, and the inefficiencies associated with 

excessive leverage are not fully reflected in the cost of debt. 

We examine three ways a bank can reduce its leverage. Pure recapitalization involves buying 

back debt using new equity, without changing the assets held by the bank. Alternatively, leverage can be 

reduced by selling assets and using the proceeds to buy back debt ("deleveraging"), or by issuing new 

equity and acquiring new assets. We show that under some conditions, shareholders are indifferent among 

these approaches to reducing leverage; all are equally undesirable. For example, if there is one class of 

debt, and asset sales or purchases do not, by themselves, generate value or change the risk of the assets, 

I In banking jargon the misleading phrase "hold more capital" is often used instead of the much more accurate 

"funding with more equity." This misleading phrase leads many to believe that "holding" capital is similar to 

holding idle reserves. Nothing could be further from the truth, since capital (equity) concerns how assets are funded. 

not what assets are held. 
125 


79691.040

then all three approaches to leverage reduction lead to the same loss for shareholders. Asset sales, 

however, are the preferred way to reduce leverage in a number of situations. One example is when there 

are multiple classes of debt and shareholders can repurchase the most junior classes. In this case, debt 

buy backs financed by asset sales create a wealth transfer from senior debt holders to shareholders. Such 

preference for "de1everaging" can persist even if such sales are inefficient and reduce the total value of 

the bank to its investors and to the economy. 

Policy Implications 

Debt overhang creates distorted incentives and conflicts of interests with respect to reductions in 

leverage. Specitically, bank managers have incentives to make decisions that are in direct conflict with 

creditors and the public, and which may not even be in the combined interest of the banks' investors. This 

highlights thc critical importance of regulation. 

The hannful effects of debt overhang, which can include reduction in lending when banks are 

distressed, are created by high leverage. The inefficiencies can be reduced if banks are funded with 

significantly more equity on a regular basis. This calls for much higher equity requirements. This is 

particularly important for large banks that are "systemic," because market participants would not address 

the inefficiencies in the presence of government guarantees. 

The analysis in this paper reinforces the conclusions of our previous paper that equity 

requirements significantly higher than those currently considered would provide large social benefits at 

little if any social cost. The studies that have been put forth to support the specific Basel 1Il "numbers" are 

flawed. For example, by treating the required return on equity as fixed, or neglecting the inefficiencies, 

distortions and externalities that high leverage generates, the studies over-estimate the cost of equity 

requirements and ignore some of their benefits. 

If banks "deleverage" through asset sales, or avoid making loans due to debt overhang, lending 

may be reduced inefficiently. If this is a concern, regulators should limit banks' discretion. Rather than 

targeting a ratio, the focus should be on restricting payouts that deplete equity, and possibly mandating 

specific amounts of new equity, e.g., through rights offering. Such actions would make sure banks have 

sufficient funds to make worthy loans even as they become better capitalized.' 

Conflicts of interests similar to those analyzed here give incentives to bank managers to make large 

cash payouts such as dividends and share buybacks that maintain high leverage and harm creditors and 

the public. Cash paid to shareholders or managers is no longer available to pay creditors. European 

countries whose banks are clearly in distress should have banned such payouts long ago. Similarly, recent 

decisions by the Federal Reserve to allow most large US banks to increase their payouts before even 

reaching Basel III levels were misguided. Some of these banks face significant riskS and would impose 

large costs on the economy if they became distressed. By contrast, a useful approach was recently used by 

the Bank of England's Financial Stability Committee, which pressed UK banks to issue new equity in 

order to pay bonuses to executive, rather than using cash. 

2 Our discussion does not distinguish assets by their contribution to risk and focuses on leverage measured as equity 

to total assets. The impact of capital requirements can be distorted by the use of risk weights that bias banks' 

decisions away from traditional lending and create other risks. For example, bank managers compensated on the 

basis ofRGE have strong incentives to bias their investments away from !ending and towards risky investments such 

as sovereign debt that have low regulatory risk weights but have a higher yield to compensate for their actual risk. 

ii 
126 


79691.041

WRITTEN TESTIMONY 

OF 

TERRENCE A. DUFFY 

EXECUTIVE CHAIRMAN and PRESIDENT 

CME GROUP INC. 

BEFORE THE 

FINANCIAL INSTITUTIONS AND CONSUMER CREDIT SUB-COMMIITEE AND THE INSURANCE, 

HOUSING AND COMMUNITY OPPORTUNITY SUB-COMMITTEE 

November 29,2012 

Chairwoman Capito, Ranking Member Maloney, Chairwoman Biggert and 

Ranking Member Gutierrez thank you for the opportunity to testify on the Federal 

Reserve Board, FDIC and OCC regulatory capital rules implementing the Basel III 

Interim Capital Framework. I am Terry Duffy, Executive Chairman and President 

of CME Group, whose clearing house division of the Chicago Mercantile 

Exchange Inc. ("CME or CME clearing") is among the largest central counterparty 

("CCP" or "clearing house") clearing services in the world. I CME provides 

clearing and settlement services for exchange-traded contracts as well as for overthe-counter ("OTC") derivatives. In 2011, CME processed and cleared 

approximately 3.4 billion contracts. In its capacity as a clearing house, CME is 

III CME Group Inc. is the holding company for four exchanges, CME, the Board of Trade of the City of Chicago Inc. 

("CBOr), the New York Mercantile Exchange, Inc. ("NYMEX"), and the Commodity Exchange, Inc. ("COMEX") 

(collectively, the "CME Group Exchanges"). The CME Group Exchanges offer a wide range of benchmark products 

across all major asset classes, including derivatives based on interest rates, equity indexes, foreign exchange, 

energy, metals, agricultural commodities, and alternative investment products. The (ME Group Exchanges serve 

the hedging, risk management, and trading needs of our global customer base by facilitating transactions through 

the CME Group Globex electronic trading platform, our open outcry trading facilities in New York and Chicago, and 

through privately negotiated transactions subject to exchange rules. 

1 
127 


79691.042

registered with the Commodity Futures Trading Commission as a derivatives 

clearing organization ("DCO") and also has status as a Financial Services 

Authority Recognized Overseas Clearing House. In July 2012, CME was 

designated as a systemically important Financial Market Utility under Title VIII of 

Dodd-Frank. 

CME Group applauds the Federal Reserve Board, FDIC and OCC for 

deferring the final capital rules implementing the Basel III (BSCS 227) Interim 

Capital Framework. Both Dodd-Frank and the G-20 mandates aim to reduce 

systemic risk and increase transparency. Our concern is that Basel Ill's "one size 

fits all" rules for capital charges based on the risk of cleared derivatives is at odds 

with these objectives. 

The Basel interim framework treats all cleared derivatives as if they require 

margin to cover a five day period of risk. This means that highly liquid derivatives 

contracts that trade by means of a central limit order book and that may be quickly 

and efficiently liquidated without substantial risk are put into the same category as 

OTC contracts that are not liquid or transparently traded. This blanket 

categorization is unrealistic and market distorting. Derivatives clearing houses 

recognize this distinction and require margin levels based on periods of risk that 

are justified by the actual risks inherent in liquidating the positions. In the U.S. 

2 
128 


79691.043

this means one or two day periods of risk for futures and five day period of risk for 

less liquid swaps. The failure to base capital charges on properly measured risk 

may have the unintended consequence of encouraging the use of higher risk 

instruments. This is inconsistent with both Dodd-Frank and the G-20 policy goal 

to reduce risks in derivatives trading by moving from opaque to transparent 

markets. 

If the capital rules for bank holding companies diverge from the prudential 

rules at the clearing level for Broker-DealerlFCM subsidiaries, consequential 

market distortions will follow. If clearing houses properly set margins for liquid 

derivatives to cover a one day risk period while banking regulators impose a 

capital charge based on five days, banks and their affiliated brokers, will be 

required to take a capital charge measured by the difference between the prudential 

clearing level margin for futures and the presumptive Basel III five day period of 

risk margin. The cost of the capital will be passed on to customers trading liquid 

products in the form of a demand for higher collateral or higher fees. Once again, 

contrary to Dodd-Frank. This may distort customers' product choices. Customers 

may move away from trading liquid exchange traded derivatives. There is a 

potential that central limit order book exchange-traded products could be more 

3 
129 


79691.044

expensive. The last thing we want to do is drive customers back into an opaque 

OTC market because of a "one size fits all" margin period. 

Basel III's "one size fits all" margin period of risk is also inconsistent with 

international standards, e.g., CPSS-IOSCO Principles for Financial Market 

Infrastructures followed by the CME and other qualified CCPs. Those standards 

recognize that margin levels should correspond to risk and liquidity profiles, and 

unique attributes of each product and market, and that margin periods of risk will 

vary among products based on these differing characteristics. 

Liquid central limit order book-traded and cleared derivatives, unlike OTC 

swaps, are standardized, have transparent pricing, and trade in deep liquid markets. 

They turn over almost 10 times more frequently than OTC swaps. Those 

characteristics permit rapid offset, liquidation or hedging in the event of an 

emergency. Broad participation within the exchange-traded derivatives market 

further demonstrates efficient position and risk management in these events. For 

example, following the bankruptcy of Lehman Brothers Inc. in 2008, CME took 

control of Lehman's proprietary positions and liquidated the portfolio the same 

day, with a liquidation value well within the portfolio's $2.3 billion margin 

requirement. 

4 
130 


79691.045

CME also maintains extensive historical price data that further demonstrates the 

adequacy of data used in establishing margin levels and the appropriate exposure 

period to capture. For instance, we maintain price data for some of the most liquid 

exchange traded products dating back to 1982 for the first S&P 500 index contract, 

1981 for Eurodollar futures, and 1977 for the first Treasury bond futures contract. 

There is no risk management benefit to banks, their affiliated brokers, or the 

financial system by imposing capital charges on them beyond the clearing level 

margin period of risk established for these liquid contracts. 

CME Group has expressed these concerns in the comments filed during the 

Agencies rule-making2

, in discussions with Federal Reserve Board staff, and in a 

joint letter to the Financial Stability Board, the Basel Committee on Banking 

Supervision and other standard setters from CME and 11 other exchanges located 

, See attached letter to OCC, FED and FDIC dated October 22, 2012 

Regulatory Capital Rules: Standardized Approach for Risk-weighted Assets; Market Discipline 

and Disclosure Requirements (OCC Docket ID OCC-2012-0009'FRB Docket No, R-1442' FDIC RIN 

3064-AD96) 

Regulatory Capital Rules: Advanced Approaches Risk-based Capital Rule' Market Risk Capital 

Rule (OCC Docket ID OCC-2012-0010;FRB Docket No. R-1442;FDIC RIN 3064-AD97) 

5 
131 


79691.046

in each of the Americas, EMEA and APAC. 3 The World Federation of Exchanges 

has also raised concerns in a separate letter to them. 4 

The Agencies capital rules should be amended to eliminate the addition of four 

days of capital on top of one day margin for exchange traded derivatives. It should 

be replaced with an approach consistent with the CPSS-IOSCO Principles 

recognizing that adequate margin periods vary and will be set based on the 

liquidity, transparency and other risk-reducing characteristics of each product and 

market. 

Thank you for the opportunity to appear before you today. 

3 See attached Joint Letter to FSB, BCBS, CGFS and CPSS dated November 27,2012 

4 See attached WFE letter dated November 27, 2012. 

6 
132 


79691.047

i)CMEGroup 

VIAE-MAil 

October 22,2012 

Office of the Comptroller of the Currency 

2S0 E Street, SW 

Mail Stop 2-3 

Washington, DC 20219 

regs, co mments@o£c,treas,gov 

Ms. Jennifer J. Johnson 

Secretary 

Board of Governors of the Federal Reserve System 

20th Street and Constitution Avenue, NW 

Washington, DC 20551 

regs.comments@fl'cteralreserve.gov 

Mr, Robert E. Feldman 

Executive Secretary 

Federal Deposit Insurance Corporation 

550 17th Street, NW 

Washington, DC 20429 

com ments(w FDICgov 

Re: Regulatory Capital Rules: Standardized Approach for Risk-weighted Assets; Market Discipline 

and Disclosure Requirements (OCC Docket 10 OCC-2012-0009; FRB Docket No. R-1442; FDIC RIN 

3064-AD96) 

Regulatory Capital Rules: Advanced Approaches Risk-based Capital Rule; Market Risk Capital 

Rule (OCC Docket 10 OCC-2012-0010; FRB Docket No. R-1442; FDIC RIN 3064-AD97) 

ladies and Gentlemen: 

CME Group Inc, ("CME Group"), on behalf of the Chicago Mercantile Exchange Inc. ("CME Inc.") clearing 

house division ("CME Clearing" or "CME") appreciates the opportunity to comment on the proposed 

regulatory capital rules that the Office of the Comptroller of the Currency ("OCC), Board of Governors 

of the Federal Reserve System ("Board"), and Federal Deposit Insurance Corporation ("FDIC") 

(collectively, the "Agencies") published in severa! notices of proposed rulemakings ("NPRs") in the 

Federal Register on August 30, 2012, CME is among the largest central counterpartv ("CCP") dearing 

services in the world. CME provides clearing and settlement services for exchange-traded contracts as 

well as for over-the-counter ("OTC") derivatives' In 2011, CME processed and cleared approximately 3.4 

1 eME's parent company ((ME Group Inc.) operates four separate exchange5, including (ME, the Board of Trade ofthe City of 

Chicago, Inc, ("CBOT"), the New York Mercantile Exchange, loc, ("NYMEX"t and the Commodity Exchange, Inc, ("COMEX") 

(collectivefy, the "(ME Group Exchang.es"), The (ME Group Exchanges offer a wide range of benchmark products across all 
133 


79691.048

October 22, 2012 

Page 2 

billion contracts, averaging 13.4 million contracts per day. In its capacity as a CCP, CME is registered with 

the Commodity Futures Trading Commission ("CFTC) as a derivatives clearing organization ("OCO") and 

also has status as a Financial Services Authority Recognized Overseas Clearing House. 

On July 18, 2012, the Financial Stability Oversight Council designated CME Inc, as a systemically 

important financial market utility ("designated FMU") under Title VIII of the Dodd-Frank Wall Street 

Reform and Consumer Protection Act ("Dodd-Frank Act"). Provisions within section 805 of the DoddFrank Act, enacted by the Board through Regulation HH Designated Financial Market Utilities 

("Regulation HH"), require the Board to promulgate risk management standards for designated FMUs. 

Regulation HH grants authority to the CFTC to act as CME's designated Supervisory Agency and prescribe 

regulations that integrate the CPSS-IOSCO Principles for Financial Market Infrastructures ("PFMls") and 

existing prudential requirements when designing risk management standards_ To recognize the systemic 

protections and robustness of designated FMUs who adhere to the I'FMls ("Qualified CCI''' or "QCCI'''), 

the NPRs invite capital incentives for exposures to a Qualified CCP relative to a non-Qualified CCP. 

This response focuses on certain elements of the proposed capital framework that stand to motivate 

and influence the expansion of central counterparty clearing for derivatives. Bank capitalization 

requirements are a critical and fundamental element of the overall financial regulatory system. 

Consequently, the decisions of the Agencies concerning the capitalization framework will have a 

material impact on the evolution of central clearing. We believe it is particularly important that CME and 

other CCPs provide meaningful feedback to the Agencies at a time when crucial decisions over the 

future of financial regulation are being formulated. 

CME recognizes the Agencies have largely adopted international capital standards proposed by Basel 

Committee on Banking Supervision ("BCBS"). CME actively participated in each consultative process 

administered by the BCBS related to Capital requirements for bank exposures to central counterpartie,. 

Within our responses' we advocated for a framework that assures greater transparency, safety and 

efficiency in the global financial markets and encourages greater utilization of CCPs by market 

participants. However, we also raised several fundamental concerns related to the capitalization of 

exposures to CCPs that we believe will critically influence the migration towards central clearing. 

To efficientfy implement the objectives stated by the G20 and installment provisions of the Dodd-Frank 

Act and the European Market Infrastructure Regulation ("EMIR"), CME and important market 

participants across key jurisdictions agree that certain aspects of the proposed capital framework may 

require further refinement to properly reflect the risk management benefits of CCP clearing. 

I'rovided below are targeted responses to certain inquiries and recommendations of the NPRs. With 

acknowledgement to footnote 42 of the Standardized Approach NI'R, our comments reflect the 

expected inclusion of provisions stated in BCBS227 ("BCBS interim framework"). 

major asset classes:, including dedvatives: based on interest r.3tes, equity indell;es, foreign exchange, energy, metals, agricultural 

commodities~ and alternative investment products. The eMf Group Exchanges. serve the hedging, risk man~gernent. a.nd 

trading needs of our global customer ba.s.e by facilitating transactions through the (ME Gfobex electronk trading platform. our 

open outcry trading facilities in New York and Chicago, and through privately negotiated transactions. 

'- CME Group res.ponse to BCBS206 ihttp://www,his,urglpublfbc:bs206!cme.QQf), BCes.190 

(b!.t!1lL;,~l'i!!Li!tt"QrJt!l'lgQljbcbsl~pj"n:!tll;r\"mQdJJ and BCBS164 (IJl!Q;[bL'ArW"bi!.&mIs!vJ:tILb.£gH~;'iJ£m];_~f9"PJ'df) 
134 


79691.049

October 22, 2012 

Page 3 

I. Capitalization of Bank Exposures to Central Counterparties 

Question 12 of the Standardized Approach NPR and Question 5 of Advanced Approaches and Market 

Risk NPR request comment on whether the proposal provides an appropriately risk sensitive treatment 

of (11 a transaction between a banking organization that is a clearing member and its client and (2) a 

clearing member's guarantee of its client's transaction with a CCP treating these exposures as aTC 

derivative contracts. 

The Agencies also reguest comment on whether the adiustment of exposure amount would address 

possible disincentives for banking organizations that are clearing members' to facilitate the clearing of 

their clients' transactions. What other approaches should the Agencies consider? 

Recommendation 111: To acknowledge certain practices and efficiencies afforded by central dearing, 

we support the recognition of shorter close-out periods for cleared transactions. We further 

encourage the Agencies to recognize varying close-out period conventions for specific cleared 

products that are commensurate with the risks, liquidity profiles, applicable dose-out periods and 

further characteristics of these products as accredited within the CPSS-IOSCO Principles for Financial 

Market Infrastructures. 

CME agrees that the final rules should incorporate shorter close-out periods for certain cleared and 

cleared-only derivative transactions relative to un-cleared bilateral transactions. To provide greater 

harmonization among various regulatory standards applicable to CCP clearing, we further recommend 

the Agencies utilize close-out period assumptions commensurate with the risks, liquidity and 

transparency, market composition and concentration characteristics of products that already exist in a 

cleared environment, relative to products recently introduced to centralized clearing. CME believes the 

BCBS interim framework's blanket assignment of a 5-day margin period of risk ("MPOR") for all cleared 

transactions lacks appropriate consideration for exchange traded derivatives and certain products that 

exemplify analogous features ("ETDs"), for instance, that exist in a central limit order book environment 

with substantial transaction volumes. with 

). The NPRs make multiple references to banking organizations as dearing members. To date, eME has not accepted U.S, 

insured depOSitory institutions as clearing members due to certain issues arising from the Federal Deposit Insurance 

Corporation's receivership and conservator:;hlp procedures. SpecificaUy. we understand that aU cQunterparties of a bank.-

induding any CCP that has. accepted the bank as a clearing member -.are subject to a one~busine5s day stay in insolvency. We 

recommend an exception to this stay for CCPs. This would be consistent with the exception for clearing organizations in the 

Orderly Liquidation Authority provis.ions of Dodd-Frank Act, which states: 

... if the receiver foils to satisfy any such margin, col/ateral, or settlement obligatians under the rules r>f the 

clearing organization, the clearing organization shaJJ have the immediate right to exercise, and shoJI not be 

stayed jrom exercising. all oj its rights and remedies under its rules and (}pplicable low with respect to any 

qualified financial contract oj the covered financial company, including, without limitation/, the right to 

liqUidate all positions Olld coJloteral oj such covered financial company under the company's qualified 

fincmcial contracts, and suspend or ce(lse to oct jar such cOl/ered financial company, 011 in accordance with 

the rules of the clearing organization. 

§ 21O(c)(8)(G). We al,o note that the Committee 00 Payment and Settlement Systems' ("CPSS") and Technical Committee of the 

International Organization of Securities Commi5sjons~ ("IOSeO") April 2012 Principles for Financial Market Injra~tructl.lres 

(,'PFMlslf) provide that a Financial Market Infrastructure l''fMI''') (a term that includes (CPs) "should have a high degree of 

certainty that {actions taken under its default rules] will not be VOided, reversed, or 5ub)ect to stays, including with respect to 

rao/utlon regimes appricable to its panicipants. Ambiguity about the enforceability of procedures could delay and pos.sibly 

pre .... ent an FMI from taking actions to fulfill its obligations to non~defaulting participants or to minimize its potentiallosses<" 

See paragraph 3.1.9 (emphasis added). 
135 


79691.050

October 22, 2012 

Page 4 

I. Capitalization of Bank Exposures to Central Counterparties, cont. 

commensurate historical price and liquidity characteristics that demonstrate a shorter dose-out period 

is appropriate. 

For instance, the evaluation of the market depth and product turnover draws further distinction 

between ETOs and over-the-counter ("OTC") derivatives. A TABB Group study' performed in 2010 

indicated that ETOs turned OVef almost 10 times more frequently than OTC derivatives over the course 

of a year, with OTC derivative notional values turning over 2.7 times per year whereas ETOs notional 

values turned over 25 times per year. In addition to the higher notional turnover demonstrated by the 

ETD market, the study further notes transaction volumes of 3 billion in the ETO market versus 16 million 

in the OTe market. 

Moreover, the clearing for ErOs is characterized as "positional" in nature as compared to the 

"transactional" nature of clearing for OTC derivatives. Positional-based dearing provides natural and 

automatic compression for long and short positions of the same contract that are novated into a single 

open position whereas transactional-based clearing maintains each open trade as an individual gross 

position. Although compreSSion is available for some market participants in the orc cleared 

environment, it remains a highly specialized and at times manual process that may challenge the 

efficiency for porting and liquidation. Therefore, the more compressed nature of ETOs provides greater 

efficiency, transparency and access to price and volume information in liquidation scenarios due to the 

breadth of the central limit order book. This further motivates and allows access to a broader group of 

market participants to partake in auctions whereby they can efficiently manage or liquidate the resulting 

exposure. As of 2010 the Tabb Group study estimates the number of market participants in the ETO 

market to be 5 million as compared to 30,000 in the OTe market. 

Further, broad market participation within the ETO market further demonstrates efficient management 

of positions in both stressed and default scenarios. CME has encountered several scenarios in which 

large central limit order book product portfolios were liquidated in less than one day at a cost within 

margin requirement. For example, follOWing the bankruptcy of Lehman Brothers Inc. in 2008, CME took 

control of Lehman's positions and conducted an auction that was completed the same day with a 

liquidation value well within the portfolios' $2.3 billion USO margin requirement. 

CME maintains extensive historical price data that further demonstrates the adequacy of data in 

establishing margin levels and the appropriate exposure period to capture. For instance, we maintain 

price data for some of the most liquid exchange traded products dating back to 1982 for the first S&P 

500 index contract, 1981 for Eurodollar futures, and 1977 for the first Treasury bond futures contract. 

With regard to daily volume, eME's Eurodollar, S&P and Treasury contracts combine for an average daily 

volume of approximately 7 million contracts in 2012, accounting for approximately 60% of CME's total 

average dally volume.' 

-= A TABB Group Study: The Global Risk Transfer Marker. Developments in ore and Exch(Inge~Traded Derivatives, November 

2010 

'CME Group data October 19, 2012 YTD 
136 


79691.051

Octo ber 22, 2012 

Page 5 

I. Capitalization of Bank Exposures to Central Counterparties, cont. 

With consideration to the above arguments, we recommend the Agencies provide greater consideration 

to the distinct characteristics of ETDs in establishing the appropriate MPOR and agree that for cleared 

swaps that aforementioned certain liquidity characteristics of ETDs a 5·day MPOR is appropriate. 

In addition to demonstrable characteristics evidencing shorter close·out periods for ETDs, we call further 

attention to international gUidance issued by CP55·IOSCO and adopted by the Fed through Regulation 

HH with regard to designated FMU's adherence to the PFMls. Consistent with key considerations 

detailed in Principle 6: Margin of the PFMls, CME prescribes initial margin requirements that are, along 

with additional risk·based considerations, commensurate with the risk, liquidity, and close-out periods 

applicable to the variety of products and asset classes transacted on our exchanges. As described in 

Principle 6: Margin Requirements 3.6.3 " ... OTC deriyatives require more-conservative margin models 

because of their complexity and the greater uncertainty of the reliability of price quotes. Furthermore, 

the appropriate close·out period may vary among products and markets depending upon the product's 

liquidity, price and other characteristics." 

Further consistent with Principle 6: Margin Close·out period 3.6.7/ in establishing initial margin 

requirements, CME provides extensive consideration to historical price and liquidity data that are 

further stressed and meticulously back·tested to ensure the appropriate exposure period is adopted. 

Proper appreciation for certain products that demonstrably adhere to the PFMls and demonstrate a risk 

profile that does not require a S·day MPOR would ensure that capital diSincentives aren't introduced 

that undermine the efforts and sensible conclusions of other broad-based regulatory efforts (not least 

the Dodd·Frank Act and EMIR). As currently proposed, the capital framework appears inconsistent with 

various frameworks governing margin requirements for cleared exchanged-traded derivatiyes and 

therefore invites disproportionate capital requirements that are in conflict with clearing incentives. 

The Agencies may attach confidence in the applied methodologies through a CCP's adherence to the 

PFMls that, among other considerations, prescribe stringent confidence intervals, exposure coverage, 

back-testing analysis and independent model validations for margin models. CME notes that adherence 

to such principles, in addition to other PFMls, is necessary to be considered a Qualified CCP, a 

designation we aspire to achieve. 

7 PFMI Principle 6: 3.6.7. Clos.e~out period. A C(P should select an appropriate dose-out period for each product that it dears. 

and document the dose-·out pe:riods. and related analysis fOf each product type. A CCP Should base its determination of the 

dose-out periods for its initial margin model upon historical price and liquidity data~ as welt as reasonably foreseeable events In 

a default scenario. lhe: dose-out period should account for the impact of a participant's derault on prevailing market 

conditions. Inferences about the potential impact of a default on the dose-out period should be based on historical adverse 

f!:vents in the product cleared, such as Significant reductions in trading or other market dislocations. The dose-out period should 

be based on anticipated close-out times in stressed market conditions but may also tatke into account a CCP's abHitv to hedge 

effectively the defaulter's portfono. Further, close-out periods should be set on a product-s.pecific basis because less~liquid 

products might require signifiuntiv longer dose-out periods. A CCP should also consider and address position concentraUons. 

which can lengthen dose-out timeframes and add to price volatility during close outs. 
137 


79691.052

October 22, 2012 

Page 6 

I. Capitalization of Bank Exposures to Central Counterparties, cont. 

Question 13 of the Standardized Approach NPR and Question 6 of the Advanced Approaches and Market 

Risk NPR request comment on the proposed calculation of risk-based capital requirements for exposures 

to a QCCP. The Agencies question if there are specific types of exposures to certain gccps that would 

warrant an alternative risk-based capital approach. 

Recommendation 112: To acknowledge the protections afforded to client accounts under regulations of 

the SEC and CFTC and to further distinguish additional client protections asserted by certain account 

structures, we request the Agencies confirm, through adoption, the stated eligibility criteria as 

provided for on page 52906 and 52988 of the Standardized Approach NPR and Advanced Approaches 

and Market Risk NPR, respectively. 

Throughout the NPRs the Agencies draw distinction between typical CCP account structures where the 

clearing member acts as a financial intermediary ("principle model") and where the clearing member 

guarantees the performance of the client ("agency moden. As referenced in prior comment letters, 

greater credence should be afforded to QCCPs that employ an agency model whereby the clients' trades 

are effectively a trade between the client and the CCP, not least to appreciate the dient protection 

scheme promulgated by the SEC and CFTC. in the event of a clearing member default, the structure of 

an agency relationship between the clearing member and its clients would facilitate various operational 

efficiencies including, but not limited to, the protection and portability of client positions and collateral. 

This agency relationship is fundamental to the operation of CME and is imbued throughout the rules of 

CME Group and the Commodity Exchange Act as well as the regulations of the CFTC. 

CME supports the Agencies' statement within the preamble that the omnibus account structure in the 

United States would satisfy thiS requirement due to customer protections afforded under existing 

Securities and Exchange Commission ("SEC) and CFTC regulations including the CFTC's Part 190 

Bankruptcy Rules (17 C.F.R. Part 190). To provide further clarity and provide assurance, we request the 

Agencies explicitly adopt the preamble's position in the final standards, 

Recommendation #3: To recognize the distinction among the various components of trade exposure, 

we recommend the Agencies decouple the link between risk weights assigned to collateral trade 

exposure and those assigned to other components of trade exposure. 

Under proposed sections _35(b)(3)(i} and _133(b)(3)(i), if collateral posted to a QCCP by a client is not 

protected from losses in a joint default scenario, the client's entire trade exposure-including collateral, 

current exposure, and potential future exposure-is ineligible for the 2 percent risk weight. CME 

believes that this result improperly conflates collateral-related exPosure with other components of 

trade exposure. While protections against joint default may affect the safety of client collateral, such 

protections are demonstrably disconnected from the risk associated with current credit exposure and 

potential future exposures. Accordingly, CME recommends that the AgenCies decouple the risk weight 

for client collateral from the risk weight for other components of a client's trade exposure. 

, L 
138 


79691.053

October 22, 2012 

Page 7 

II. Capitalilation of Default Fund Contributions to Central Counterparties 

Question 13 of the Standardized Approach NPR and Question 6 of the Advanced Approaches and Market 

Risk NPR request comment on the proposed calculation of risk·based capital requirements for exposures 

to a QCCP. The Agencies question if there are specific types of exposures to certain QCCPs that would 

warrant an alternative risk-based capital approach. 

Recommendation 114: To recognile the robust and proven risk management models employed by 

Qualified (CPS, compliant with CPSS-IOSCO Principles for Financial Market Infrastructures and onward 

by prudential regulators, the Agencies should permit Qualified CCPs to apply approved Internal 

Models to quantify exposures related to CCP default fund contributions. 

CME continues to champion the installation of a risk sensible approach to quantify capital requirements 

arising from clearing member default fund contributions. This position is supported by overwhelming 

industry feedback and by initial results of Quantitative Impact Studies administered by the BCBS. The 

current framework should be recalibrated to best appreciate the lIarying structures, practices, credit 

quality and financial resources afforded by a Qualified CCP. The primary components employed by CCPs 

to mitigate counterparty credit exposures, in addition to enterprise risk management practices, are 

funded initial margin, variation margin and clearing member default fund contributions; additionally, 

some CCPs contribute their own resources to the default waterfall, which should be taken into 

consideration as well (collectively, "aggregate CCP resources"). 

We were encouraged to hear the BCBS interim framework contemplated an alternative methodology; 

however we remain apprehensive that this method, method two, prudently considers aggregate CCP 

resources, a similar shortfall observed in superseded versions of method one, and might introduce 

incentives that are adverse to the intention of the capital standards. Similarly, we maintain that method 

one is risk insensitive and stands to create a variety of perverse incentives for clearing members to 

reduce both default fund contributions and margins or increase margins at the expense of reduced 

default fund contributions. 

We further understand that the BCBS and CPSS·IOSCO have formed a working group to reconsider the 

interim methodologies and other certain aspects of the BCBS interim framework. CME supports 

exploring alternative solutions and would encourage the opportunity to discuss and jOintly assess how 

each alternative translates into regulatory capital requirements to ensure a sensible and risk prudent 

measure is ultimately adopted. We encourage the Agencies to adopt a method that holistically considers 

the aggregate CCP resources (and corresponding conformance to the PFMls) to ensure fair consideration 

is accorded to CCPs that employ varying methodologies when sizing margin and default fund 

requirements. 

Consistent with the practices of the current bank capital framework, the Agencies should permit 

Qualified CCPs to utilize approved internal models. Further to QCCP adherence to the PFMls, the use of 

internal models could be conditioned on observance to applicable CFTC and SEC (or other applicable) 

regulations and supervisory requirements governing risk modeling. To the extent the Agencies require 

review of any QCCP internal models, the Agencies could arrange an examination in coordination with 

Title VIII designated FMU review procedures. Acknowledging certain QCCPs may not maintain a level of 

expertise to qualify for internal models, the Agencies could prescribe a fallback to the prevailing interim 

methodologies. 
139 


79691.054

October 22. 2012 

Page 8 

Ill. Additional Recommendation 

Recommendation #5: To better recognize acceptable collateral standards employed by certain 

Qualified CCPs, the Agencies should consider adjusting holding period assumptions under certain 

models to better align with the liquiditv characteristics of such collateral. 

The standard supervisory market price volatility haircuts described in the Standardized Approach NPR, 

as originaUy designed for the bilateral market, however, applicable to certain cleared transactions, 

prescribes a 10-day holding period assumption in computing the applicable haircut. We are concerned 

that these haircuts lack consideration to the profile and characteristics of collateral polkies adopted by 

CCPs and that are further governed by pnudential regulation. For example, the overwhelming majority of 

collateral on deposit at CME can be liquidated to cash on a same day baSis under stressed market 

scenarios. CME routinely conducts liquidation drills with qualified, independent third parties to assess 

the liquidity profile of its collateral holdings. To complement our liquidity resources, CME maintains a 

committed, secured credit facility sized with consideration to assets that could challenge same day 

liquidation in a stressed market environment. The facility gives CME access to proceeds of a draw within 

60 minutes of borrowing. Additionally, CME contracts with liquidation agents to facilitate prompt 

liquidation of collateral in a clearing member default. We therefore request the Agencies consider 

adjusting the holding period assumptions or allow CCPs to utilize alternative methods to compute 

appropriate haircuts for cleared transactions. 

CME recognizes that the standard haircut schedule was designed to achieve a balance between 

simplicity and risk-sensitivity. However, for instance, the standard supervisory haircut table assigns 

mutual funds the most punitive haircut applicable to any security in which the funds invest. For money 

market funds ("MMFs"), that generally invest in short-term government securities, certificates of 

deposit, commercial paper, and other low-risk securities, the haircut table could assign a 25 percent 

haircut that appears to discount the enhanced standards and criteria relative to other mutual funds. In 

the U.S., it is accepted market practice to utilize MMFs to meet margin reqUirements; however, punitive 

haircut treatment could invite collateral inefficiencies to clearing. The distinctive features of MMFs, as 

governed and further enhanced in response to the 2008 credit crisis by SEC rule 2a-7, B provide a 

principled basis to distinguish MMFs from all other mutual funds. 

We believe, the Agencies can effectuate this distinction without fundamentally altering the table. eME 

recommends that the Agencies bifurcate the "mutual funds" row of the standard supervisory haircut 

table into two rows, one labeled "money market funds" governed by SEC rule 2a-7 and the other labeled 

"other mutual funds." This treatment would parallel the current separation of equities into "main index 

equities" and "other publicly-traded equities." For MMFs, CME suggests a risk weight that reflects the 

cash-like characteristics of these instrUments. As a starting point, the Agencies might consider the 

haircut assigned by the Federal Reserve Discount Window to the instruments that money market funds 

II SEC Rule 2a-7 provides that MMFs. may invest only in securities rated in one of the two highest short-term rating categories or, 

if unrated~ of comparable quality to such securities; must invest at least 97 percent of their assets in securities rated in the 

highest short~term rating category or~ if unrated, of compa rable quality to such securities; must maintain a maximum weighted 

average maturity of 60 davs and a maximum weighted average life of 120 days; and cannot invest more than 0.5 percent of 

their total assets in securities of a single issuer that is rated in the second·highest short-term ratmg category or, jf unrated, of 

comparable quality to such securities. 

:\ I' 
140 


79691.055

October 22, 2012 

Page 9 

invest in, namely Certificates of Deposit, Bankers' Acceptances, Commercial Paper, and Asset Backed 

Commercial Paper (currently 3 percent).'o 

IV. Conclusion 

CME reiterates our support of the Agencies' efforts to provide greater incentives for central clearing, 

consistent with CPSS·IOSCO standards, and the need for careful evaluation of the motivations inspired 

by the proposed adjustments to the capital framework. 

CME would like to thank the Agencies for the opportunity to provide these comments. We would be 

happy to further discuss and clarify any of the above issues with agency staff. If you have any comments 

or questions regarding this submission, please feel free to contact Tim Doar, Managing Director and 

Chief Risk Officer by telephone at (312) 930-3162 or bye-mail at Tim,Doar@cmegroup.wn:!. 

Sincerely, 

--) 

/:I,j~! '0 ' 

Tim Doar 

Managing Director and Chief Risk Officer, CME Clearing 

Chicago Mercantile Exchange, Inc. 

20 South Wacker Drive 

Chicago, IL 60606 

10 CME also notes that the baseline 2S percent haircut proposed for corporate debt securities regardless of credit quality or 

maturity is unusuallv severe compared to the Agencies' existing rules and both existing and proposed international agreements. 

Under the Agencies' current Intern~I-Ratings-Based and Advanced Measurement Approaches rules, only beIDw·investment .. 

grade corporate debt receives a 25 percent haircut Short~term corporate debt that is investment grade currently receives a 

haircut in the low·to~mid single digits.. Likewise. under 8aselll/ Sase! m. and the recently-published BeSS consultative document 

Margin requirements fDr nDn·centrally~cJeored derivatives (july 2012)/ short4erm, high quality corporate debt is assigned 

standard supervisory haircuts In the low-to-mid single digits. 
141 


79691.056

CMEGroup M::=:= 

~MexDer NA5DAqQMX J.IiL NYSE 

.' EURONEXT 

SGX T~ 

November 27, 2012 

MarkCamey 

Chairman, Financial Stability Board IFSBj 

Stefa n Ingves 

Chairman, Basel Committee on Banking Supervision (BC8S) 

William Dudley 

Chairman, Committee on the Global Financial System (CGFS) 

Paul Tucker 

Chairman, Committee on Payment and Settlement Systems (CPSS) 

Masamkhi Kona 

Chairman, 10SCO Technical Committee 

Rf: BCBS 2Z7 Interim Capital Framework 

Dear Sirs: 

The undersigned represent derivatives e)Cchanges from jurisdictions across the world and a majority 

of the global exchange-traded derivatives (HO) market. We support the G-20 objeclives to 

strengthen the international financial system through regulatory reforms that will increase 

transparency in derivatives markets and reduce systemic risk. Although the weU~established and 

highly regulated ETD markets did not contribute to the financial crisisl there are countless aspects of 

the current regulatory reform framework that will impact our markets and our customers, 

International standard setters and regional and national regulators must make every effort to avoid 

unintended consequences and ensure an appropriate level of regulatory consistency across 

juris.dictions. These objectives are critical to preserving the price discovery and risk management 

benefits that liquid and transparent ElO products provide for wholesale financial markets and the 

broader economy. 

As described in detail below, we are concerned that provisions in BCSS 227 (Interim Capital 

Framework) that require capita! to cover a S-day margin period of risk (MPOR) for all cleared 

derivatives will significantly increase costs for ETDs and potentially make ETOs more expensive 

relative to cleared products that do not share the same Uquidily, transparency and other riskreducing characteristics. This result cuts directly against G-20 policy objectives to move opaque 

markets onto transparent trading venues. It is also inconsistent with the CPSS-IOSCO Principles for 

Financial Market infrastructure (PFMt), regional and national regulatory frameworks, and clearing 

house risk-management practices which all appropriately recognize that that ETDs are less risky and 

therefore should be eligible for less burdensome margin treatment than other derjvatives. 

Unfortunatelv, the Interim Capital Framework is near final implementation in many jurisdictions. 

We urge the fSB and relevant international standard setting bodies to act qUkkly to eliminate the 

inappropriate one-size-fits-all approach by modifying the blanket 5-day requirement for all cleared 

instruments before regional and national capital reqUirements are finalized. The Bces should 
142 


79691.057

consult with the industry and other standard setters to develop an alternative approach consistent 

with the PFMI and based on criteria reflective of the risk profile of the derivative product. 

We are cognizant that inconsistent or conflicting provisions under banking, derivatives or other 

international standards have and will inevitably continue to arise due to the breadth and depth of 

the global reform effort. The fSB plays a critical role in monitoring the policy development work of 

the international standard setting bodies to ensure proper coordination. We commend the fSB for 

establishing its OTC Derivatives Working Group (ODWG) to look holistically at reforms to identify 

overlaps, gaps or conflicts in national frameworks that might compromise the achievement of the G· 

20 commitments. 

We express our deep concern with the S·day requirement within the broader context of other 

critical capital, margin, and market structure issues that are currently under deliberation by 

international standard setters. We urge the FSB and ODWG to ensure continued progress towards 

resolving other issues with BCBS standards that have the potential to undermine clearing of 

standardized products and access to client clearing. We also support international level efforts to 

appropriately calibrate market structure approaches across jurisdictions in order to avoid an un-level 

global playing field, market distortions, and regulatory arbitrage. 

The Interim Capital Framework will Increase the Cost of ETOs and Could Potentially Make ETOs 

More Expensive than Less liquid and less Transparent Products 

The interim Capital Framework establishes capital requirements for banks' exposures to CCPs and to 

clients for whom they perform clearing services as direct dearing members of CCPS.' There are two 

related aspects oftne BCSS standards that are going to Significantly increase costs for ErDs, and 

could potentially make ETDs more expensive than less liquid and transparent products from a capital 

standpoint: 

First, the Interim Capital Framework will require clearing members to hold capital equivalent 

to a 5-dilY M paR for aU client "cleared derivative" positions: Under the existing capital 

framework, products that demonstrate certain characteristics such as those exhibited by 

cleared ETOs are afforded capital treatment that matches the risk of the product. This 

would no longer be the case under the Interim Capital Framework. 

Second, under the bank capital framework, clearing members generally can reduce the 5-

day capital requirement by applying the margin used to collateralize client positions. Under 

the PFMI and related national derivatives laws, cleared ETDs typically carry a l-day or 2-day 

margin requirement versus the S·day margin requirement assigned to cleared OTC 

products! Applying the different margin requirements applicable to cleared products 

against the standard 5-day capital requirement could potentially result in higher costs for 

ErOs relative to products that do not share the same liquidity and transparency 

characteristics. 

We understand the attraction of a simplistic capital rule that can be applied across jurisdictions 

without regard to the strength of the local clearing and regulatory regimes. However, applying this 

general and inflexible approach could unnecessarily drive trading to less transparent and less liquid 

venues, cutting against the goals to reduce systemic risk and increase transparency that are central 

to the G-20 mandates. 

1 Be8S, Capital Requirements jor Bank Exposures to Central Counterparties, July 2012 (8C8S 227). 

, BC8S 227, Paragraph 113, Clearing Member Exposures to Cfients. 

, ESMA 2012/600 Draft technical standards under the Regulation (EU) no 64S/l012 of the EP and of the EC on 

OTC Derivatives, CCP's and TR's, Art. 26 no 1 and 4; Commodity Exchange Act, Part 39, Section 

39.13(g)(2)(ii)(a), 76 FR 69334 (1l/g/20ll). 

2 
143 


79691.058

Making ETDs More E)(penslve Cuts Directly Against the G·20 Objectives to Increase Price 

Transparency 

The G·20 mandate called for all standardised OTC derivative contracts to be traded on exchanges or 

electronic trading platforms where appropriate, by the end of 2012 at the lates!.' The FSB's recently 

published progress report on implementation of OTC derivatives market reforms recognizes the 

particular uncertainty that exists regarding future requirements for trading products subject to the 

clearing mandate on organized platforms,' For example, the Commodity Futures Trading 

Commission's (CFTC) Swap Execution Facility (SEF) rules are not yet finalized in the U.S., basic 

elements of Organized Trading Facilities (OTF) are still being debated at the EU legislative level under 

MiFID II/MiFIR, and a trading requirement has not been proposed in Asian jurisdictions, 

In contrast, there has been significant progress across jurisdictions in implementing mandatory 

clearing of OTC derivatives. Although this progress furthers one critical G·20 goal to reduce systemic 

risk through central clearing, raising the cost of ETOs cuts directly against another key G·20 objective 

to increase price transparency. The BeBS standards should promote price transparency by 

incentivising the use of more liquid and transparent products rather than create economic 

disincentives to use ETOs. 

CPSS·IOSCO and National Regulators have Recognised that Cleared Products with Certain 

Characteristics Warrant Shorter MPORs in Relation to Other Cleared Transactions 

International frameworks and regional regulations recognize that products with different risk 

profiles warrant different levels of coliateralization, In particular, these different risk profiles are 

clearly recognized within the PFML For example, Principle 6 states that, "A eep should establish 

margin levels that are commensurate with the risks and unique attributes of each product, portfolio 

and market it serves.'" The explanatory notes elaborate further, " .. ,the appropriate close-out period 

may vary among products and markets depending upon the product's liqUidity, price and other 

characteristics.'" 

This principle is reflected in regional and national derivatives laws and general ecp practice in setting 

margin: cleared ETOs tYpically carry a 1·day or 2·day MPOR versus the 5·day MPOR assigned to 

cleared bi-Iateral trades. These distinctions are made on the baSis that: 

ETOs have transparent pricing in deep, liquid markets which turn over almost 10 times more 

frequently than OTe derivatives· 

ETOs are more standardized than other cleared products, providing greater effiCiency, 

transparency and access to price and volume information in liquidation scenarios due to the 

concentration of interest in fewer distinct contracts, 

4 G-20 Leaders' Statement, The Pittsburgh Summit, September 24 - 2S, 2009, p. 9, 

s FSB, OTC Derivatives Market Reforms, Fourth Progress Report on Implementation, 31 October 2012, p. 36. 

"Trading infrastructure is less developed than infrastructure for central clearing and trade reporting, owing to 

uncertainties about the scope and form of future regulatory frameworks for organized platform trading," 

, PFMI, March 2011, Principle 6, p. 40. 

7 PFMI, March 2011, Principle 6, Explanatorv Note 3,6.3, p. 41-

• TABB Group, The New Global Risk Transfer Market: Transformation and the Status Quo, August 2012. 

3 
144 


79691.059

£TDs are effiCiently liquidated and pose less risk than privately negotiated, highly 

customized, infrequently traded derivatives. Exchange trading and dearing of standardized 

products results in immediate netting of offsetting positions and thus permits swift, efficient 

liquidation of the portfolio. 

We Urge the FSB to Resolve this Inconsistency at the International level to Avoid the Potential for 

Conflicting Jurisdictional Approaches 

We believe this issue requires immediate enhanced cooperation and action among the BCaS, CFGS, 

CPSS, and 10SCO due to the chililenges faced in obtaining appropriate resolution at national levels. 

The SCSS Interim Capital Framework should be amended to modify the S-day capital charge for 

clearing members using ETDs and replace it with a standard consistent with the PFMI and basE'd on 

the riSK profile, transparency and other characteristics of the product. As operators of global 

markets, we want to correct this disparity between international standards at the international level. 

Any alternative could result in inconsistent national outcomes and work against the G-20 objectives 

to promote adherence to international standards and further international harmonization. 

We greatly apprE'ciate your consideration and are aVililable to discuss this issue further at your 

convenience. 

t~/ ,,,,-'" 

Edemir Pinto, Chief Executive Officer, 

BM&F Bovespa 

Chong Kim Seng, Chief Executive Officer, 

Sursa Malaysia Derivatives 

at~fiL~ Phupinder S. Gill, Chief Executive Officer, 

CME Group 

Christopher 

~~ Fix, Chief Executive Officer, 

Dubai Mercantile Exchange 

I 

I 

k 

Andreas Pr~uss, Chief Executive Officer, 

Eurex 

'"tI,-liIL 

Finbarr Hutcheson, Chief Executive Officer, 

NYSE Uffe 

Fernando Centelles, Chief Executive Officer, 

MEFF 

i 

" Jorge Alegria, Chief Executive Officer, 

MexDer 

~~xecUtiVeViCe President, 

NasdaqOMX 

.,~~~.r.~c ,,:-t.""':t~-··+ 

Kotara Yarhaz~lNa, Managing Director, 

Osaka Securities Exchange 

Y'"->~~ 

Yeo lian Sim, Chief Regulatory and Risk Officer, 

SGX 

J1.r--

Tom Kloet, Chief 

Ii· 

Executive 

~ Officer, 

TMXGroup 4 
145 


79691.060

\A j,.. WORLD fEDERATION 

Y'J~ OF EXCHANGES 

Paris, 27 November 2012 

Mark Carncy 

Chairman, Financial Stability Board (FSB) 

Stefan Illgves 

Chairman, Basel Commit1ee on Banking Supervision (BCBS) 

William Dudley 

Chairman, Committee 011 the Global Financial System (CGFS) 

Paul Tucker 

Chairman, Committee 011 J>ayment and Settlement Systems (CPSS) 

Masamichi Kono 

Chairman, 10SCO Technical Committee 

RE: Ad\'ancing the G20 OTC Market Reforms by Correcting Inconsistencies in 

Derivative Margin J<'ramework.~ to Renect Liqnidity and Efficiency of Exchange 

Traded Derivative Markets 

Dear Sirs: 

The World Federation of Exchanges (WFE) is the global assoclalJon representing the 

interests of 59 publicly regulated stock, futures, and options exchanges, as well as the central 

clearing houses that many of these exchanges operate. Collectively, WFE members represen1 

the vast majority of the global exchange-traded equities and derivatives markets. The 

International Options Markets Association (TOMA) is the WFE's global association of 

options and futures exchange leaders. The member list of WFE is included in the annex to 

this letter. 

During and immediately following the global financial crisis in 2008, the WFE vigorously 

advocated for reform and regulation of the OTe derivatives markets, which were identified as 

having made significant contributions to financial turmoil. WFE applauded the OTC refonn 

commitments made by the G20 Finance Ministers at their November 2009 meeting in 

Pittsburgh. In Sllpport of the G20 commitments to increase transparency in derivative 

markets and to promote central clearing, ollr associations and members have continually 

engaged with global standard setters as well as national and regiOllal policymaking bodies to 

im plemen! regulatory retorms and address gaps and redundancies in national approaches and 

global frameworks. 
146 


79691.061

With respect to risk management and margin standards, the WFE encourages the Financial 

Stability Board (FSB) to ensure that inconsistencies in the international guidelines in relation 

to exchange traded derivative (ETO) margin standards and banking regulatory capital 

standards do not undermine the G20 commitments of moving standardized derivatives to 

central clearing and, when appropriate, to highly transparent trading platforms such as the 

regulated exchanges operated by WFE members. 

Specifically, we ask that the FSB coordinate and collaborate with the Basel Committee on 

Banking Supervision (BeBS), the Committee on the Global Financial System (CGFS), the 

Committee on Payment and Setilement Systems (CPSS) and the International Organization of 

Securities Commissioners (lOSCO) to resolve dilTcrences between the initial margin 

approach sel out in the CPSS-IOSCO Principles for Financial Market Infrastructure (PFMls) 

(and reflected in some national regulatory rules or proposals for ETOs) and the conflicting 

Basel Committee on Banking Supervision (BCBS) Interim Capital Framework. 

The Interim Capital Framework referred to above seeks 10 apply a blanket 5-day margin 

period of risk standard to highly liquid and transparent ETOs. The CPSS-IOSCO PFMls 

appropriately distinguish benveen the risk profiles of ETOs and cleared OTC products. I 

CPSS-IOSCO PFMl's are reflected in regional and national margin and risk management 

regulatory frameworks around the world. These margin Irameworks recognize the deep 

liquidity, transparent pricing, significant turnover rates, and overall efficiency of most ETOs 

relative to OTC derivatives and, in some cases, apply a I to 2-day margin period at risk 

standard for ETOs.2 

The significant liquidity and turnover advantages of ETD markets are confirmed by a recent 

study commissioned by the WFE and completed by the TABB Group which estimates that 

there are approximately 9,800 OTC trades per day across all OTC asset classes contrasted 

with nearly 6.2 million trades per day in global interest rate futures market alone. This 

equates to a 630 times greater turnover rate for exchange traded interest rate contracts 

compared to the turnover rate of an of the asset classes that make up the OTC derivatives 

market. 3 Due to their significant liquidity and turnover advantages as well as the extensive 

, (PS5-/0SCO Principles for Financial Market Infrastructure. "When setting margin requirements, • ((f> should 

have a margin system that establishes margin levels commensurate with the risks and particular attributes of 

each product, portfolio, and market it serves. Product risk characteristics can include, but are not limited to, 

price volatility and correlation, non-linear price characteristics, jump-to·default risk, market liquidity, possible 

liquidation procedures (for example, tender by or commission to market-makers), and correlation between 

price and position such as w(ong~way risk Margin requirements need to account for the complexity of the 

underlying instruments and the availability of timely, high·quality pricing data. For example, aTe derivatives 

require more-conservative margin models because of their complexity and the greater uncertainty of the 

reliability of price quotes" (Explanatory Note 3.6.3). "A eep should adopt initial margin models and 

parameters that are risk-based and generate margin requirements that are sufficient to cover its potential 

future exposures to partiCipants in the interval between the last margin collection and the dose out of 

pOSitions follOWing a participant default. Initial margin should meet an established Single-tailed confidence 

level of at least 99 percent with respect to the estimated distribution of future exposure." (V. Appendix 3.6.6). 

2 ESMA 2012/600 Draft technical standards under the Regulation (EU) no 648/2012 of the EP and of the EC on 

aTe Derivatives, (CP's and TR's I Art. 26 no 1 and 4 Title: 17 CFR Parts 1, 21, 39 and 140 Derivatives Clearing 

Organilatian General Provisions and Core Principles. U.S. Federal Register Citation: 76 FR 69334 (11/8/2011). 

'TABB estimates that there are 4300 trade per minute in the global interest rate futures markets which equals 

an average of 6,192,000 trades in a 24 haUl period. TABB estimates that 6.8 trades per minute occur in the 

Page 12 
147 


79691.062

availability of pricing data, ETDs are usually efficiently liquidated and generally pose less 

risk than privately negotiated, customized, and less frequently traded OTe derivatives. 

If adopted by the BeBS and implemented by national bank regulators, the static 5-day 

margin period of risk standard will not only be in conflict with the CPSS-IOSCO PFMls but 

also have the effect of increasing costs for client users of ETDs. 4 This may force exchange 

users (e.g. manufacturers, food producers, employee pension funds, and invcstors) to either 

discontinue critical hedging practices or move activity to the less transparent OTC derivative 

markets. Such outcomes wou ld clearly undermine the G20 OTe market reform 

commitments. 

The WFE respectfully requests global standard setters to eliminate the 5-day margin period of 

risk banking capital standard for exchange traded derivatives and demonstrate international 

support for the more appropriate I to 2-day standard for the highly liquid, transparent, and 

efficient exchange traded derivative markets. This standard should apply across all methods 

pennitted under the Basel framework to compute counterparty credit risk exposure for 

ETDs. Such action by global standard setters will be instrumental in advancing the 020'5 

commitment to bring increased transparency and the safety and soundness of central clearing 

to the global derivatives market and broader financial system. 

As the global associations for exchanges and clearing houses, the WFE and IOMA appreciate 

your consideration and stand ready to lend our members' collective expertise to this critical 

discussion. 

Cordially yours. 

U.WI 

Huseyin Erkan 

Chief Executive Officer 

Word Federation of Exchanges 

Jorge A legria Formoso 

Chairman, 10M A, and 

Chief Executive Officer, MexTJer 

entire OTC market which equals 9,792 trades in a 24 hour period. See pages 40-41: The New Global Risk 

Transfer Marl<et: Tramformotion and the Status Quo, TASS Group, August 2012. 

'The Interim Capital Framework establishes capital requirements for banks' exposures to CCPs and to clients 

for whom they perform clearing services as direct dearing members of (CPs. There are two drivers that will 

result in higher capital requirements for ETOs, or prompt a significant increa~ in collateralisatlon 

requirements established by banks offering clearing services: l}The Interim Capital Framework will require 

clearing members to hold capital equivalent to a 5·day margin period of risk (MPORl for ail dient "deared 

derivativeFi positions. Under the prior capital framework, products that demonstrated certain characteristics 

such as those exhibited by deared ETDs were afforded capital treatment that matched the risk of the product; 

and 2) The Interim Capital Framework allows dearing members to offset this 5-day capital requirement with 

the margin held against the dient positions' Under the PFMls and related national derivatives laws, deared 

ETOs typically tarry a I-day Of 2-day margin requirement versus the 5-day margin requirement assigned to 

deared OTC products.' This offset results in a 4-day or 3-day capital charge for ETDs versus Q·day charge for 

eleared OTe BCBS_ Capitol Requ;remf'nts for flank Exposures to Central Counterpart;e., July 2011 (BCBS 227) 

Page 13 
148 


79691.063

STATEMENT OF 

GEORGE FRENCH 

DEPUTY DIRECTOR, POLICY 

DIVISION OF RISK MANAGEMENT SUPERVISION 

FEDERAL DEPOSIT INSURANCE CORPORATION 

on 

EXAMINING THE IMPACT OF THE PRPOSED RULES TO IMPLEMENT 

BASEL III CAPIT AL STANDARDS 

SUBCOMMITTEE ON FINANCIAL INSTITUTIONS AND CONUMER CREDIT 

AND 

SUBCOMMITTEE ON INSURANCE, HOUSING AND COMMUNITY 

OPPORTUNITY 

COMMITTEE ON FINANCIAL SERVICES 

U.S. HOUSE OF REPRESENTATIVES 

November 29, 2012 

2128 Rayburn House Office Building 
149 


79691.064

Chairman Capito, Chairman Biggert, Ranking Member Maloney, Ranking 

Member Gutierrez and members of the Subcommittees, thank you for the opportunity to 

testify today on behalf of the Federal Deposit Insurance Corporation (FmC) regarding 

the recently proposed changes to the federal banking agencies' regulatory capital 

requirements. The FDIC has had a longstanding concern for stronger bank capital 

requirements, and we welcome the opportunity to discuss these important proposals. The 

federal banking agencies have received and are carefully reviewing a significant number 

of comments on these proposals. 

Background 

As you know, in June of this year, the federal banking agencies issued for public 

comment three separate Notices of Proposed Rulemaking, or NPRs, proposing changes to 

the regulatory capital requirements. Two of the NPRs would implement the recent Basel 

III standards developed by the Basel Committee on Banking Supervision and update our 

regulations in conformity with Section 939A of the Dodd-Frank Wall Street Reform and 

Consumer Protection Act (Dodd-Frank Act). The first of these, the Basel III NPR, would 

strengthen the quality of bank capital and increase its required level for all institutions, 

including community banks. The Basel III NPR also includes selected Basel III capital 

requirements applicable only to banking organizations that use the agencies' Advanced 

Approaches capital regulation. The second NPR, the Advanced Approaches NPR, 

proposes additional requirements from the Basel III agreement and other Basel standards 

for these large Advanced Approaches organizations. The third NPR, referred to as the 
150 


79691.065

Standardized Approach NPR, proposes changes to the risk-weighting of assets and 

replaces credit ratings in the agencies' capital regulations in accordance with Section 

939A of the Dodd-Frank Act. This NPR would apply to all institutions. The comment 

period on all three NPRs closed on October 22,2012. Also, in June of this year, the 

agencies finalized regulations that change the way banks with a large volume of trading 

activity calculate capital requirements for market risk. 

The agencies proposed the NPRs to address deficiencies in bank capital 

requirements that became evident in the recent banking crisis. A number of banking 

organizations failed or required federal assistance during the crisis, and the U.S. 

government provided capital, liquidity and guarantees to a significant portion of the 

financial sector, including depository institution holding companies and their affiliates. 

Since January 1,2008,463 FDIC-insured banks have failed. 

In light of this experience, strengthening bank capital requirements seems to be an 

appropriate and important step. All banks need strong capital to navigate periods of 

economic turbulence while continuing to serve their important role as financial 

intermediaries to the economy. The changes proposed in the NPRs are intended to 

address identified deficiencies in the existing capital regime and provide greater comfort 

in the capital adequacy of our banking system. At the same time, reviewing the 

numerous comments received will help us address concerns about the costs and potential 

unintended consequences of various aspects of the proposals. 

2 
151 


79691.066

My testimony will describe the proposed rules in more detail, along with some of 

the most frequently identified concerns among the more than 2000 comments we have 

received. It is worth emphasizing that the rulemaking process is ongoing and the 

agencies have not yet reached final decisions regarding how to address the various issues 

that have been raised with respect to the NPRs. 

The Basel III NPR 

One of the critical lessons learned from the recent financial crisis was that highquality, loss-absorbing capital is essential to ensuring the safety and soundness of 

financial institutions. As such, in the aftermath of the crisis, the FDIC and the other U.S. 

banking agencies participated in an intensive international effort to strengthen bank 

capital standards. The result of these efforts is the Basel III capital agreement. In broad 

terms, the Basel III capital standards aim to improve the quality and increase the required 

level of bank capital. Collectively, Basel III and other standards published by the Basel 

Committee address a number of features of capital regulation that allowed for an 

excessive use of leverage in the years leading up to the crisis. 

The FDIC Board of Directors voted to issue the Basel III NPR for public 

comment on June 12,2012. The Basel III NPR proposes to strengthen the definition of 

regulatory capital to better absorb losses than under current rules, and to increase the 

required level of capital. These changes are proposed to be phased in over time. The 

NPR also includes selected requirements that apply only to banks using the agencies' 

Advanced Approaches capital regulation. 

3 
152 


79691.067

The Basel III NPR proposes a number of changes to strengthen the definition of 

capital. The most important of these changes are described below. 

• Under current rules, common equity is permitted to comprise as little as half of 

Tier 1 capital, reducing the loss absorbency of, and market confidence in, the 

regulatory capital measure. The Basel III NPR proposes a new risk-based capital 

requirement for "common equity Tier 1," a form of regulatory capital that would 

be more reliably available to absorb losses. 

• Intangible assets, except for a limited amount of mortgage servicing rights, are 

deducted from capital in the Basel III NPR. Intangible assets, which are generally 

difficult to sell in order to absorb losses, are subject to limits in current capital 

rules, but the NPR makes these limits more stringent. 

• Deferred tax assets are subject to stricter limits in the Basel III NPR. These 

assets, as analysts noted during the crisis, may have little value when a bank is 

losing money and capital support is most needed. 

• Investments in the capital instruments of other financial institutions that exceed 

specified thresholds are deducted from capital in the Basel III NPR. It was 

evident in the recent crisis that inclusion of large amounts of such investments in 

a banking organization's capital can create a chain of interconnected losses that 

exacerbates a banking crisis. 

4 
153 


79691.068

• Minority interests in consolidated subsidiaries are subject to stricter limits in the 

Basel III NPR. Minority interests can absorb losses in a specific subsidiary but 

may be unavailable to absorb losses throughout an organization. 

• Trust Preferred Securities (TruPS) are subject to a phase-out from Bank Holding 

Companies' (BHCs) Tier I capital in the Basel III NPR (a three year phase-out for 

large BHCs and a ten-year phase-out for smaller BHCs). TruPS can absorb losses 

in a failure, but do not absorb losses on a going-concern basis. The application of 

this proposed change to smaller BHCs, and the change to the treatment of 

accumulated other comprehensive income described below, have been frequent 

subjects of concern from commenters. 

• Accumulated other comprehensive income (AOCI), whieh includes unrealized 

gains and losses on available-for-sale (AFS) securities, is proposed to be included 

in the calculation of capital under the Basel III NPR. i Incorporating these gains 

and losses as proposed in the NPR may result in a better indicator ofthi: bank's 

capital strength if it is forced to sell these securities in an adverse economic 

environment. 

Wc are carefully considering the comments we have received on each of these proposed 

changes to the definition of capital. 

1 Under existing regulations, unrealized gains and losses on AFS debt securities are not included in 

regulatory Tier I capital. Unrealized losses On AFS equity securities with readily determinable fair value 

are included in Tier I capital, while a portion of unrealized gains on AFS equity securities can be included 

in Tier 2 capital. 

5 
154 


79691.069

As noted above, the Basel III NPR proposes to establish a new risk-based capital 

requirement for "common equity Tier 1" capital. Under the NPR, banks would need to 

hold common equity Tier 1 capital in an amount that is at least 4.5 percent of riskweighted assets in order to be considered "Adequately Capitalized." The NPR also 

proposes to increase by two percentage points the minimum and "Well Capitalized" 

levels for the Tier 1 risk-based capital ratios that are part ofthe agencies' Prompt 

Corrective Action (PCA) regulations. 

The Basel III NPR also proposes a capital buffer incorporating a sliding scale of 

dividend restrictions for banks whose risk-based capital ratios are less than 2.5 

percentage points higher than the regulatory minimums. The purpose of the buffer is to 

encourage banks to maintain a cushion of capital above the regulatory minimums so they 

will be able to continue to lend during periods of economic adversity without breaching 

those minimums. The Basel III buffer is similar to the statutory requirement that the 

agencies' PCA regulations include a capital ratio threshold for banks to be considered 

"Well Capitalized." 

In addition, the Basel III NPR requires banks that use the Advanced Approaches 

capital regulation to comply with a supplementary leverage ratio that includes certain offbalance sheet items in the denominator. The FDIC views the leverage ratio as a 

foundational measure of capital, and we are highly supportive of its inclusion in the Basel 

framework. The complexities specific to the Basel III leverage ratio, however, are 

mainly relevant for very large institutions with extensive off-balance sheet activities. For 

6 
155 


79691.070

that reason, the agencies have proposed that the Basel III leverage ratio would be a 

supplementary requirement, and only applied to banks using the Advanced Approaches 

capital regulation. The existing U.S. leverage ratio requirements would remain in effect 

for all U.S. banks. 

The Basel III NPR also requires Advanced Approach banking organizations to 

hold additional capital in the form of a "countercyclical buffer" if the agencies determine 

that the banking industry is experiencing excessive credit growth. The NPR indicated 

that the countercyclical buffer initially would be set at zero, with the agencies acting 

jointly to raise that level, if and when credit conditions warranted putting this buffer into 

effect. If a determination was made that the buffer was necessary, the amount of the 

buffer could be as much as 2.5 percent of risk weighted assets. The countercyclical 

buffer would serve to provide additional capital for the losses that often follow a period 

of excessive credit growth, and may itself serve as a check on excessive growth. Again, 

the NPR indicates that the countercyclical buffer would only be in effect when credit 

conditions warrant and would be zero at other times. 

The minimum capital ratios and capital buffers proposed in the Basel III NPR 

were developed as part of a Basel Committee effort, in which the agencies participated, to 

estimate the amount of bank capital needed to absorb losses in severe economic scenarios 

including the losses experienced in banking crises in different countries over time. The 

results of this analysis were published in October, 2010? The results suggest that bank 

2 "Calibrating Regulatory Minimum Capital Requirements and Capital Buffers: A Top-down Approach," 

October, 2010, Basel Committee on Bank Supervision; http://www.bis.orglpubllbcbs180.htm. 

7 
156 


79691.071

capital ratios at the levels agreed to by the Basel Committee and proposed in the Basel III 

NPR would provide reasonable assurance that banks would be able to absorb losses 

during a period of economic adversity while continuing to be able to lend -- and certainly 

greater assurance than exists under the current rules. 

While working as part of the Basel Committee to develop the capital ratios that 

were proposed in the Basel III NPR, the agencies were mindful that while the 

requirements should be sufficient to enable banks to withstand a period of economic 

adversity, they should not be so high as to choke off prudent lending or normal economic 

activity. The agencies participated in international efforts to evaluate the potential effect 

of the higher bank capital requirements on economic activity. This work focused on two 

issues. One issue is the potential costs to the broader economy of an insufficiently 

capitalized banking system. Experience suggests that banking crises have consistently 

been followed by large and long-lasting reductions in economic activity. The other -- and 

competing issue -- is the costs that higher capital requirements might impose by 

increasing the cost of credit and reducing the volume of lending. 

The literature reviews and other analysis conducted as part of these international 

efforts generally concluded that within the range of capital requirements being 

considered, the economic benefits of higher capital requirements from reducing the 

frequency and severity of banking crises would exceed the economic costs resulting from 

a modest increase in the cost of credit. 3 This analysis supports the overall conclusion that 

3 "An Assessment of the Long-Tenn Economic Impact of Stronger Capital and Liquidity Requirements," 

August,2010; Basel Committee on Bank Supervision; hltp:!/www.bis.orglpubl/bcbs173.htrn, and 

8 
157 


79691.072

an increase in bank capital requirements from current levels is warranted. Pre-crisis 

increases in leverage permitted by the current capital rules did stimulate financial 

institution growth and earnings for a time, but the real economy ultimately suffered a 

significant cost when the financial cycle turned. In addition to the financial institution 

failures and government assistance mentioned earlier in this testimony, the U.S. economy 

experienced a loss of over eight and a half million payroll jobs as a result of the 

recession, and it suffered a 35 percent decline in home prices as well as over 10 million 

new foreclosures. The decline in employment and economic activity reduced revenues at 

all levels of government, with fiscal effects that reverberate back to the real economy. 

While we view strengthening bank capital requirements as an appropriate goal to 

reduce the likelihood and severity offuture banking crises, the agencies also are mindful 

that the proposals in these three NPRs represent significant change. The review of 

comments that is now underway is expected to shed considerable light on the potential 

for unintended consequences associated with specific aspects of these proposals. 

Advanced Approaches NPR 

In addition to the Basel III NPR the FDIC Board of Directors approved a separate 

NPR on June 12 that proposes a number of enhancements to the calculation of riskweighted assets for the large, complex banks using the Advanced Approaches. This NPR 

proposes to implement aspects of Basel III that are designed to improve and strengthen 

modeling standards, the treatment of counterparty credit risk, credit risks associated with 

"Assessing the Macroeconomic Impact of the Transition to Stronger Capital and Liquidity Requirements 

(MAG Analysis)," December, 2010, Financial Stability Board and Basel Committee on Bank Supervision; 

ht1;p:llwww.bis.org/publlothp12.pdf. 

9 
158 


79691.073

securitization exposures, and disclosure requirements. The proposal also contains 

alternatives to credit ratings consistent with Section 939A of the Dodd-Frank Act. The 

proposals in this NPR would strengthen the existing Advanced Approaches capital rules, 

particularly those related to capital requirements for derivatives. 

The FDIC has had a longstanding concern about the reliance in the Advanced 

Approaches rule on a bank's own models and risk estimates. Section 171 of the DoddFrank Act (the Collins Amendment) addresses this concern by placing a floor under the 

Advanced Approaches capital requirements that ensures that the Advanced Approaches 

capital requirements are not less than the requirements that are generally applicable to 

other banks. 

Standardized Approach NPR 

The third NPR, the Standardized Approach proposal, includes a number of 

proposed changes to the calculation of risk-weighted assets in the agencies' general riskbased capital rules. The proposal also includes alternatives to credit ratings consistent 

with Section 939A of the Dodd-Frank Act. The capital requirements proposed in the 

Standardized Approach NPR are separate and distinct from those under the Basel III 

framework. 

The Standardized Approach proposal was designed to address shortcomings in the 

measurement of risk-weighted assets that became apparent during the recent fmancial 

crisis. In part, this is addressed by implementing certain changes based on the Basel II 

10 
159 


79691.074

Standardized Approach contained in the Basel international regulatory capital standards 

and by replacing credit ratings consistent with section 939A of the Dodd-Frank Act. The 

proposed risk-weightings and segmentation methodologies for residential mortgages were 

developed by the federal banking agencies in response to issues observed during the 

financial crisis. Among other things, the proposed rule would: 

• revise risk weights for residential mortgages bascd on loan-to-value ratios and 

certain product and underwriting features; 

• increase capital requirements for past-due loans, high volatility commercial real 

estate exposures, and certain short-term loan commitments; 

• expand the recognition of collateral and guarantors in determining risk-weighted 

assets; 

• remove references to credit ratings; and 

• establish due-diligence requirements for securitization exposures. 

FDIC-insured institutions have strengthened their capital ratios since 2008. We 

have estimated that the large majority of insured banks would meet the capital 

requirements resulting from the combined implementation of the Basel III NPR and the 

Standardized Approach NPR. The attachment to this testimony describes the 

methodology for these estimates and the results for banks in different size groups. These 

estimates suggest that for most insured banks, the proposals would not rcsult in a need to 

raise new capital. It should be emphasized that these are estimates, and that institutions 

themselves will have better information about the specific factors used in the proposed 

11 
160 


79691.075

capital calculations than the agencies currently collect in financial reports. In particular, 

our estimates did not attempt to address the extent to which institutions might feel the 

need to hold additional capital buffers beyond those specifically proposed, for example, 

to offset future changes in AOCI. Our review of the public comments is expected to shed 

additional light on such issues. 

Final Market Risk Rule 

On June 12, the FDIC Board of Directors also approved the final regulation 

making improvements to the Market Risk Rule. This final regulation, which takes effect 

on January I, 2013, addresses important weaknesses of the current Market Risk Rule to 

reflect lessons learned in the financial crisis. Leading up to the crisis, low capital 

requirements under the current Market Risk Rule encouraged institutions to place illiquid, 

high-risk assets in their trading books. Large mark-to-market losses on these assets 

played an important role in fueling the financial crisis during its early stages. The final 

regulation requires an appropriate increase in the stringency of the Market Risk Rule that 

will better address such risks. 

This final rule applies only to the largest institutions that have significant trading 

activities. It is based on reforms that were agreed to internationally with the Basel 

Committee's 2009 revisions to the Basel II market risk framework. These revisions are 

part of what is generally referred to as the Basel 11.5 reforms. 

12 
161 


79691.076

Concerns have been expressed that the Market Risk Rule, while improved, is still 

too reliant on internal models. The idea of establishing a simple, non-modeled and higher 

minimum capital floor for all trading book capital requirements is worthy of further 

study, and is in fact being considered as part of a fundamental review of trading book 

capital requirements being conducted by the Basel Committee. 

Outreach and Comments 

As the primary federal supervisor for the majority of community banks, the FDIC 

is particularly focused on ensuring that community banks are able to properly analyze the 

capital proposals and assess their impact. Since the Basel III NPR and the Standardized 

Approach NPR would affect all banks, the FDIC undertook an outreach agenda to assist 

community banks in analyzing the impact of the proposals. 

First, both the Basel III NPR and the Standardized Approach NPR contain a 

relatively short and concise addendum designed to aid smaller banks in identifying and 

understanding the aspects of the proposal that would apply to them. 

Second, FDIC staff hosted six community bank capital outreach sessions, one in 

each of the FDIC regional offices. Each session included an FDIC staff overview of the 

NPRs that identified the most significant changes for community banking organizations, 

and a question-and-answer session for the bankers in attendance. 

13 
162 


79691.077

Third, the FDIC posted an on-demand video on its Website that contains the same 

information provided by the FDIC in the live outreach sessions. Copies of the materials 

provided to bankers at the live outreach sessions are also posted online. 

Fourth, FDIC staff hosted a national call to address the questions most frequently 

asked by attendees at the live outreach program sessions. 

Finally, the FDIC, along with the other banking agencies, developed a Regulatory 

Capital Estimation Tool designed to assist community banking organizations and other 

interested parties in evaluating the potential effect that the Basel III NPR and the 

Standardized Approach NPR could have on their capital ratios. 

We believe that these outreach efforts have helped many bankers understand these 

proposals and identify the issues that are of concern to them. As of November 16, the 

FDIC had received more than 2000 comments. The vast majority of these comments are 

from community banks. Their comments have been highly substantive and provide 

significant information regarding the possible impact of the proposals. 

The FDIC is in the process of reviewing all of the comments received. To date, 

many commcnters have raised concerns about the generally higher level of capital 

requirements for community banks. A number of commenters have requested that the 

agencies not apply the Basel III or Standardized Approach NPRs to community banks. 

14 
163 


79691.078

Some commenters have requested that the agencies withdraw the Standardized Approach 

NPR. 

In addition to these general comments, a few more specific topics have been 

mentioned quite frequently. First, many commenters have expressed concern that the 

Basel III NPR proposes to include AOCI in the calculation of regulatory capital, thereby 

including gains and losses on available-for-sale debt securities. These commenters 

believe that the inclusion of AOCI will increase the volatility of regulatory capital, 

forcing banks to hold additional capital buffers, and complicate their ability to manage 

interest rate risk and comply with legal lending limits. Also with respect to the Basel III 

NPR, many commenters have expressed concern that trust preferred securities issued 

before May 19,2010, by community bank holding companies with less than $15 billion 

in assets are proposed to be phased out of Tier 1 capital. 

With respect to the Standardized Approach NPR, many commenters have 

expressed concern about the increased complexity and systems costs of the proposed new 

methods for asset risk weighting, as well as the proposed increase in risk weight for 

certain exposures, particularly past due exposures and residential mortgages. Many 

community bank commenters have indicated that the proposed risk-weightings for 

residential mortgages will force them to curtail or exit residential mortgage lending 

because of what they view as the excessively high level of some of these risk weights. 

Commenters also express concern about how the new risk weights might interact with a 

number of pending mortgage regulations whose final form remains uncertain. 

15 
164 


79691.079

Conclusion 

In conclusion, along with our fellow regulators, the FDIC is carefully reviewing 

the comments we have received regarding the NPRs. These are proposed rules, and we 

expect to make changes based on the comments. The basic purpose of the Basel III 

framework is to strengthen the long-term quality and quantity of the capital base ofthe 

U.S. banking system. In light ofthe recent financial crisis, that would appear to be an 

appropriate and important goal. However, that goal should be achieved in a way that is 

responsive to the concerns expressed by community banks about the potential for 

unintended consequences. 

16 

79691.080

Bank Impact Analysis 

Impact of: Basel 3 with Standardized approach 

Source: Call report data (3.31.12) and FDIC estimates 

• Count of bank. that fail to meet the 8asellll and Standardized Approach capital standards do not include approximately 233 banks that do 

the current RBe standards. 

AbbrelJaitions· 

R8C = Risk Based Capital 

CCB ::: Capital conservation buffer 

CET1 = Common Equity Tier 1 

B = billions 

M = millions 
166 


79691.081

FDIC Methodology for Estimating the Impact of the Basel III and Standardized Approach NPRs on US Banks 

FDIC staff analyzed the impact Dfthe proposed changes contained in the Basel III and Standardized Approach NPRs using Call 

Report data and the assurnpti(lns provided below. 

Jig.§eJ III (Numerator of risk-based capital ratios) 

The chart below summarizes the approach and assumptions used to estimate common equity tier]. tier 1 and total capital. 

Call Report cau Report 

Ca itatco nent line Field Notes and assum tions 

+ Common Stock 

I + Surplus 

+ Retained Earnings 

+ AOCI 

+ Other Equity Capital Components 

GoodmH & Other Intangible Assets 

Change in FV of Financial Liabilities 

peeR and Non~Mortgage Sen1cing Assets 

Net deferred tax assets 

+ Minority lnterest 

RC·24 

RC-25 

RC·26 a 

RC-2Iib 

RG26c 

l'tC-R·7a 

RC-R-7b 

RC-M-2b 

R(>Y-2 

RC-R-6 

Deductipns for components exceeding 100/..,/15% threshold !imitations 

Deferred Tax Assets not preVIOusly deducted RC·F-2 

In~stments in financial institutions RC-8 

+ Non¥Qualifying Perpetual Preferred RC'-R-S 

A.lhnwnce for loan and le<l'ic losses includible in Tier 2 RC_R 14 

Standardized Approach (penominator of risk-based capital ratios) 

RCmJlIJ9 

RCfD36J2 

RCfDB530 

RCFDAllO 

RCFDE15W 

ROW'"' 

RCFDBm6 

RCFD214S 

RCfD2148 

RCFD2130 

RCFDBS88 

'RCfDS310 

RCFD8594 

[)eductga:M,lIddbacklosses 

CakuJahon f A~su"",,,d 4O'A. dedu(\t.s u '"any 

fOfWMd'DTA~ 

CaJculllhCln I AssuJred4C";;' included III CETI 

eap~ai 

CalculatIOn f A.sumed 60'10 ofDTAs related to 

'''I'Il'Olary dlff~rerc"s 

Cakulal1onfAuuITII'd4i1'4ofinn-stmonlsIII Fls 

~uid bem the formofeorJI'Mn ~tock 

To estimate the effects of the Standardized Approach, FDIC staff started with each bank's currentrisk-weighted assets (RWA), as 

reported on the Call Report, and adjusted R W As for ac;set categories where risk weights would change under the proposed rule. The 

chart below shows the a'iset categories and assumed change in risk-weights proposed under the Standardized Approach. Following the 

chart is a description the assumptions used in the analysis. 

Asset category 

1¥4 Family Residential Loans 

High Volatility Commercial Real Estate (HVCRE) loans 

Non~accruing & 90 days or more past due loans 

Intangibles (MSA, DTA not deducted in de[cap) 

SecuritiZlltions 

Deriw.tives 

Fed Funds Sold and Securities Purchased to Resell 

Securities Lent 

Current: 

AppendixARW 

50% 

100% 

100% 

100% 

50% 

00/0/20%150% 

00/0/200/0/100% 

0%/200/01 500/0/100% 

Projected: 

Standardized RW 

75% 

150% 

150% 

250% 

75% 

0%/4%/10% 

0%/8%/40% 

0%1 80/0/20%1 40% 
167 


79691.082

Assumptions: 

1-4 Family Mortgages: FDIC staff used data from Lender Processing Services (LPS) to estimate the risk-weight on the stock 

of residential mortgage loans in the banking industry. LPS collects data on mortgage originations, including some mortgage 

loan characteristics such as loan-to-value ratios. 

High-Volatility Commercial Real Estate WCRE) loans: HVCRE loans are a sub-set of commercial and land development 

(C&D) loans, which are reported on regulatory reports. FDIC staff estimated the amount of C&D loans classified as HVCRE 

by comparing Call Report and FFIEC 10l data. 

Non-Accruing and 90 day past due loans: FDIC staff used existing Call Report data on non-accruing and past due loans to 

assess the impact of a 150% risk weight. 

~: FDIC staff used existing Call Report data on intangible assets. 

Securitizations: FDIC staff assumed a 50% increase in the risk weight of securitization exposures based on Call Report data 

and discussions with bank examiners. FDIC staff assumed that the average risk weight for securitizations would increase 

because banks, particularly community banks, typically invest in senior tranches, whose risk-weight is less affected by the 

SSFA. In addition, the Standardized Approach includes the gTOSS~Up treatment which represents no change from current 

rules. 

Derivatives and Reoo srvle transactions: FDIC staff estimates there will be a significant reduction in risk~weights for certain 

exposure under the collateral haircut approach and from the expansion of assets that would be recognized as eligible 

coJiateral under the proposal. 
168 


79691.083

Statement of 

James M. Garnett, Jr. 

Head of Risk Architecture for Citi 

on 

The Impact of the Proposed Rules to Implement Basel III Capital Standards 

Before the 

Subcommittee on Financial Institutions and Consumer Credit 

and the 

Subcommittee on Insurance, Housing and Community Opportunity 

of the 

Committee on Financial Services 

U.S. House of Representatives 

November 29,2012 
169 


79691.084

Good morning, Chairman Capito, Chairman Biggert, and Members of the subcommittees 

on Financial Institutions and Consumer Credit and Insurance, Housing and Community 

Opportunity. My name is Jim Garnett, and I am the Head of Risk Architecture for CitL In this 

capacity, I am responsible for implementing the Basel III capital rules for Citi within the United 

States and the other countries in which Citi operates around the globe. I want to thank you for 

holding a joint hearing on this very important topic. 

Background 

Citi today is among the best capitalized major banking institutions in the world, and we 

support strong capital requirements as one of the critical pillars of a safe, sound, and effective 

financial system. We have added over $140 billion in new capital to our capital base. Our 

capital strength is more than five times higher than it was during the crisis, and although the 

Basel III capital requirements do not fully kick in until January of 2019, Citi is well underway 

towards complying with them, both the baselines and surcharges. We are in a position to put 

our financial strength to work for our clients during challenging and uncertain economic times, 

and we are doing so. 

In addition to increasing our capital, we have gone back to the basics of banking and 

have streamlined our company to focus on our core areas of strength - consumer banking and 

institutional banking including transaction services with a clear structure and a clear strategy. 

Since 2009, we have invested in core businesses while reducing non-core assets. After 

completing more than 60 divestitures, we have reduced Citi Holdings by $600 billion and it now 

represents less than 10 percent of Citi's balance sheet. Our risk management has been 

completely overhauled and is a strong, independent function. Since the financial crisis, we have 

put in place a robust governance structure. We have significantly increased our liquidity 

resources; cash and available-for-sale securities represent 25 percent of the balance sheet; and 

2 
170 


79691.085

our available liquidity resources - cash and highly liquid securities - are in excess of $400 

billion. By successfully executing our strategy, we have achieved sustainable earnings with 11 

straight quarters of profitability. In short, we are now a simpler, smaller, safer, and stronger 

institution than we were a few years ago. 

The Impact of Capital Rules Proposed by U.S. Banking Regulators 

Citi broadly supports the goals of the Basel III capital rules proposed by the U.S. banking 

regulators. As a global bank, Citi has long supported risk-based capital standards along with 

heightened liquidity standards. We recognize the importance of capital to serve as a buffer 

against changing market and economic conditions. Aligning capital with economic risks ensures 

that adequate capital exists to cover risks and avoids excess capital, which can unnecessarily 

constrain lending and investment activities that support the real economy. 

There are, however, certain features of the proposed rules that deserve refinement in 

order to avoid unintended, negative consequences. We are concerned that the cumulative 

capital levels will unnecessarily constrict credit for all but the nation's most credit-worthy 

borrowers. Additionally, we believe the elimination of the filter for accumulated other 

comprehensive income (AOCI) in calculating Tier 1 Common Equity will negatively impact the 

ability of banking organizations to extend new credit and cause banks to reduce investments in 

certain U.S. Treasury and agency debentures and mortgage-backed securities (MBS). 

We are also concerned about the apparent lack of uniform application of capital and 

other supervisory standards within the U.S, and globally. U.S. and international banking 

regulators need to ensure that the Basel III rules are applied consistently and uniformly. 

Deviations in risk weighing should not be allowed. 

3 
171 


79691.086

Finally, we believe that capital rules should be tailored to different types and sizes of 

banks. We support a simpler set of risk-based rules for small, traditional community banks. 

I will address each of these issues in the balance of my remarks. 

Credit Availability 

The financial crisis demonstrated a need for banks and other financial institutions to hold 

greater levels of capital. We support strong capital requirements and, as noted above, we have 

dramatically increased our capital since the crisis. At the same time, there is clearly a trade-off 

between higher capital and credit availability and cost. The obvious challenge is to find the right 

balance between capital levels necessary to withstand periods of economic stress and capital 

levels that do not choke off credit availability and investment. 

We are concerned that under Basel III, consumers who do not have pristine credit 

histories will find credit to be less available and more expensive. This result will be particularly 

evident for consumers with weaker credit histories seeking residential mortgage loans or home 

equity lines of credit. Small business owners also will be adversely affected in the form of 

higher credit costs and constrained credit availability, particularly because small businesses do 

not have direct access to the capital markets - i.e., they cannot borrow by issuing commercial 

paper or longer term notes and bonds, in contrast to the largest corporations who have the 

capital markets as an alternative source of credit. Basel III penalizes those who need credit the 

most across all institutions. 

To help avoid capital standards that divide consumers between the "haves" and the 

"have nots," we support the industry's call for a quantitative impact study of the proposed rules. 

Such a study would enable Congress, the federal banking regulators, and others to better 

4 
172 


79691.087

understand the impact of the proposed rules and, if appropriate, to make adjustments that avoid 

an unintended contraction in credit to many customers, 

AOCI Filter for Gains and Losses on Securities Available for Sale 

In a major change from the current capital rules, the proposed rules would require 

unrealized gains and losses on securities that are held as "available for sale" by a bank to flow 

through to a bank's regulatory capital levels, Current capital rules impose a "filter" that prevents 

fluctuations in the value of such securities from passing through to regulatory capital. We 

believe that the elimination of this filter is ill-advised, The elimination of the filter will create 

inaccurate reports of actual capital strength; it will mean that capital will look like it is increasing 

as interest rates fall and decreasing as interest rates rise but neither result will reflect reality, 

Since fluctuations in interest rates impact the value of the securities held for sale, Citi 

and other U,S, banking organizations will be required to hold capital buffers to account for the 

potential swings in capital levels, This will exacerbate the aforementioned impacts of holding 

excessive capital in the banking system, 

The removal of the filter also will cause Citi and other U,S, banking organizations to 

favor shorter duration securities over longer-dated Treasuries and MBS, because the value of 

shorter duration securities is less subject to swings in interest rates. This will inevitably impact 

the issuance and cost of Treasury securities and housing credit. 

The removal of this filter will reduce a bank's flexibility in managing liquidity and diminish 

liquidity in the underlying debt markets. Additionally, the removal of the buffer provides a 

disincentive for prudent asset and liability management activities as banks will need to weigh 

the tradeoff between managing the risk of AOCI volatility and economic risk, 

5 
173 


79691.088

Finally, the removal of this filter will create an unlevel playing field between U.S. and 

foreign banks, since foreign banking organizations that follow international accounting standards 

are permitted to defer gains and losses by accounting for certain debt securities as loans. 

We understand the rationale behind this proposed change given the credit related losses 

incurred during the recent crisis that were not reflected in capital. However, a better solution 

would be to continue to exclude unrealized gains and losses in Basel III Tier 1 Common Capital 

for available for sale securities of only the most creditworthy and liquid issuers. In other words, 

the filter should remain in effect for obligations issued or guaranteed by the U.S. government or 

government agencies. This approach would create consistency between the regulatory capital 

treatment of securities and the regulatory capital treatment of the deposit liabilities they are 

largely hedging, and it would reduce the negative consequences caused by volatility in 

regulatory capital levels. 

Global Harmonization 

One of the fundamental goals of the Basel Capital Accords is the harmonization of 

capital standards among industrialized countries. Having uniform and consistently applied 

capital standards ensures market confidence in banking organizations and promotes safety and 

soundness. Recently, however, regulators and investors have raised concerns about 

differences in risk-weighting systems used by banks in some countries. Asset risk-weights are 

a central feature of the Basel capital standards; they can determine how much - or how little -

capital a bank needs to hold against a particular asset. It is imperative that U.S. and 

international banking regulators ensure that the Basel rules are applied uniformly and 

consistently by all banks. Otherwise, the integrity of the international capital standards will be 

compromised. 

6 
174 


79691.089

An unlevel Basel playing field across national jurisdictions can arise from two different 

sources. First, banking supervisors in different countries may apply different standards when 

approving internal models or internally calculated risk parameters. There is a great deal of 

concern that supervisors in some countries, like the U.S., will adhere to high standards of 

approval while those in other countries will adhere to laxer standards. An excellent method for 

determining if different supervisory standards are used is to require each bank to calculate the 

risk-weighted assets (RWA) of benchmark portfolios using the bank's current methods and 

assumptions. In fact, the Basel Committee's Standards Implementation Group has begun 

working on the use of benchmark portfolios to this end, as have some national regulators. 

A second reason for an unlevel playing field could be that even if the Basel rules are 

adopted and implemented uniformly, a given rule can have a disparate impact across national 

jurisdictions because of differences in market structure and associated accounting standards 

across countries. For example, Mortgage Servicing Rights (MSRs) are a large asset for many 

U.S. financial institutions, from small community banks to larger multinational banks. Basel III 

initially excluded all MSRs from inclusion in Tier 1 Common. The final version of Basel III 

limited MSRs to only 10 percent of Tier 1 Common. MSRs are essentially only a U.S. bank 

issue. They arise from the combination of residential mortgage securitization and the details of 

generally accepted accounting principles (GAAP). Consequently, the limitation on the 

recognition of MSRs essentially only affects U.S. banks. 

Community Banks 

We believe there is a good case for applying a more simplified risk-based capital regime 

than the Basel III rules for small community banks. While the Basel I regime is overly simplistic 

for large banks, it can be an effective capital regime for smaller, community banks that do not 

have complex balance sheets. These types of traditional community banks primarily make 

7 
175 


79691.090

commercial real estate and residential real estate loans, automobile and other consumer loans, 

and business loans. They also have investment portfolios that are largely composed of 

Treasury securities and MBS. They do not need the highly granular risk categories proposed in 

Basel II!. 

Basel III also poses greater operational and compliance challenges for community banks 

than for large banks. Basel III is a comprehensive rewrite of the capital rules, and compliance 

with these rules carries significant costs. Large banks, like Citi, already have incurred many of 

these costs in preparation for Basel II. Large banks also enjoy economies of scale in 

technology and systems. Community banks are justifiably concerned about the compliance 

costs imposed by Basel III. The federal banking regulators should reconsider the application of 

Basel III to traditional community banks that do not have complex balance sheets and permit 

such institutions to continue to comply with Basel I or some other simplified risk-based capital 

regime. 

Conclusion 

Thank you again for the opportunity to appear before the subcommittees to discuss 

some refinements to the Basel III rules that we believe are needed to avoid unintended, 

negative consequences. 

8 
176 


79691.091

For release on delivery 

10:00 a.m. EDT 

November 29,2012 

Statement by 

Michael S. Gibson 

Director 

Division of Banking Supervision and Regulation 

Board of Governors of the Federal Reserve System 

before the 

Subcommittee on Financial Institutions and Consumer Credit 

and 

Subcommittee on Insurance, Housing, and Community Opportunity 

U. S. House of Representatives 

November 29, 2012 
177 


79691.092

Chainnan Capito, Chainnan Biggert, Ranking Member Maloney, Ranking Member 

Gutierrez, and members of the subcommittees, thank you for the opportunity to testify on the 

proposed interagency changes to the regulatory capital framework for U.S. banking 

organizations. In today's testimony, I will provide an overview of the proposed changes and the 

main themes arising from the public comment process, especially as they relate to conununity 

banking organizations and depository institution holding companies with insurance activities. 

Overview of Proposed Changes 

The recent financial crisis revealed that the amount of high-quality capital held by 

banking organizations in the United States was insufficient to absorb losses during periods of 

severe stress. The effects of having insufficient levels of capital were further magnified by the 

fact that some capital instruments did not absorb losses to the extent previously expected. While 

robust bank capital requirements alone cannot ensurc the safety and soundness of the banking 

system, we believe they playa key role in protecting the banking system and financial stability 

more broadly. 

As demonstrated during the recent financial crisis, banking organizations with strong 

capital positions are better equipped to absorb losses from unexpected sources. Furthennore, 

strong capital positions help to ensure that bank losses are borne by shareholders, rather than 

taxpayers. The June 2012 interagency proposal to amend the bank regulatory capital framework 

applies the lessons of the crisis, in part, by increasing the quantity and quality of capital held by 

banks.' For all banking organizations, the proposal would introduce a new common equity tier I 

capital requirement, raise existing minimum tier 1 capital requirements, and implement a capital 

conservation buffer to increase bank resiliency during times of stress. TIle proposal also updates 

and hannonizes the existing capital rules with a standardized approach for the calculation of risk-

, See press release and proposal, www.federalreserve.gov/newsevents/presslbcregl20120612a.htm. 
178 


79691.093

- 2 -

weighted assets, incorporating a more risk-sensitive treatment for certain asset classes to address 

weaknesses identified in the capital framework in recent years. 

For large, internationally active organizations, the proposal would introduce a 

supplementary leverage ratio, a countercyclical capital buffer, and would effectively raise the 

capital requirement by updating aspects of the advanced approaches risk-based capital rule. 

These amendments, along with other recent regulatory capital enhancements, will require the 

large, systemically important banking organizations to hold significantly higher levels of capital 

relative to other institutions. Under the proposal, savings and loan holding comparues would, for 

the first time, be subject to consolidated capital requirements, as required by the Dodd-Frank 

Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). With this proposal, U.S. 

bank capital requirements would reflect international Basel III agreements reached by the Basel 

Committee on Banking Supervision as well as relevant domestic legislative provisions, including 

sections 171 and 939A of the Dodd-Frank Act. 

In developing this proposal, the Federal Reserve sought to strike the right balance 

between safety and soundness concerns and the regulatory burden associated with 

implementation, including the impact on community banking. It is important to note that 

numerous items in this proposal, and in other recent regulatory refonns, are focused on larger 

institutions and would not be applicable to community banking orgaruzations. These items 

include the countercyclical capital buffer, the supplementary leverage ratio, enhanced disclosure 

requirements, the advanced approaches risk-based capital framework, stress testing requirements, 

the systemically important financial institution capital surcharge, and market risk capital reforms. 
179 


79691.094

- 3 -

Impact 

The Federal Reserve has assessed the impact of the changes proposed by this rulemaking 

on banking organizations and the broader financial system through domestic analyses and 

through its participation in cost-benefit analyses performed by the Basel Committee on Banking 

Supervision. The Macroeconomic Assessment Group, a working group ofthe Basel Committee, 

fOlmd that among intemationally active banks, the stronger capital standards proposed under 

Basel III would significantly lower the probability of banking crises and their associated 

economic losses, while having only a modest negative effect on gross domestic product and the 

cost of credit.2 Furthenmore, these modest negative effects can be mitigated by the phase in of 

the standards over time, which is why we have included extensive transition periods for several 

aspects ofthe proposal. The Federal Reserve believes that the benefits of the proposed changes, 

in tenms of the reduction of risk to the U.S. financial system and to the broader economy, 

outweigh the compliance costs to the financial industry and any costs to the macroeconomy. 

In developing the proposal, each of the federal banking agencies prepared an impact 

analysis of the proposed requirements on banking organizations that currently meet the minimum 

regulatory capital requirements, based on each agency's own key assumptions using regulatory 

reporting data. The Federal Reserve's analysis and assumptions are included as an attachment to 

today's testimony.3 The overall conclusion ofth~se analyses was that the vast majority of 

banking organizations would not be required to raise additional capital because they already 

meet, on a fully phased-in basis, the proposed higher minimum requirements. In addition, 

2 See "Assessing the macroeconomic impact of the transition to stronger capital and liquidity requirements" (August 

2010), www.bis.org/pubVothpIO.pdf; and "An assessment of the long-term economic impact of stronger capital and 

liquidity requirements" (August 2010), http://www.bis.org/pubVbcbsI73.pdf. 

, See Attachment A - FRB Impact, Methodology, and Assumptions. 
180 


79691.095

-4-

approximately 90 percent of community banking organizations already have sufficient capital to 

meet or exceed the proposed buffer, thus avoiding restrictions on capital distributions and certain 

executive bonus payments. While many oflhe largest banking organizations do not already meet 

the proposed new minimums and the buffer on a fully phased-in basis, they are generally making 

steady progress toward meeting these standards before they are phased in. However, the Federal 

Reserve is mindful that other burdens exist for banks, such as systems changes and other 

compliance costs, which were outside the scope of our analysis. 

Public Comments on the Proposed Changes 

The federal banking agencies released the proposed rulemaking in early June with an 

extended comment period ending on October 22, giving interested parties more than four months 

to comment on the proposal rather than the typical two- or three-month comment period. The 

agencies have received thousands of comment letters from the public, including banking 

organizations of all sizes, trade groups, academics, public interest advocates, and private 

individuals.4 Agency staffs are reviewing these letters carefully and will continue to do so in the 

coming weeks. Comments include general views on the proposal, including concems regarding 

overall complexity and burden, as well as suggestions for specific policy changes and technical 

modifications aimed at better conforming the proposal to market practices. 

The most common specific areas of concem noted by the financial industry, regardless of 

institution size, relate to the proposed treatments of accumulated other comprehensive income, 

otherwise known as AOCI, and residential mortgage exposures. The proposed treatment of 

AOCl would require unrealized gains and losses on available-for-sale securities to flow through 

to regulatory capital as opposed to the current treatment, which neutralizes such effects. 

4 See comment letters, www.federalreserve.gov/apps/foiaIViewComments.aspx?doc _id=R-1442&doc _ ver=l. 
181 


79691.096

- 5 -

Cornmenters have expressed concern that this treatment would introduce capital volatility, due 

not only to credit risk but also to interest rate risk, and affect the composition offirms' securities 

holdings. The proposed treatment of AOCI is part of the Basel III Accord and is meant to better 

reflect an institution's actual loss-absorption capacity; however, we are analyzing cornmenters' 

concerns and will be assessing potential ways forward in this area as we finalize the rule. 

In light of observed high loss rates for residential mortgages during the crisis, the 

agencies proposed a modified treatment aimed at better differentiating the risks of these 

exposures, which are generally assigned preferential risk weights under our current approach. 

Commenters have expresscd concern that the operational burden and compliance costs of the 

proposed methodology for risk weighting residential mortgage exposures and the higher risk 

weights for certain types of mortgage products will increase costs to consumers and reduce their 

access to mortgage credit. The Federal Reserve, along with the other federal banking agencies, 

will take these and all comments received into consideration as we finalize the rule. 

Community Banks 

The Federal Reserve believes capital requirements that improve the quantity and quality 

of regulatory capital would benefit the resiliency of all banking organizations regardless of size. 

However, as we consider comments from industry participants and other interested parties 

regarding the proposed regulatory capital requirements, the Federal Reserve, along with the other 

federal banking agencies, will remain sensitive to concerns expressed by community banking 

organizations. The Board recognizes the vital role that community banking organizations play in 

the U.S. financial system. Community bankers typically have deep roots in their communities, 

allowing them to gain insights on their local economies and to forge strong relationships with 
182 


79691.097

- 6-

customers. As a result, they can provide relationship-based lending to small businesses, families, 

and others in their local communities in a manner that larger institutions would find difficult to 

duplicate. 

When the agencies were developing these proposals, we recognized the need to carefully 

assess their impact on community banking organizations. While we conducted internal analysis 

to estimate the impact of the proposal (as discussed earlier), the Federal Reserve also recognized 

the importance of soliciting feedback directly from community banking organizations to 

understand more specifically the potential effects on their business activities. To facilitate 

review of the proposal, the agencies provided summaries of the requirements that were most 

relevant for community banking organizations, provided a tool to help smaller organizations 

estimate their capital levels under the proposal, and extended the comment period so that 

interested parties would have more time to assess the proposals and submit their comments. TIle 

Federal Reserve also engaged in substantial industry outreach to hear the views of cOlmnunity 

bankers and encourage submission of comments. For example, we held a series of "Ask the 

Fed" sessions aimed primarily at banking organizations supervised by the Federal Reserve that 

provided an overview of the proposals and gave bankers an opportunity to ask us questions. 

Following these sessions, which were attended by more than 3,000 bankers, we published a 

summary of answers to frequently asked questions in a new Federal Reserve publication for 

community bankers.5 Throughout the comment process, Board members and staff also met with 

various industry associations to clarify and discuss aspects of the proposaL 

5 See "Community Banking Connections: A Supervision and Regulation Publication" (Third Quarter, 2012), 

www.communitybankingconnections .orglarticlesl20 121Q31CBCQ320 12.pdf. 
183 


79691.098

- 7-

Through outreach efforts and as part of the comment process, community banking 

organizations have expressed concerns about particular elements of the proposed requirements, 

indicating that they do not adequately take into account the community banking business model 

and that some aspects would have potential disproportionate effects on their organizations. In 

particular, they have asserted that the proposed treatment of AOCI would have more of an 

impact on community banks because they have fewer available strategies to address the resultant 

capital volatility relative to larger institutions. In addition, they have expressed concern that the 

relatively higher risk weights assigned to certain mortgage products would penalize loan 

products that community banking organizations typically provide their customers. We will be 

mindful of these comments when considering potential refinements to the proposal and will work 

to appropriately balance the benefits of a revised capital framework against its costs. As we 

work toward finalizing the rule, we will seek to further tailor the requirements as appropriate for 

community banking organizations. 

Insurance Holding Companies 

The proposal would apply consolidated risk-based capital requirements that measure the 

credit and market risk of all assets owned by a depository institution holding company and its 

subsidiaries, including assets held by insurance companies. In addition, the proposal would 

capture the risk of insurance underwriting activities included in the consolidated holding 

company capital requirements by requiring deduction of the minimum regulatory capital 

requirement of the relevant state regulator for insurance companies in the consolidated group. 

Currently, capital requircmcnts for insurance companies are imposed by state insurance laws on 
184 


79691.099

- 8 -

a legal entity basis and there are no state-based, consolidated capital requirements that cover the 

subsidiaries and non-insurance affiliates of insurance companies. 

The proposed capital requirements have been criticized by savings and loan holding 

companies that are not currently subject to consolidated capital requirements and that have 

significant insurance activities. Before mentioning some of the concerns raised by the industry, I 

would like to provide some background regarding the policy rationale for this proposal. The 

proposed application of consolidated capital requirements to savings and loan holding companies 

is consistent with the Board's long-standing practice of applying consolidated minimum capital 

requirements to bank holding companies, including those that control functionally regulated 

subsidiary insurance companies. Importantly, such an approach eliminates incentives to engage 

in capital arbitrage by booking individual exposures in the legal entity in which they receive the 

most favorable capital requirement. 

The proposed requirements are also consistent with the Collins Amendment in section 

171 of the Dodd-Frank Act, which requires that the agencies establish consolidated minimum 

risk-based and leverage requirements for depository institution holding companies (bank holding 

companies and savings and loan holding companies) that are no less than the generally 

applicable risk-based capital and leverage requirements that apply to insured depository 

institutions under the prompt corrective action framework. At the same time, the proposal 

included provisions assigning specific risk weights to assets typically held by insurance 

companies but not depository institutions, namely policy loans and non-guaranteed separate 

accounts. These provisions were designed to appropriately risk weight assets particular to the 

insurance industry while at the same time ensuring that the proposals complied with section 171 
185 


79691.100

- 9-

of the Dodd-Frank Act and fulfilled the policy goals for consistent consolidated capital 

requirements previously described. 

Through the comment process, depository institution holding companies with insurance 

activities raised overarching concems that the proposed regulatory capital requirements, which 

have plimarily been developed for banking organizations, are not suitable for the insurance 

business model. In particular, they assel1 that the proposal does not appropriately recognize the 

longer-term nature of their liabilities and their practice of matching asset and liability matulities. 

They also assert that the proposal would disproportionately affect longer term assets held by 

lilany insurance companies, thus causing them to fundamentally alter their business strategy. 

These holding companies also have requested a longer transition period to implement 

consolidated capital requirements for the first time. Currently, those savings and loan holding 

companies that are also insurance companies report financial statements to state insurance 

regulators according to Statutory Accounting Principles and would have to begin reporting under 

the Generally Accepted Accounting Principles to comply with consolidated regulatory capital 

requirements, a change they assert would be unreasonably costly. 

The Federal Reserve takes these comments seriously and will consider them carefully in 

determining how to appropriately apply regulatory capital requirements to depository institution 

holding companies with significant insurance activities. 

Timeline 

Given the breadth of the proposed changes, many industry participants have expressed 

general concem that they may be subject to a final regulatory capital rule on January 1,2013, as 

contemplated in the proposals, and that this would not provide sufficient time to understand the 
186 


79691.101

- 10-

rule or to make the necessary systems changes. Therefore, the agencies clarified on Friday that 

they do not expect to finalize the proposal by January 2013.6 We are working as quickly as 

possible to evaluate comments and issue a final rule that would provide the industry with 

appropriate transition periods to come into compliance. 

Thank you. I would be pleased to take your questions. 

6 See "Agencies Provide Guidance on Regulatory Capital Rulemakings," 

www.federalreserve.gov/newsevents/presslbcreg/2012Jl09a.htm. 

79691.102

Top-tier oncs that meet 1 minimums under the current anti proposed rule 

Dntnas of March 31, 2012 

CuTtt'nt rule, (Bnsell) 

>"'$500mand< 

BHCtot1l1 assets\zc $IOb >$10 b 

l'otalll-top-tier8HCs 877 7B 

Number of BHCs that meet 4% tier J minimum today 859 77 

% 98% 99% 

Ayg $ Amount of tier ! in excess of minimum (SOOOS) SIII,428 $10,479,89& Avg multiple orticr 1 hcld {tier I required 3.8 3.6 

Proposed rule (Busel 111) 

>""$500m(lnd< 

Total 

955 

936 

98% 

SHC \()Iai asset size SlOb >$10 b Towl 

TOlal filop-tier BHCs 877 18 955 

Number ofBHCs lhal meel6% tier 1 minimum as pmposc<i BID 74 884 

% 92% 95% 93% 

Averuge.$ amount oflier 1 iTl excess of minimum (SOOOs) Average multiple of tier I held I ticr 1 required 

171.115 

2.1 

$5,658,259 

1.9 

AT

To-p-tier BUCs Ihilt do not meet tier 1 minimums under the current nnd proposed rule 

Da1<1 as of Mllrch 31,2012 

Current rules 

>'" $500m und 

I3HCtolalassetsiz.c <SlOb >$10 b 

Total # lop-tier SHes 877 78 

Number of SHes that do [lot meet 4% lief I mimmum today 18 1 

% 2% 1% 

Avcmgc S amount aflier I shortfall of minimum (SOOOs) ·$34,166 S497,448 Aggregate S amount artier I shortrall of minimum (SOOOs) ·S625,791 .$497,448 

Proposed rule- (8"5£01 un 

>"'$500mand 

BHClOlalllsscts)ze <SlOb >SIOb 

Total II- lop-tier SHes 877 78 

Number ofBHCs IhB! do not mcct 6% tier 1 minimum liS proposed 

% 

Avefil.gc 5; alnount of tier 1 sJlortrall of minimum ($OOOs) ·$32,716 .S688,217 

Aggregate S amount oflicr 1 shortfall ofminimum (SOOOs) -$2,191.942 .$2,752,868 

PrQl!osed rule 1Bnsci UQ e>:cluuing those who f"iI tier 1 min tndnl 

,"""S500m nnd 

SHC !<){al as.wl size .:::$lOb >SIO b 

Tota! /I top-tier I3HCs 877 78 

Tier! 

Number ofBBCs lhat do not meet 6% tier 1 minimum as proposed ,9 

%oftola! 6% 4% 

Avef.llgc $ amount of tier ! shortfall of minimum ($0005) -$.17,124 .$309,260 Aggregute $ nmount oftlcr I shortthH of minimum (SOOOs) ·$839.087 .$927.781 

Common eguitv tier I fCET!) 

Number ofEBCs that do not 4,5% CET! mmimum as proposed 

lI/o 

Avcrtlgc $ amount ofCETl 4.5% shonfaH orminimllm ($0005) a:S I 5.3-''i5 ...$21,8&8 Aggreglltc $ amount ofCET1 4.5% short rail of minimum ($OOOs) H$829,181 .$21,888 

Number ofBHCs thllt do not mcct 7% CETI minimum as proposed 

% of total 

Average $ amount ofCETl 7% shonfall or minimum ($OOOs) .S23,483 -$152,523 

Aggreg.lltc S .Ilmount ofeET! 7% shortfall orminimum {S{JOOs} .$3,522,450 -$6,020,186 

79691.103

Bunks that meet tier 1 minimums under the cllrrent nmlllr'oroscd rule 

Datil as of March J J, 2012 

Current ruj($ 

Bonk lotal osset sile 

Total II banks 

Number of banks that meet 4% lier 1 minim\lm today 

%Oflotol 

Avg.$ amount of tier 1 in excess of minimum (S0005) 

Avg of tier 1 held I tier 1 required 

j'roposed rule (BnselIll} 

<SlOb 

7,:269 7,213 

99% 

S30,1l0 

5.7 

Bank lotal asset sile < SlOb 

To!al # banks 

>-SIOb 

107 107 

100% 

S6,05j,069 

4.1 

>-"$lOb 

107 

that meet 6% tier I minimu.m fl5 proposed 

Avurage S arnllunl oflier 1 in excess of minimum (SOOOs) 

Avcragemultiple t held J lier 1 reglliretl 

$24,184 

3.7 

$4,153,418 

2.4 

Total 

7,376 7,320 

99% 

Totnl 

7,376 

7.200 

--;mz 

Bunks that do not meet tier I minimums under the current nnd proposed rule 

Data as of March 31, 2012 

Current (8I1sell) 

Bank tom! asset size 

TotaliJ banks 

Number ofbnnks that do not meet 4% tier 1 minimum today 

%oflotl\1 

Average S ammmt of tier I shortfall of mini mUlTI (SOOOs) Aggregllte S amount artier 1 shortfflll of minimum ($0005) 

PropOllc:d XliJe (Bnsei HI) 

Book !otalllsset si1.c 

Totul # banks 

Number of banks that do n01 meet 6% tier 1 minimum as prDp0sed 

%oftotnl 

Average: S DmOtlnt orticr 1 shortt'oll of minimum (SODOs) Aggregate Somollnt of tier 1 shortfElIi ofmillimmn (SOOOs) 

Proposed rule (Bosel 111) excluding thnse whn fnil tier' 1 min todny 

<SlOb 

7,269 

56 

J% 

·$2,344 

·5131.254 

< SlOb 

7,:269 

175 

2% 

.$5.)0) 

·$928.108 

::.=SIOb 

107 

0 

0% 

SO SO 

>-""'SIOb 

107 

1 

1% 

·,106,263 

·$106.263 

AT

Bank: total osset size < SlOb >"'$ lOb 

Total #- banks 7,269 107 Tier I 

Number of banks that do not meet 6% lier I minimum as proposed 

%oftotnl 

Average $ amount aftier 1 shonfall of minimum (SOOOs) 

AggrclJate $ amDunt ortier 1 shortfall oflmnimum ($0005) 

Common equity tier J (eET!) 

119 

2% 

.$4,273 

·,508.437 

I 

-1106,263 

·S106,263 

Number of banks thaI do not meet 4.5% CETI minimum as proposed 59 

% oftutal 1% 0% 

Average $ amount orCET! 4.5% shOrlfall of minimum (SooOs) AggregateS nmount ofCETl 4.5% shortfall of minimum (£0005) 

Number of banks that do not meet 7% CETI minimum as proposed 

%oftotnl 

Average $ amount ofCETI 7% shortfa!1 of minimum (SODOs) 

Aggregate $ amount ofCET! 7% shortfall of minimum (SOOOs) 

.$6,694 

.$394.934 

187 

3% 

·S6,2[)6 

.$1.160,524 

SO 

$0 

2% 

·$196,296 

·$392,592 
189 


79691.104

ATTACHMENT A 

lmpact Analysis Methodology for Basel 3 NPRs 

Staff conducted an analysis to assess the impact of the proposed changes to the definition of capital (Basel III NPR) and to 

risk-weighted assets (Standardized Approach NPR) for banks and top-tier bank holding companies using available data, as 

of March 31, 2012, from the commercial bank Call Reports and the holding company FR Y-9C reports. Because required 

data was not always available, staffmClde certain assumptions (listed below) to calculate the Basel III requirements. 

Definition of capital (numerator of risk-based capital ratios) 

\Vith respect to the regulatory deductions from capital, staff made assumptions regarding the amount of: 

o outstanding DTAs subject to full deduction and the amount subject to the threshold deductions; 

o investments in the capital of unconsolidated financial institutions subject to the threshold deductions; & 

common equity tier 1 and tier I minority interest based on outstanding Class A minority interest. 

Standardized approach risk-weighted assets (denominator of risk-based capital ratios) 

To estimate Basel III risk-weighted assets, staff used line items from the Call Report and Y ~9C to estimate changes in the 

risk-weighted asset amount for residential mortgage exposures, high-volatility commercial real estate (HVCRE) exposures. 

past-due loans, and securitizations. 

The risk weight for HVCRE exposures (defined as construction,land development, and other land loans for this analysis; 

available on the regulatory reports) was increased from a risk-weight of 100% to ] 50%. 

Residential Mortgage Exposures 

First-lien residential mortgage exposures as reported on the regulatory reports (currently risk weighted at 50%) were 

assumed to be category 1 exposures, while junior lien exposures~ including home equity lines ofcredit, (currently riskweighted at 100%) were assumed to be category 2 exposures. 

o To distribute residential mortgages across the proposed risk weights, which are based on LTV. an LTV distribution for 

firms' first and second lien mortgage portfolios was estimated using loan LTV data from industry databases (McDash 

and Corelogic) and then spread across the Category I risk weights (35%J to 100%) and Category 2 risk weights (100% 

to 200%), as appropriate. 

Past-due loans (loans past due 90 days or more and nonaccrualloans, excluding residential mortgages and sovereign 

exposures), which currently are risk~weighted at 100%, were assigned to the J50% risk weight. 

For foreign sovereign exposures, used the public cross~border claims and the foreign-office claims on local residents in 

non-local currency from the FFIEC 009 report to find a distribution of foreign sovereign exposures by country, which was 

assumed to be representative across all institutions. Assigned risk weights by country: under Basel I, OECD countries 

received a zero percent risk weight, while all other countries received a 100% risk weight; under Basel III, assigned 

countries risk weights according to their CRC ratings. Applied country distribution, with associated risk weight, to foreign 

debt securities line items from the regulatory report. 

Securitization exposures 

o An interagency analysis was conducted using the simplified supervisory formula approach to calculate risk weights on 

tranches within 60 securitization transactions downloaded from an industry database (lntex) 15 deals each were 

selected for credit cards, autos, residential mortgages, and commercial mortgages. 

To calculate average risk weights under Basel [, each tranche of the selected transactions was assigned a risk weight 

according to the general risk-based capital rules with certain assumptions. As a result, certain exposures were 

assigned risk weights according to the ratings-based approach. most mezzanine and junior positions were assumed to 

receive a 1,250% under the gross-up approach. and low-rated senior positions were assigned a 100% risk weight. To 

calculate average risk weights under Basel IH, the SSFA was applied to each tranche of the selected transactions. 

o The current balance of each transaction was lIsed to calculate a weighted average risk weight across each transaction 

type, These risk weights were then applied to each bank's value of summed items from the regulatory report for 

RMBS, CMBS, auto, and credit card. 
190 


79691.105

ATTACHMENT A 

I. Steps for estimating the numerator changes for the capital ratios under the Basel 3 proposal 

Staff from an inter-agency work group used both qualitative measures (such as discussions with banks), 

as well as quantitative measures (such as QIS data) to create the assumptions used to estimate capital as 

proposed in the Basel 3 NPRs. 

The assumptions include: 

40% ofa bank's deferred tax assets (OTAs) are used as a proxy for "carry-forward OTAs," 

which would be subject to full deduction 

60% ofOTAs are used as a proxy for "temporary differences OTAs," which would be subject to 

strict limits 

80% of qualifying non-controlling (minority) interests in consolidated subsidiaries is used as a 

proxy for qualifying "common equity tier 1 minority interest" 

20% of qualifying non-controlling (minority) interests in consolidated subsidiaries is used as a 

proxy for qualifying "tier I minority interest" 

40% of investments in unconsolidated subsidiaries and associated companies is used as a proxy 

for "significant investments in unconsolidated financial institutions in the form of common 

stock" 

Regarding tier 1 deductions resulting from the corresponding deduction approach, trust preferred 

securities issued by financial institutions are used as a proxy for investments in the capital of 

unconsolidated financial institutions 

1. Basel 3 Common equity tier 1 (CETl) calculation 

The following items from the regulatory reports were used in the Basel 3 CETl numerator calculations: 

Item Banks BHCs 

(Call Report) (Y-9C) 

Common stock RCFD3230 BHCK3230 

Surplus RCFD3839 BHCK3240 

Retained Earnings RCFD3632 BHCK3247 

AOCI RCFDb530 BHCKb530 

Other equity capital components RCFDa130 BHCKa130 

Qualifying non-controlling (minority) interests in RCFDb589 BHCKG214 

consolidated subsidiaries 

Goodwill RCFDb590 BHCKb590 

Cumulative change in fair value of all financial RCFDf264 BHCKf264 

liabilities accounted for under a fair value 

option that is included in retained earnings and is 

attributable to changes in the bank's own 

creditworthiness 

Purchased credit card relationships and RCFDb026 BHCKb026 

nonmortgage servicing assets 

Net deferred tax assets RCFD2148 BHCK2148 

Investments in unconsolidated subsidiaries and RCFD2130 BHCK2130 

associated companies 

Mortgage servicing assets RCFDa590 BHCK6438 
191 


79691.106

ATIACHMENTA 

The Basel 3 CETl base 

The Basel 3 CETl base used for the 10 and 15% threshold limitations described below is calculated by 

adding common stock, surplus, retained earnings, AOCI, other equity capital components, and 80% of 

qualifying non-controlling (minority) interests in consolidated subsidiaries (CETl minority interest). 

Subtracted from that value is goodwill, the cumulative change in fair value offinanciaLliabilities, the 

purchased credit card relationships and nonmortgage servicing assets, and the 40% of OTAs ("carryforward OT As"). 

The 10 and 15% threshold limitations on MSAs, DTAs, and significant investments in 

unconsolidated subsidiaries in the form of common stock 

The 10% potential deduction for MSAs, "temporary differences OTAs" and significant investments in 

unconsolidated financial institutions in the form of common stock is calculated using the CETl base 

described above. 

The 15% limitation for MSAs, "temporary differences DTAs" and significant investments in 

unconsolidated financial institutions in the fonn of common stock is equal to 17.65% ofthe Basel 3 CETl 

base, less the sum of the 10% deductions described above. 

Basel 3 CETI capital calculation 

Basel 3 CETI is equal to the Basel 3 CETl base, less deductions resulting from the 10% limitations, less 

deductions resulting from the 15% limitation described above. 

2. Basel 3 Tier 1 capital calculation 

The following items from the regulatory reports were used in the Basel 3 tier I numerator calculations: 

Item Banks (Call Report) BHCs(Y-9C) 

Perpetual preferred stock and related surplus RCF03838 BHCK3283 

Non-qualifYing perpetual preferred stock RCFDb588 BHCKb588 

QualifYing non-controlling (minority) RCFDb589 BHCKG214 

interests in consolidated subsidiaries 

Trust preferred securities issued by financial RCFDg349 BHCKg349 

institutions 

(HTM fair value from HC-B) 

Trust preferred securities issued by linancial RCFDg35I BHCKg351 

institutions 

(AFS fair value from HC-B) 

Trust preferred securities issued by financial RCFDg299 BHCKg299 

institutions (consolidated from HC-D) 

Basel 3 tier 1 capital calculation 

Basel 3 tier I capital is estimated to be equal to the Basel 3 CETl base plus perpetual preferred stock and 

related surplus, plus tier I minority interest, less non-qualifying perpetual preferred stock and less any 

amount of investments in the capital of unconsolidated financial institutions above the 10% threshold 

limitation. 
192 


79691.107

ATTACHMENT A 

2. Basel 3 Tier 2 and total capital calculation 

The following items from the regulatory reports were used in the Basel 3 tier 2 and total capital numerator 

calculations: 

Item Banks (Call Report) BHCs (Y-9C) 

QualifYing subordinated debt and RCFD5306 BHCKg217 

redeemable preferred stock 

Cumulative perpetual preferred RCFDb593 BHCKg218 

stock includible in Tier 2 capital 

Allowance for loan and lease RCFD5310 BHCK5310 

losses includible in Tier 2 capital 

QualifYing restricted core BHCKg215 

elements (other than cumulative 

perpetual preferred stock) 

Unrealized gains on AFS equity RCFD222I BHCK222I 

securities includable in Tier 2 

capital 

Other Tier 2 capital components RCFDb594 BHCKb594 

Basel 3 tier 2 capital calculation 

Basel 3 tier 2 is calculated by adding qualifying subordinated debt and redeemable preferred stock, 

cumulative perpetual preferred stock includible in tier 2 capital, allowance for loan and lease losses 

includible in tier 2 capital, unrealized gains on available-far-sale securities includable in tier 2 capital, 

other tier 2 capital components, and qualifying restricted core elements (other than cumulative perpetual 

preferred stock), which is the value of the trust-preferred securities that were removed from tier I capital. 

Basel 3 total capital calculation 

Basel 3 total capital is calculated by adding tier I and tier 2 capital as described above. 

II. Steps for estimating the denominator changes for the capital ratios under the Basel 3 proposal 

(standardized approach) 
193 


79691.108

ATTACHMENT A 

To determine the impact of the changes to risk-weighted assets under the standardized approach, staff 

used existing risk-weighted assets (less numerator deductions), and then added the Basel III "impact" for 

the following categories: foreign sovereign exposures, foreign DI exposures, high volatility commercial 

real estate (HVCRE), past-due loans, residential mortgage exposures, and securitization exposures. 

1. "Base" risk-weighted assets and risk-weighted asset impact by category 

The "base" (reported) risk-weighted asset value for each bank was first adjusted to reflect any ofthe 

capital deductions described in part I (numerator changes). Staff then estimated a change in risk-weighted 

assets for each category (foreign sovereign exposures, foreign DI exposures, HVCRE, past-due loans, 

residential mortgage exposures, and securitization exposures) by pulling line items for each category, and 

comparing the risk-weighted exposure amount under Basel I versus under Basel III. 

A. Foreigll Sovereigll Exposures. 

I) Sum line items RCFD 1742, RCFD 1744, and RCFD 2081 for each bank, finding one value, 

"sovereign amount" per bank. 

2) Sum the exposure amounts from 009 Report line items FCEX C916 and C919 for each country. Find 

the % by country by dividing total for country over total exposures for all countries for FCEX C916 and 

C919. Will have one % for each country. This "distribution" will be used for all banks and bank holding 

companies. 

For this analysis: 

Removed countries where there were no exposure values 

Removed lines that were regions or sums of countries (ie only included individual country data) 

3) Find appropriate risk weight under Basel I and Basel \II per country as outlined below: 

Basel I (baseline) 

4) Exposures to OECD member countries receive a zero percent risk weight, while exposures to all other 

countries receive a risk weight of 100 percent. Multiply applicable risk weight (zero or 100) by exposure 

amount per country. Sum the amounts per country, per bank to find risk-weighted exposure amount by 

asset size group. 

CRC Ratings Risk Weight 

0-1 00/0 

2 20% 

3 50% 

4-6 100% 

7 150% 

NoCRC 100% 

4) Use CRC table to find appropriate risk weight per country. Multiply risk weight by the distribution 

percentage found in step 2; then mUltiply by exposure amount per bank. 

B. Foreign DI Exposures. 

I) PuUline RCFD B532 for each bank as "foreign OJ amount." 
194 


79691.109

ATTACHMENT A 

2) Sum the exposure amounts from 009 Repolt line items FCEX C915 and C918 for each country. Find 

the % by country by dividing total for country over total exposures for all countries for FCEX C915 and 

C918. Will have one % for each country. This "distribution" will be used for all banks and bank holding 

companies. 

3) Find appropriate risk weight under Basel 1 and Basel III per country as outlined below: 

Basell (baseline) 

4) Foreign DI exposures to OECD member countries receive a 20 percent risk weight, while exposures to 

all other countries receive a risk weight of 100 percent. Multiply applicable risk weight (20 or 100) by 

exposure amount per country. 

4) Use CRC table below to find appropriate risk weight per country. Multiply risk weight by the 

distribution percentage found in step 2; then multiply by exposure amount per bank. 

CRC of Sovereign Risk Weight (%) Incorporation 

0-1 20 

2 50 

3 lOa 

4-7 150 

NoCRC 100 

C. Higl! Volatility Commercial Real Estate (HVCRE) 

Steps for analysis: 

J) Pull line item RCONf159 by bank as "HVCRE." 

Basell 

2) HVCRE under Basel 1 is 100% risk-weighted. 

Basellll 

2) HVCRE under Basel III is 150% risk-weighted. 

D. Past-due loallS 

Steps for analysis: 

I) Sum line items: rcfdfl71 rcfdfl70 rcfd546I rcfd5460 rcfd 1256 rcfdl255 rcfd 1253 rcfd 1252 rconc229 

rconc237 rconc230 rconc239 rcfdfl67 rcfdl597 rcfd539I rcfd5390 rcfd5382 rcfd538I rcfd5379 rcfd5378 

rcon3495 rcon3494 rconfl83 rconf181 rconf180 rconf182 rcfnb574 rcfnb573 rcon5400 rcon5399 

rcon3501 rcon3500 rcfdl583 rcfdk215 rcfdk214 rcfdk217 rcfdk218 rcfdb577 rcfdb576 rcfd3506 rcfd3507 

rconf177 rconfl75 rcfdfl68 rconfl76 rconfl74) as "Past Due Loans" per bank. 

Basel I 

2) Past Due loans under Basel I are 100% risk-weighted. 

Basel III 
195 


79691.110

ATIACHMENT A 

2) Past Due loans under Basel 1II are 150% risk-weighted. 

E. Resitlential Mortgage Exposures. 

Steps for analysis: 

I) Pull line item RCON 5367 (first liens) per bank as "RCON 5367." Sum line items RCON 1797 and 

RCON 5368 Gunior and revolving liens) for each bank as "RCON 1797+RCON 5368." 

Basel I 

2) Multiply "RCON 5367" by 50% (RW); multiply" RCON 1797 +RCON 5368" by 100% (RW). Sum 

these values by bank to find the risk-weighted exposure amount for residential mortgages. 

BasellI! 

2) Distribute "RCON 5367" according to table and multiply that amount by appropriate risk weight, per 

the table. Sum the values by bank. Note for this analysis, used the original LTV category (per ALH). 

Distributions for Category I and Category 2 loans are based on analysis from Paul Calem (document 

titled "ltv distributions.IX!"). 

Original LTV 80% of First Category J risk 20% of First liens Category 2 risk liens are Category Category 1 weight are Category 2 weight 

<=60 32.73 35% 4.02 100% 

> 60 and <= 80 60.81 50% 18.04 100% 

> 80 and <= 90 2.89 75% 26.44 100% 

>90 3.58 100% 51.5 200% 

3) Distribute "RCON 1797 +RCON 5368" according to table and multiply that amount by appropriate 

risk weight, per the table. 

Percent of principal balance by Category 2 residential 

LTV Category category mortgage eXjlosure risk weights 

<=60 22% 100% 

> 60 and <= 80 40% 100% 

> 80 and <= 90 24% IjO% 

>90 14% 200% 

Total 100% 

F. Securitization Exposures. 

Approach: The New York RB and the Philadelphia RB provided a file of anonymized securitization data 

trom large banking organizations across five product types (CLOs, non-agency RMBS, Credit Card, 

Auto, and CMBS) with the necessary data points including an external rating, attachment point and 

detachment points, and cumulative loss data. For each of these product types, risk weights were 
196 


79691.111

ATTACHMENT A 

calculated for 25 securities under the Baseline and the SSFA. The average risk weights under the 

Baseline and the SSFA for these securities were used as a proxy to estimate the impact. 

1. For each product type, provide the weighted average for the Baseline R Wand the SSFA risk weight. 

Baseline Ave R W SSFA Ave RW 

TYEe (Basel J treatment) (Basel III treatment) 

Credit Cards 109% 170.4% 

Autos 52% 67% 

CMBS 164% 239.5% 

RMBS' 365% 445% 

*to find Basel I risk weight for RMBS, using interagency-supplied securitization data: 

1) Used "current" cycle date data only 

2) anything with a detachment point of 100 (senior) got 100% risk weight, all else got 1250% as 

"B I risk weight" 

3) used current bal to find a weight per transaction 

4) multiplied weight by B 1 risk weight; summed risk weights to find one weighted average risk 

weight 

2. Baseline reporting line items: 

Type Baseline Call Report Line Items Baseline BHC Line Items 

Credit Cards RCFD B838, RCFD B841 BHCK B838, BHCK B841 

Autos RCFD B846, RCFD B849 BHCK B846, BHCK B849 

RCFD KI46 RCFD K149, RCFD K154, BHCK K146, BHCK K149, BHCK 

CMBS RCFDK157 K154, BHCK K157 

RCFD G30S, RCFD G311, RCFD G320, BHCK G308, BHCK G311, BHCK 

RMBS RCFD 0323 G320, BHCK 0323, 

3. For each product type, aggregate and average the Call Report line items and apply the Baseline (Basel 

I) risk weights and SSFA risk weights (Basel 3). 

3. Calculate impact and Basel III risk-weighted assets 

For each category (foreign sovereign exposures, foreign 01 exposures, HVCRE, past-due loans, 

residential mortgage exposures, and securitization exposures), multiplied the line items from the 

regulatory reports first by the risk weight for Basel I, which represented the risk-weighted assets under 

Basel I for that category. This step was replicated for Basel III by multiplying the line items from the 

regulatory reports by the risk weight for Baselll!, which represented the risk-weighted assets under Basel 

III for that category. 

The "impact" of Basel III was the Basel III amount per category less the Basel I amount per category, per 

bank, which represented the increase in risk-weighted assets for that category. The impact amount from 

each category was added to the "base risk-weighted assets" calculated in step I per bank. The sum of the 
197 


79691.112

AITACHMENT A 

base risk-weighted assets plus the impacts of each category represented the Basel III risk-weighted asset 

amount. 

4. Additional Notes: 

This analysis was replicated for banks and bank holding companies. 

For the bank holding company analysis, used only top-tier BHCs with more than $500 million in 

total assets. 

Instances where tier J. as reported in the Call Report or Y -9C was negative was left in the 

analysis, assuming that the reported figures were accurate. 
198 


79691.113

TESTIMONY OF 

GREG GONZALES 

COMMISSIONER OF FINANCIAL INSTITUTIONS 

TENNESSEE DEPARTMENT OF FINANCIAL INSTITUTIONS 

On behalf of the 

CONFERENCE OF STATE BANK SUPERVISORS 

On 

"EXAMINING THE IMPACT OF PROPOSED RULES TO IMPLEMENT BASEL III 

CAPITAL STANDARDS" 

Before the 

FINANCIAL INSTITUTIONS AND CONSUMER CREDIT SUBCOMMITTEE 

INSURANCE, HOUSING, AND COMMUNITY OPPORTUNITY SUBCOMMITTEE 

COMMITTEE ON FINANCIAL SERVICES 

UNITED STATES HOUSE OF REPRESENTATIVES 

Thursday, November 29, 2012, 10:00 a.m. 

Room 2128 Rayburn House Office Building 
199 


79691.114

Introduction 

Good morning, Chainnan Capito, Chainnan Biggert, Ranking Member Maloney, 

Ranking Member Gutierrez, and distinguished Members of the Subcommittees. My name is 

Greg Gonzales, and I serve as the Commissioner of Financial Institutions for the State of 

Tennessee. I am also the Chairman of the Conference of State Bank Supervisors (CSBS). It is 

my pleasure to testify before you today on behalf of CSBS. 

CSBS is the nationwide organization of banking regulators from all 50 states, the District 

of Columbia, Guam, Puerto Rico, and the U.S. Virgin Islands. State banking regulators 

supervise, in cooperation with the Federal Deposit Insurance Corporation or the Federal Reserve, 

approximately 5,400 state-chartered insured depository institutions. Further, most state banking 

departments also regulate a variety of non-bank financial services providers, including mortgage 

lenders. For more than a century, CSBS has given state supervisors a national forum to 

coordinate supervision of their regulated entities and to develop regulatory policy. CSBS also 

provides training to state banking and financial regulators and represents its members before 

Congress and the federal financial regulatory agencies. 

Today's hearing focuses on one of the most significant public policy matters facing the 

banking industry. The Basel III and Standardized Approach proposals would introduce 

sweeping changes to the regulatory capital framework and would significantly impact banks' 

credit allocation decisions and tolerance for risk. These proposals have emerged in a period 

when industry participants and policymakers alike are attempting to restore stability to the U.S. 

economic system and foster job growth. This also occurs at a time when many smaller 

institutions are expressing concern about regulatory burden and the impact regulation may be 

having on their long-term viability. As I will discuss more thoroughly, I believe it is in the best 

interest of the financial industry and the broader economy for the federal banking agencies to 

consider significant revisions to the proposals. 

We appreciate the agencies' outreach to facilitate the industry's understanding of the 

capital proposals. They have gone to great lengths to deliver the facts ofthe proposals to the 

pUblic. Their efforts have included hosting webinars, roundtables, and developing a calculator 

for banks to get a sense of their position within the context of the proposals. Indeed, I believe 

one of the main reasons for the volume of comment letters is due to their outreach. I have never 

seen a public policy matter to which the industry and other relevant stakeholders have been so 

well-infonned and so well-versed. The educational aspect of the process has created a healthy 

and thorough dialogue on the proposals. 

To be clear, we absolutely support enhancing the quality of capital and increasing 

required minimum capital. State bank regulators believe the agencies should pursue this effort 

outside of the Basel III process. But I also believe the issue at hand presents an opportunity for 

all of us to thoroughly evaluate our methods for developing meaningful and effective public 

policy to support our regulatory and economic goals. I am certain the lawmakers, federal 

regulators, and state bank regulators here today share the collective goal of supporting the effort 

to strengthen our financial system and generate stability for the American people. This is the 

fundamental concept that will frame my comments and suggestions. 
200 


79691.115

Effective and Forward-looking Capital Regulation Requires a Balanced and Realistic 

Approach 

The proposed capital rules are a symptom of a much bigger problem. Banking rules are 

increasingly being written with greater complexity and placing more burden on institutions. 

Federal policy, by its nature, tends to cover the entire industry with limited differentiation. The 

banking system is very diverse with over 7,200 banks ranging in size from a few million dollars 

in assets to well over one trillion dollars. Over 6,500 of these banks have assets under one 

billion dollars. Federal banking policy often applies to the whole industry, even if it is aimed at 

addressing issues particular to the largest, most complex institutions. As a result, these policies 

are increasingly inconsistent with how most banks conduct their business. Bankers are 

concerned they are losing their flexibility to exercise judgment which is critical to how a 

community bank functions. For most institutions, capital adequacy and risk management are not 

quantitatively or model driven. The management of risk for community banks is largely based 

on a thorough understanding of the underlying credit risk, a deep knowledge of its customer 

base, and an alignment between the success of the bank and its customers. State bank regulators 

fundamentally believe this is a model that must be maintained for our collective economic 

benefit. 

We are concerned that regulatory policy is driving the industry to be too conservative. 

Leading up to the financial crisis, some institutions were over-extended in their risk tolerance in 

certain asset classes. This was matched by a regulatory environment which misj udged the 

bank's ability to manage risk and absorb losses. However, state bank regulators do not believe 

that the answer to every problem should be more capital. We must learn from these mistakes and 

expect more from banks in terms of risk management and improved supervisory processes. 

These are more difficult tasks, but I believe we have done this and can do more. The rules as 

proposed will do little more than limit credit to the most conservative exposures. 

We need rules that ensure safety and soundness but permit banks to achieve economic 

success. It is important for us to remember that while 463 banks have failed in this cycle, over 

7,000 banks survived. In addition, the resolution regime established by Congress and funded by 

the industry through the FDIC worked exactly as designed for all but our largest banks. The 

objective of our system-wide regulatory apparatus should not be to prevent all bank failures. 

Banks need to take prudent risks to serve their communities. When they make mistakes or when 

the economy moves against their exposures, we need to have confidence in a system that tailors a 

specific regulatory response according to the circumstances, while minimizing the economic and 

consumer impact. Banks must have the possibility of fai lure to have the opportunity for success. 

The Proposed Rules Have Consequences for Economic Recovery and Job Growth 

These proposals are fundamentally about economic development and job growth. 

Banks, all models and sizes, are a critical component of our economic engine. In particular, 

community banks are the primary drivers of local economic activity and small business job 

growth. CSBS is deeply concerned that the proposed capital framework will hamper banks' 

ability to take prudent risks in a period when general economic activity is minimal. In this sense, 

the proposals run counter to our efforts to restore the economy and foster job creation. We need 

2 
201 


79691.116

to seek policies that will encourage economic recovery in a prudent fashion, not policies that will 

further suppress the flow of credit or drive business from the regulated and insured depository 

system. Regulatory policy, both state and federal, has very local and very real economic 

consequences. When community banks are challenged, the communities they serve are 

challenged, as well. 

We do not believe there is a sufficient understanding of the impact these proposals would 

have on the industry and credit availability. The agencies have published little analysis ofthe 

economic impact ofthese proposed rules, a step we believe is imperative before adopting such 

consequential measures. This lack of analysis bolsters uncertainty in the market and contributes 

to general business hesitancy. Four business days bcfore the comment deadline for the 

proposals, the FDIC published for comment its statutorily mandated analysis of the impact the 

Standardized Approach proposal would have on banks with assets less than $175 million. The 

OCC and FRB have not yet published their analyses. The FDIC's conclusion, which finds that 

the Standardized Approach proposal will in fact have a significant economic impact on a large 

number of small entities, is troubling. It is important to note that this analysis was only 

performed for those institutions below $175 million in assets. The same type of analysis, if 

applied to the rest of the industry, may yield more striking results. 1 

Through the comment solicitation process, banks and other commenters have provided 

good examples of how the proposals will negatively impact traditional business lines that are 

fundamental to banks' operations and important to economic growth. We need to clearly 

understand how the proposals will change the type of credit available, the manner in which a 

bank lends, and the economic impact. 

The Capital Rules Must be Part of a Targeted and Forward-Looking Regulatory Regime 

Beyond the need to appropriately assess the proposals' impact on economic recovery and 

job growth, I strongly believe the proposals present an opportunity for us to critically evaluate 

our policy development approach. The industry has been very vocal about its concerns regarding 

regulatory burden. In our own experience, this is relatively easy to understand, but difficult to 

address. There is an opportunity for the industry and policymakers to discuss a prudent "rightsizing" of regulatory expectations. Furthermore, we can do much to address these concerns by 

carefully evaluating current proposals through the lens of regulatory burden and the 

appropriateness of regulation for the wide variety of institutions that operate within the U.S. The 

Basel III and Standardized Approach proposals are perfect examples of policy matters that we 

need to get correct immediately. We must take a long-tenn view ofthe industry and offer 

appropriate flexibility to accommodate the diversity of our financial system and the dynamic 

nature of the U.S. economy. 

There are legitimate concerns about the complexity of the proposals, especially the 

Standardized Approach. I fully recognize that particular aspects of to day's financial services 

industry present complex issues which must be addressed. However, not all transactions are 

complex and need a complex solution. Most of traditional banking follows the fundamentals: 

character, repayment ability, and collateral protection. If we want to effectuate change, it should 

1 Exhibit A: CSBS comment letter on FDIC's Regulatory Flexibility Analysis for the Standardized Approach Proposal 

3 
202 


79691.117

be focused on risk management and consistent with how the bank operates. Complexity that 

serves to discourage certain types of lending leads to credit allocation, which will increase the 

cost of credit for consumers and drive industry consolidation. 

State bank regulators believe the Basel III and Standardized Approach proposals are 

highly reactionary to the latest crisis. We do not believe a capital regime that is reacting on a 

transaction-by-transaction basis to crises is good public policy or in the long-term interest of the 

banking system. To illustrate my point, I'll reference my counterpart from Oklahoma's 

comment letter on the proposals. In the letter, Oklahoma Commissioner Mick Thompson points 

out that the mortgage issues which underlie the financial crisis never existed in Oklahoma, but 

the proposed risk weights for mortgage loans in the Standardized Approach proposal will have a 

significant impact on banks' ability to lend. This not only affects the banks in Oklahoma, but 

has a direct effect on the availability and cost of credit for the citizens of Oklahoma. 

Because of the remarkable diversity in the U.S. economy and in the banking industry, it is 

important that we focus on improving risk management and supervision, not on trying to steer 

individual credit decisions. This is the most logical method for addressing the types of issues 

that are the focus of the Basel III and Standardized Approach proposals. Simply adjusting the 

capital rules in response to every financial issue is not the answer. Once we head down this 

path, it is difficult to imagine where we will stop. 

Regulation Should Address "Too Big to Fail" in a Targeted Manner 

One of the primary points made by the supporters of Basel III is the need to address the 

weaknesses of systemic institutions. CSBS would support any rulemaking the agencies pursue to 

address these issues, if they are applied to the largest internationalIy active banks, as intended by 

the international accord. The Dodd-Frank Act also requires a range of measures geared toward 

subjecting Systemically Important Financial Institutions (SIFIs) to stricter standards, including: 

enhanced prudential standards; living wills; Orderly Liquidation Authority; stress testing; 

concentration limits; and designations. We support the efforts ofthe federal agencies to finalize 

and enforce these provisions as they arc our best hope to address the problem of "too big to fail." 

CSBS Positions in Brief 

The federal banking agencies' rulemaking comprised three proposals to revise the U.S. 

regulatory capital framework. These were the Basel III, the Standardized Approach for RiskWeighted Assets, and the Advanced Approaches proposals. I will focus my comments on the 

Basel III and Standardized Approach proposals, which apply to the entire commercial banking 

industry. 

The Basel III proposal revises minimum regulatory capital levels, introduces a new 

common equity ratio, makes changes to the definitions of capital, re-works the Prompt 

Corrective Action (PCA) framework, and creates new standards in the area of Trust-Preferred 

Securities (TruPS). The Standardized Approach for Risk-Weighted Assets proposal outlines a 

radically new structure for risk-wcighting assets used to calculate risk-based capital ratios. The 

4 
203 


79691.118

new risk weights will affect asset classes such as residential mortgages, certain commercial real 

estate loans, off-balance sheet exposures, securitizations, and equity exposures, among others. 

I believe it is critical to understand the intended scope of Basel III and the actual scope of 

the framework the agcncies have proposed. The Basel III Accord clearly states that it is intended 

to apply to those institutions addressed in Basel II. Basel [J addresses large, internationally 

active banks. Basel II! was never intended to apply to the entire banking industry. The 

framework the agencies have proposed therefore goes beyond the scope of the international 

agreement. It is important to further clarify that the Standardized Approach proposal is not 

included in the Basel 1II agreement. State bank regulators believe the agencies should reevaluate the content of the proposals as a whole and re-propose Basel III to apply only to those 

institutions to which it was originally intended to apply. Ifthere is a desire to raise required 

minimum capital for all banks, this should be pursued outside of the Basel III implementation 

process. The agencies have authority to establish minimum required capital. Any necessary 

adjustment to the minimum required capital should be proposed and justified in terms of the 

needs and risks of domestic institutions. 

In general, the proposals are highly reactionary to the most recent crisis and attempt to 

remedy the various issues of the financial crisis on a transaction-by-transaction level. My fellow 

state bank regulators and I believe this approach is likely to yield a capital framework that is far 

more prone to volatility. In our estimation, regulators and policymakers do not have to address 

all financial vulnerabilities and risks identified during the financial crisis through capital 

standards. I strongly believe we should strive to address appropriate issues through risk 

management and the supervisory process. Additionally, state bank regulators believe the 

agencies have an obligation to provide empirical support for their recommended course of action, 

especially related to the risk-weighting figures. In many cases, there does not seem to be 

adequate logic to support many of the proposed risk weights. Further, as I will address in my 

analysis of the proposals, the agencies' proposed rules will present significant challenges for key 

lending markets, particularly mortgage lending. 

To address the substance of the proposals more specifically, state bank regulators find the 

complexity of the Basel III proposal problematic and strongly oppose the proposed inclusion of 

gains and losses on Available for Sale (APS) securities in capital and the proposed phase out of 

TruPS. Within the context ofthe Standardized Approach proposal, we are troubled by the 

proposed risk-weighting scheme [or residential mortgages, High Volatility Commercial Real 

Estate (HVCRE), and past-due exposures. Additionally, we believe further clarity is needed 

surrounding the proposed treatment of sccuritizations and equity exposures. 

The Basel III Proposal 

Shifting to the specific aspects of the proposals, I reiterate that state bank regulators 

support efforts to improve the quantity and quality of capital in the banking system. The crisis 

clearly demonstrated that capitallcvels at many institutions, although above minimum capital 

ratios for regulatory purposes, were inadequate to support the risk being assumed. However, 

there is a balance to be struck to promote a stable banking system, which is also attractive to 

capital. While we do not believe the proposed minimum capital levels contained in the Basel ITI 

5 
204 


79691.119

proposal are unreasonable, we do believe the proposed Basel III framework is too complex. The 

proposal would result in too many consequential ratios and benchmarks to which institutions 

would have to manage. For instance, the proposed capital conservation buffer, the level of which 

is not necessarily problematic, becomes operationally burdensomc for institutions when 

compared to the proposed PCA framework, which does not factor in the buffer. Situations are 

likely to emerge where institutions will be "well-capitalized" for PCA purposes, yet will face 

mandatory dividend and bonus restrictions because they are under the total capital figure that 

combines the minimum ratio and the conservation buffer. Sueh operational complexity will 

present tremendously awkward and confusing positions for institutions, especially those that do 

not have sophisticated compliance functions. 

Beyond the complexity associated with the capital levels, we are very concerned about 

the proposed incorporation of unrealized gains and losses on AFS securities in the Common 

Equity ratio. This provision is not workable or meaningful for the majority of banking 

institutions and will skew capital ratios, generating more volatility in an institution's capital 

position. 

We also strongly oppose the agencies' proposed treatment of TruPS in the Basellll 

proposaL We believe this issue was thoroughly debated in Congress. The Dodd-Frank Act 

established a reasonable transition period for institutions. Currently, institutions with assets 

below $15 billion are allowed to let TruPS roll off. The agencies have proposed a phase out 

schedule for these institutions beginning in 2013 and increasing 10% cvery year thereafter. No 

TruPS would qualify as capital in 2022. This provision will be detrimental for institutions that 

have based their long-term capital planning process on the standards established by Dodd-Frank .. 

adding an additional layer of uncertainty for institutions' business planning. 

As detailed in our Basellll comment letter, 2 CSBS encourages the agencies to revise and 

re-propose Basel III to focus on the institutions intended by the international agreement-large, 

internationally active banks. There may be reason to review and revise the general domestic 

capital structure but not under the Basel III umbrella, and not in the manner in which this 

proposal is fashioned. 

The Standardized Approach Proposal 

The Standardized Approach proposal is highly reactionary to the most recent crisis, does 

not include empirical support for the proposed risk-weightings, and, if adopted as proposed, 

likely will not serve our long-tcnm economic interest. As detailed further in our comment letter,3 

the agencies have not demonstrated in the proposal an adequate understanding of the impact 

these adjustments would have on credit allocation and availability. 

Further, when comparing the relative risk-weightings under the proposed framework 

across asset classes, we run into a series of internal inconsistencies. As an example, unsecured 

lending under the proposed rule receives a 100% risk-weighting, whereas many fonms of lending 

backed by collateral receive well above a 100% risk-weighting. This notion defies basic banking 

2 Exhibit B: CSBS Comment Letter on Basel III NPR 

3 Exhibit C: CSBS Comment Letter on Standardized Approach for Risk-Weighted Assets 

6 
205 


79691.120

principles. Regulators and bankers generally believe that collateral is better than no collateral. 

The rule seems to encourage otherwise. Possibly more striking is the risk-weightings for various 

fOTITIS of sovereign debt compared to Acquisition, Development & Construction (ADC) loans. 

Sovereign debt in default receives a 150% risk-weighting under the proposed rule; the same as 

so-called HVCRE loans. Sovereign debt that is not in default is graded against the OECD 

Country Risk Classification Index. Countries like Greece, Spain, and Italy all receive excellent 

scores on this index, which pushes their sovereign debt risk-weighting down well below 150%. 

By rule, we are effectively telling our banks to invest in the struggling Eurozone long before they 

consider investing in the construction project down the street. In practice, I do not believe most 

institutions would make this choice. Howcver, I offer this comparison as an example of the 

unsupported logic of some of the risk weights. 

On a specific level, I am extremely concerned by the proposed treatment of residential 

mortgage assets in the Standardized Approach proposal. Traditionally, mortgage loans have 

received a 50% risk-weighting under the agencies' general risk-based capital standards. In the 

Standardized Approach framework, the agencies havc proposed to divide an institution's 

mortgage loans in two categories. The criteria for achieving Category I status is excessively 

narrow, excluding traditional products that banks have originated successfully for years. Such 

products include standard Adjustablc-Rate and balloon mortgages, Home Equity Lines of Credit 

(HELOCs), and second liens. The agencies have erroneously painted these products with a 

broad brush. These were not the products that caused the mortgage crisis and were rarely used 

improperly by banks. Mortgage products that do not fall in Category 1 are pushed to Category 2, 

where the risk-weighting is remarkably punitive, ranging from 100-200% bascd on origination 

Loan-to-Value. 

This dramatic shift in treatment of mortgage assets under the risk-based capital standards 

would have a significantly negative effect on banks' willingness and ability to engage in 

mortgage lending. It is easy to assume that the mortgage securitization market encompasses the 

entire mortgage lending industry. But this is simply not the case. Two and a half trillion dollars 

in residential mortgage exposurc currently resides on banks' balance sheets. Banks dedicate 

approximately 20% of their lending portfolios to mortgagcs, a figure which is consistent across 

the industry.4 This is not an insignificant exposure. A reduction in mortgage lending at banking 

organizations will work to the detriment of mortgage credit availability, especially in rural and 

underserved areas. It will also take away a key source of income from banks, thereby 

threatening profitability and safety and soundness. It is important to note that second lien 

HELOCs are frequently used by homeowners to finance small businesses. The impact of the 

mortgage provisions therefore extend to other critical aspects of tile economy. 

Another concerning aspect of the Standardized Approach is the proposal's treatment of 

HVCRE loans. This new designation encompasses ADC loans, with some exceptions related to 

borrower contributions and loans financing 1-4 family residential properties. The current riskweighting for such loans is 100%. The proposed risk-weighting is 150%. Through the riskweighting adjustment, the agencies have essentially signaled that they do not want banks to make 

these types of loans. This transaction-level risk-weighting does not account for concentration 

risk-management and institutional expertise. ADC loans have certainly played a major role in 

4 Exhibit D: Bank balance sheet exposures to real estate related loans 

7 
206 


79691.121

many of the bank failures that have occurred over the past few years. However, the proposed 

treatment ofHVCRE loans is a perfect example of the misuse ofrisk-weightings on a 

transactional level. Increasing risk-weightings is not the answer for every risky asset exposure. 

We must focus on improving risk management and supervision surrounding problematic asset 

concentrations. This is the most effective way to build a strong, forward-looking regulatory 

framework, while avoiding a "one-size-fits-all" approach. 

Detailed further in our Standardized Approach comment letter are suggestions 

surrounding the proposed framework for off-balance sheet exposures, securitizations, and equity 

exposures. Generally we believe further clarity is needed in these areas for specific purposes. I 

will focus my remaining Standardized Approach comments on the treatment of past-due 

exposures in the proposal. The proposal stipulates that once a loan becomes past due, its risk 

weighting jumps to 150%. Here we see another provision that will introduce more volatility to 

the capital framework. Additionally, the proposed treatment of past-due exposures ereatcs a 

"double counting" problem. Allocations for past-due loans arc generally made to loan-loss 

reserves, thereby lowering an institution's capital level. Considering the proposed treatment of 

such exposures, an institution would also have to increase its risk-weighted assets in the event of 

a past-due loan. The effect of this, when considering regulatory capital ratios, is an increasing 

denominator and a decreasing numerator. The negative effect of a past-due loan is thus 

compounded significantly within the context of the proposal. We are also concerned that this 

provision of the capital rule will impact a bank's ability to prudently and effectively manage 

credit administration by incentivizing credit extensions. This practice can be considered unsafe 

and unsound. 

The Standardized Approach proposal has the potential to significantly alter banks' credit 

decisions to the detriment of the economy. This proposal, which is not part ofthe Basel III 

Capital Accord, should be significantly revised or altogether abandoned. 

A Local Perspective 

It is important to remember that many institutions do not treat loans as anonymous 

commodities and that these proposed rules will have real consequences for institutions and 

communities. Here is one example. There is a small bank that is the only bank in a very rural 

community in Middle Tennessee. This bank has been around for almost 100 years and has a 

customer base that it has been serving for decades with products including mortgages that the 

bank holds in portfolio. The president of that bank shared with me that, based on his review of 

the proposed rules, when those same customers come seeking new loans, the proposed risk 

weights for mortgages will limit the number and volume ofloans it can originate. The 

overwhelming community bank engagement on this topic is a testament to their passion and 

conviction regarding the critical role they play in our economy. We owe it to these institutions to 

ensure the policies we develop do not unnecessarily impede their ability to serve their 

communities. 

There are matters within the context of the community banking business model that the 

industry is best equipped to addrcss, particularly those dealing with human capital, corporate 

governance, succession planning, and risk management. Further, more pertinent to our world, 

there arc adjustments we need to make to the supervisory process to facilitate progress in this 

8 
207 


79691.122

area. Specifically, we need to encourage a supervisory process that minimizcs burden and 

disruption, provides value, and gets away from the penalty mindset and returns to a corrective, 

cooperative relationship. All this said, community banks will not survive if public policies 

irresponsibly drown them out. 

Conclnsion 

The debate over these proposals, with meaningful and significant engagement from the 

industry and Congress, provides an opportunity for us to determine thc appropriate approach to 

policy development for a diverse economy and a diverse financial system. We have an 

opportunity to signal to the industry and to the rest of the economy that we are committed on a 

going forward basis to meaningful public policy development geared toward fostering economic 

recovery and job growth. Further, these proposals are relevant to the debate surronnding the 

viability of the community banking business model. This is of deep importance to me and my 

colleagues from around the country. This is also important to our citizens who do not all live in 

large metropolitan areas or have access to the services of our largest institutions. Community 

banks are the lifeblood ofthe American economy and will be a key player in the economic 

recovery. Our economy is built on diversity and locality; community banking has been the 

backbone of this success. I strongly believe that we need to explore a regulatory framework 

comprising prudcnt and meaningful rules for community banks. 

The Basel III and Standardized Approach proposals are perfect examples of policy 

concepts that need to be re-evaluated, better understood, and appropriately calibrated for our 

diverse banking system. State bank regulators have urged the agencies to significantly revise the 

proposed structure, so we have a regulatory capital framework that is meaningful for community 

banks and consistent with the practices of the business model. 

CSBS stands ready to work with Members of Congress and our federal counterparts in 

seeking the appropriate regulatory balance and pursuing our collective goal of restoring stability 

to the American economy. 

Thank you for the opportunity to testify today, and llook forward to answering any 

questions you have. 

Exhibits 

Exhibit A: CSBS Comment Letter on FDIC Initial Regulatory Flexibility Act Analysis 

Exhibit B: CSBS Comment Letter on Basel III Proposal 

Exhibit C: CSBS Comment Letter on Standardized Approach Proposal 

Exhibit D: Data on Bank Real Estate Exposures 

9 
208 


79691.123

Exhibit A 

CONFERENCE OF STl'.TE B;:'.NK SUPEF'(VISOr~S 

November 14, 2012 

Robert E. Feldman, Executive Secretary 

Attention: Comments/Legal ESS 

Federal Deposit Insurance Corporation 

550 17th Street NW 

Washington, DC 20429 

RIN 3064-AD96 

Dear Mr. Feldman, 

The Conference of State Bank Supervisors (CSBS) is pleased to comment on the Federal Deposit 

Insurance Corporation's (FDIC's) Initial Regulatory Flexibility Analysis (IRFA) for its Notice of 

Proposed Rulemaking (NPR) entitled Regulatary Capital Rules: Standardized Appraach for RiskWeighted Assets; Market Discipline and Disclosure Requirements (Standardized Approach 

proposal). 

Section 3(a) of the Regulatory Flexibility Act (RFA) requires an agency to publish in the Federal 

Register an IRFA or a summary of its IRFA, or to certify that the proposed rule will not have a 

significant economic impact on a substantial number of small entities. For purposes of the 

IRFA, a small entity includes a banking organization with total assets of $175 million or less. 

The FDIC published this IRFA addressing the Standardized Approach Proposal on October 17, 

2012 separately from the Federal Reserve Board (FRB) and the Office of the Comptroller of the 

Currency (OCC), the two agencies with which the FDIC published the proposed rule. 

FDIC CONCLUSIONS 

As detailed in the IRFA, to determine if the Standardized Approach proposal would have a 

significant economic impact on small banks and savings associations, the FDIC compared the 

estimated annual cost with annual noninterest expense and annual salaries and employee 

benefits for each institution. If the estimated annual cost was greater than or equal to 2.5 

percent of total noninterest expense or 5 percent of annual salaries and employee benefits, the 

FDIC classified the impact as significant. The FDIC has concluded that the proposals included in 

the NPR would exceed this threshold for 2,413 small state nonmember banks, 114 small savings 

banks, and 45 small state savings institutions. Accordingly, for the purposes of this IRFA, the 

FDIC has concluded that the changes proposed in the Standardized Approach NPR, when 

considered without regard to other changes to the capital requirements that the agencies 

simultaneously are proposing, would have a significant economic impact on a substantial 

number of small banks and savings associations. Further, if both the Standardized Approach 

NPR and the Basel III NPR were adopted together, the impact on small institutions would 

increase. 

1129 20'" S-n~cC'r, NVV,. NI"'TII FL,OOI~. WASHINCTON, DC. 20036 

),I\{\,yW,<::'2.f2.';;,QKQ. 202-296-2840. FAX 202-296-1928 
209 


79691.124

Exhibit A 

ECONOMIC IMPACT 

In our comments to the agencies on the Basel III and Standardized Approach proposed rules, 

we highlighted the potentially negative impact the proposals could have on the economy and 

on job growth. It seems the analysis conducted in the FDIC's IRFA supports our projections. 

The FDIC has estimated that the Standardized Approach proposal will have a significant impact 

on 2,413 institutions with assets below $175 million that are under the agency's regulatory 

purview. This is clearly a significant number of institutions. It is important to note that this 

analysis was only performed for those institutions below $175 million in assets. The same type 

of analysis, if applied to the rest of the industry, may yield more striking results. 

As detailed in our comment letters, we support the effort to quantify the impact these 

proposals could have on the industry. We therefore endorse the FDIC's work in this area, and 

we believe the FDIC employed a thoughtful and sound methodology to evaluate the potential 

impact on small institutions. Given the fact that this analysis has yielded a positive affirmation 

that the proposals would have a significant economic impact on at least those institutions 

below the RFA threshold, we strongly urge the FDIC and the other agencies to consider 

measures that may be taken to lessen the potentially negative impact their proposals may have 

on the general economy and on job growth. 

INCONSISTENCY IN EVALUATION 

CSBS would like to note the inconsistent fashion in which the agencies have performed their 

required IRFAs on the Basel III and Standardized Approach proposals. We understand the 

agencies' obligation is to focus on the institutions they individually regulate. However, we find 

it troubling that the agencies seem not to have worked closely on these analyses and did not 

develop a common understanding of the proposals' potential impact. All the agencies 

performed an IRFA on the Basel III proposal and published some preliminary economic impact 

dialogue in the Standardized Approach proposal. The methodologies the agencies have used to 

evaluate the proposals' impact are different, and the conclusions are not consistent. 

We believe it is important for the agencies to establish a unified understanding of the potential 

economic impact the Basel III and Standardized Approach proposals would have on the industry 

before releasing proposals of this magnitUde. We note that the FDIC's supplemental analysis 

was released only four business days before the end of the comment period for the proposal in 

question. The FRB and OCC still have not released their own supplemental analyses referenced 

in the FDIC's notice. The FDIC maintains that any comments on this notice will be considered in 

the development of a final rule. However, we believe the utility of the IRFA is significantly 

minimized since the public was not able to supplement its analysis of the proposals themselves 

with the agencies' prOjections. 

Overall, we are concerned that the inconsistent approach employed by the agencies to evaluate 

the impact of the proposals, combined with the actual conclusion of the analysis, which is not 

encouraging, contribute to the uncertainty surrounding the proposals and the need to reevaluate their structure. 

2 
210 


79691.125

Sincerely, 

John W. Ryan 

President and CEO 

Exhibit A 

3 
211 


79691.126

Exhibit B 

I = Je SI~CE 1<)02 

CONFERENCE OF ST/\TE BANK SUPERVISORS 

October 17, 2012 

Robert E. Feldman, Executive Secretary 

Attention: Comments/legal ESS 

Federal Deposit Insurance Corporation 

550 17th Street NW 

Washington, DC 20429 

RIN 3064-AD95 

Jennifer J. Johnson 

Office of the Comptroller of the Currency 

250 E Street, SW, Mail Stop 2-3 

Washington DC, 20219 

Docket ID OCC-2012-0008 

Secretary, Board of Governors of the Federal Reserve System 

20th Street and Constitution Avenue, NW 

Washington, DC 20551 

Docket No. R-1430; 

RIN No. 7100-AD87 

Dear Sir or Madam, 

The Conference of State Bank Supervisors (CSBS) appreciates the opportunity to comment on 

the Federal Deposit Insurance Corporation's (FDIC's), the Board of Governors of the Federal 

Reserve System's (FRB's), and the Office of the Comptroller of the Currency's (OCC's) 

(collectively, "the Agencies") joint Notice of Proposed Rulemaking (NPR, proposal, or proposed 

rule) to implement the Basel III capital accords, entitled Regulatory Capital Rules: Regulatory 

Capital, Implementation at Basel lit, Minimum Regulatory Capital Ratios, Capital Adequacy, 

Transition Provisions, and Prompt Corrective Action. 

In our view, the proposed rule is one of the most significant public policy matters facing the 

financial sector. The appropriate level of capital should enhance the resiliency of the banking 

sector, allowing institutions to remain solvent through the economic cycle. However, too much 

capital can have undesirable effects on the industry. Too much capital can have the effect of 

increasing management's tolerance for risk as they strive to provide a return for stockholders. 

An overly restrictive capital requirement also serves as a barrier to entry, discouraging capital 

from entering the banking system and further driving industry consolidation. It is critical to 

strike the appropriate balance to achieve a stable banking system, which is attractive to capital, 

and can serve as the backbone to a vibrant and diverse economy. This comment period 

provides a critical opportunity for the public to express its views on the proposed rules and the 

potential impact they will have on banks, credit availability, and economic growth. We 

encourage the AgenCies to consider not only the calibration of capital requirements to ensure a 

resilient banking system, but also what is in the best interest of both the national and local 

1129 20m STREET, N.W .• NINTH FLOOR" W,'SHINCTON. DC .. 20036 

WWW.CC;GS.ORC .. 202-296-2840 .. FAX 202-296-1928 
212 


79691.127

Exhibit B 

economies. Capital requirements must factor in the existence of an active supervisory function 

and a resolution regime, which works as designed for the vast majority of banks. 

We have provided feedback on the Agencies' Standardized Approach proposed rule in a 

separate comment letter. Our comments on the Basel III proposed rule are organized in the 

sections below. 

INTRODU ITION 

We support the Agencies' efforts to increase the minimum required capital. However, we are 

concerned with the ability to achieve this under the Basel III umbrella. The international 

agreement clearly states it is intended to cover the same institutions covered under Basel II, 1 

which targets only large, internationally active banks. The agreement was never intended to 

apply to all U.S. banks. We recommend the Agencies scale back this rulemaking to apply only 

to the intended institutions. We would support a separate rulemaking to address the minimum 

capital requirements for banks not covered by Basel II and Basel III. The proposed rule should 

be appropriately calibrated to enhance stability while serving to attract capital to the system. 

The proposed rule must be easy to understand and simple to manage. We believe the public 

comments to this rule making will provide the Agencies sufficient feedback to effectively 

structure a new proposal. 

MINIMUM CAPITAL RATIOS 

CSBS generally supports a higher level of high quality capital at banking organizations. The 

financial crisis clearly demonstrated that capital levels meeting minimum capital requirements 

for regulatory purposes are not adequate for practical purposes during stressful conditions. 

Considering the experience of the US financial crisis, the Agencies have proposed to introduce 

higher minimum capital requirements for banking organizations. 

Specifically, the Agencies have proposed to eliminate the exception for CAM ElS 1 rated 

institutions to maintain a Tier 1 leverage Ratio of 3%. All institutions will now have to adhere 

to a Tier 1 leverage Ratio of 4%. CSBS supports a higher minimum Tier 1 leverage Ratio. 

Practically, 4% is not an adequate level of operating capital for all institutions. We support the 

Agencies' comments regarding the need for institutions to hold capital commensurate with the 

risks and complexity of their business activity, regardless of the regulatory capital ratios. 

Additionally, the Agencies have proposed a new Tier 1 Common Equity Capital ratio. 

Institutions would have to maintain a minimum Tier 1 Common Equity ratio of 4.5% to meet 

minimum capital requirements. CSBS supports a renewed focus on common equity, as this is 

the strongest form of capital. Community banks typically hold a higher percentage of common 

equity than larger institutions. A new common equity ratio should contribute to a more level 

playing field between community banks and large banks. As discussed further below, we do 

not support the proposal to include unrealized gains and losses on available for sale securities 

1 Basel III: A global regulatory framework for more resilient banks and banking systems, December 2010, page 11. 

2 
213 


79691.128

Exhibit B 

in the definition of Tier 1 Common Equity. Nevertheless, we generally support the common 

equity ratio and believe it will enhance the quality of capital positions across the industry. 

For Tier 1 Risk-Based Capital, the Agencies have proposed to increase the minimum ratio from 

4% to 6%. We support the increase in Tier 1 Risk-Based Capital. The Agencies have not 

proposed to adjust the current Total Risk-Based Capital Ratio of 8%. 

CAPITAL CONSERVATION BUFFER 

The Agencies have proposed that institutions hold a capital conservation buffer comprising 

common equity tier 1 capital. The buffer represents an additional 2.5% of total risk-weighted 

assets. The buffer must be maintained to avoid restrictions on capital distributions and certain 

discretionary bonus payments. This has the effect of increasing the minimum risk based capital 

ratios by 250 basis points. 

While we support requiring greater amounts of high quality capital, to the extent the capital 

conservation buffer introduces undue operational complexity for institutions, we believe 

regulators should work to clarify expectations. As discussed further in the Prompt Corrective 

Action (PCA) section of this letter, the number of consequential capital ratios detailed in the 

proposal to which institutions would have to adhere would introduce undue complexity to the 

capital planning process for banking organizations. 

COUNTERCYCLICAL CAPITAL BUFFER AND SUPPLEMENTAL RATIO 

The Agencies have proposed to implement the Basel III countercyclical capital buffer for 

advanced approaches institutions, which generally includes institutions with assets above $250 

billion. The countercyclical capital buffer would be based on detailed market indicators and 

would require larger institutions to hold up to 2.5% of additional risk-based capital. CSBS 

supports the Agencies' proposal to apply the countercyclical capital buffer only to institutions 

with assets above $250 billion. Larger institutions have greater access to capital markets, which 

will allow them to more reasonably meet the requirements of the countercyclical buffer. We 

also support the theoretical structure ofthe countercyclical capital buffer as it applies to 

advanced approaches institutions. 

Additionally, advanced approaches institutions would be required to maintain a supplementary 

leverage ratio of tier 1 capital to total leverage exposure of 3%. We support the supplementary 

leverage provision. However, the off-balance sheet exposures and repo style transactions the 

Agencies site in support of this requirement occur frequently at large institutions that do not 

meet the advanced approaches criteria. The Agencies may consider application of the 

supplementary leverage ratio to classes of institutions with assets below $250 billion but not 

less than $50 billion on a case by case basis. 

PROMPT CORRECTIVE ACTION 

The Agencies have proposed a method for incorporating changes to minimum capital ratios in 

the Prompt Corrective Action (PCA) framework. The proposed PCA framework includes new 

3 
214 


79691.129

Exhibit B 

ratios corresponding to the various capitalization designations contained in PCA. Notably, the 

proposal does not factor the capital conservation buffer in the PCA ratios. 

In our view, under the current proposal, institutions will have to manage their capital levels 

with too many consequential measures in mind. The proposals include new minimum capital 

requirements, new additional capital requirements for capital conservation buffer purposes, 

and new PCA requirements. The Agencies should work to streamline the PCA requirements to 

acknowledge the presence of the capital conservation buffer and clarify the implications 

associated with the various thresholds. We should work to minimize the operational 

complexity at institutions that can arise from numerous regulatory capital measures. 

The currently proposed framework presents an awkward situation for institutions. For 

instance, the proposed measure of total risk-based capital to be considered "well-capitalized" 

for PCA purposes is 10%, yet the minimum total risk-based capital ratio including the 2.5% 

capital conservation buffer is 10.5%. Therefore, institutions may be "well-capitalized" but still 

have mandatory restrictions on dividend and bonus payouts. We encourage the Agencies to 

acknowledge and resolve such discrepancies that may result in confusion for bank 

management. 

UNREALIZED GAINS AND LOSSES ON SECURITIES IN COMMON EQUITY TIER 1 CAPITAL 

Under the Agencies' current general risk-based capital rules, unrealized gains and losses on 

Available For Sale (AFS) debt securities are not included in regulatory capital, unrealized losses 

on AFS equity securities are include in tier 1 capital, and unrealized gains on AFS equity 

securities are partially included in tier 2 capital. Under the proposal, unrealized gains and 

losses on all AFS securities would flow through to common equity tier 1 capital. 

CSBS does not believe this provision is workable or meaningful for banking organizations. 

Including gains and losses on AFS securities in the common equity ratio would introduce 

significant volatility in capital ratios and potentially skew institutions' capital pOSitions both in 

times of crisis and in periods of stability. The frequency and extent to which the proposed 

provision would adjust capital positions would be substantial. We believe capital 

measurements that are built on potentially significant volatility are not meaningful and may 

have detrimental consequences for the safety and soundness of our banking industry. We are 

concerned that this provision may cause banks to engage in transactions that they otherwise 

would not out of fear of the impact of potential future losses from changing market conditions. 

Incorporating this element of volatility into the capital framework is not in the long-term best 

interest of individual banks or the banking system. 

The proposal offers possible alternatives, including excluding the impact solely from changes in 

interest rates and excluding U.S. government and agency securities. Firms that provide 

investment adVisory services to the industry believe this will be nearly impossible to accurately 

quantify on a consistent basis. The Agencies should adequately research this perspective 

before finalizing any rule to ensure the option is workable and meaningful. To be clear, we 

believe the existing framework is more applicable to a traditional bank and provides for less 

complexity and greater stability. 

4 
215 


79691.130

Exhibit B 

TRUST PREFERRED SECURITIES 

Basel III eliminates Trust Preferred Securities (TPS) as qualifying capital for all banks and bank 

holding companies above $500 million in assets. For bank holding companies with assets above 

$15 billion, the Basel III proposal maintains consistency with Dodd-Frank, retaining a phase-out 

period ending in 2016. For bank holding companies with assets between $500 million and $15 

billion, the Agencies have proposed a phase-out schedule beginning at 10% in 2013 and 

increasing 10% a year for 10 years. No TPS would count beginning in 2022. The proposed 

treatment of TPS deviates from Dodd-Frank, which allows bank holding companies between 

$500 million and $15 billion to let the TPS roll-off. 

CSBS strongly opposes the Agencies' proposed treatment of TPS for institutions between $500 

million and $15 billion. The proposed rule represents a new and unnecessary extreme in the 

area of TPS. We are troubled by the Agencies' inclination to deviate from the Dodd-Frank 

standard. Implementing a sudden shift in policy related to TPS may have significantly negative 

consequences for institutions' capital planning strategies. Further, CSBS believes this matter 

was thoroughly reviewed in Congress during Dodd-Frank deliberations, and Congress elected to 

establish the framework detailed above for good reason. We therefore urge the Agencies to 

withdraw their proposed phase-out of TPS for institutions between $500 million and $15 billion 

and maintain the framework established by Congress. 

CAPITAL TRANSITION PROVISIONS AND INFORMATION GAPS 

CSBS generally believes the Agencies have proposed reasonable transition provisions for 

institutional compliance with the proposed capital requirements if the requirements are 

imposed. 

We would also like to note that a number of information gaps exist in current financial 

reporting requirements that will make it difficult to assess the potential impact of various 

provisions of the proposal. Specifically, financial positions such as Deferred Tax Assets (DTAs) 

are not reflected in current regulatory reports in adequate detail, yet there are a number of 

proposed provisions affecting these assets. In order to adequately measure the impact of such 

requirements, we need to address reporting gaps in these areas. 

5 
216 


79691.131

Exhibit B 

CONCLUSION 

We are supportive of the Agencies' efforts to improve the level and quality of minimum 

required capital. We strongly recommend the Agencies pursue a more simplistic and effective 

proposal appropriate for a diverse banking system which is largely dominated by less complex, 

community based institutions. 

As the Agencies consider a revised and narrower proposal, it is important to be able to quantify 

the impact on the industry. We appreciate the Agencies' efforts to develop the capital 

estimation tool for banks to analyze the potential impact of this rule and the proposed rule for 

the Standardized Approach. We believe it is imperative for the Agencies to understand the 

impact on an aggregate basis and, more importantly, have a better sense of how changes in the 

capital rules will impact the bank's origination of credit. 

Best regards, 

John W. Ryan 

President & CEO 

6 
217 


79691.132

Exhibit c 

CONFERENCE OF ST/\Ti=~ B~\NK SLIPEf'<VISORS 

October 17, 2012 

Robert E. Feldman, Executive Secretary 

Attention: Comments/legal ESS 

Federal Deposit Insurance Corporation 

SSO 17th Street NW 

Washington, DC 20429 

RIN 3064-AD96 

Jennifer J. Johnson 

Office of the Comptroller of the Currency 

2S0 E Street, SW, Mail Stop 2-3 

Washington DC, 20219 

Docket 10 OCC-2012-0009 

Secretary, Board of Governors of the Federal Reserve System 

20th Street and Constitution Avenue, NW 

Washington, DC 20SS1 

Docket No. R-1442; 

RIN No. 7100-AD87 

Dear Sir or Madam, 

The Conference of State Bank Supervisors (CSBS) appreciates the opportunity to comment on 

the Federal Deposit Insurance Corporation's (FDIC's), the Board of Governors of the Federal 

Reserve System's (FRB's), and the Office of the Comptroller of the Currency's (OCC's) 

(collectively, "the Agencies") joint Notice of Proposed Rulemaking (NPR, proposal, or proposed 

rule) to adjust the Agencies' general risk-based capital requirements for determining riskweighted assets, entitled Regulatary Capital Rules: Standardized Appraach far Risk-Weighted 

Assets; Market Discipline and Disclasure Requirements. 

CSBS supports the Agencies' efforts to improve capital standards for the US banking system. We 

hope the Agencies will work to establish standards that are in the best interest of all financial 

institutions and the larger US economy. We have provided feedback on the Agencies' Basel III 

proposed rule in a separate comment letter. Our comments on the Standardized Approach 

proposed rule are organized in the sections below. 

SUMMARY OF CSBS POSITION 

CSBS is opposed to the proposed rule to revise the risk weights for risk-based capital. We come 

to this very clear position after extensive study of the proposal and dialogue with state 

supervisors. This position is based on the following concerns and beliefs: 

1. The proposed rule is reactionary to the most recent crisis with a focus on housing and 

commercial real estate. 

112920"< STRETT, N.W .• NINTH FLOOR. WASHINGTON. DC. 20036 

\!'LYVYV.CSl2.~ORG. 202-296-2840 • FAX 202-296-1928 
218 


79691.133

Exhibit C 

2. The approach proposed by the Agencies will curtail bank lending in traditional 

mortgage products that they have generally managed well. 

3. There is no empirical support for the proposed risk weights. 

4. As we seek to address concerns that emerged from the financial crisis, greater 

appreciation must be paid to risk management and the supervisory process to address 

evolving risk concentrations rather than capital weightings of broad asset types based 

solely on imperfect correlations perceived from the last crisis. 

5. The proposed framework is overly complex. 

6. There is not sufficient understanding of the impact of the proposed rule on the 

industry, the potential change in business practices, and the impact on credit 

availability. 

The approach taken by the Agencies is targeted at the major risk drivers for problem banks 

during this crisis. However, while over 450 institutions failed from 2008 through the present, 

we must remember that the majority of institutions did not fail. In fact, out of the nearly 2,300 

banks with concentrations in commercial real estate loans in 2007, over 1,200 maintained a low 

level of problem assets and are profitable today. 

As we seek to improve the quality and quantity of capital, we believe it is important to resist 

the temptation to address every financial weakness through capital. We must seek to apply 

lessons learned to improving risk management and the supervision process. If not, we will 

continuously seek to make the industry more risk averse, which will curtail access to credit and 

harm economic growth. 

CSBS has supported prior agency efforts to enhance the risk sensitivity of the capital rules. We 

commented in January 2006: 

"a successful domestic capital framework will not only benefit individual financial 

institutions which effectively utilize risk management tools, but will also benefit the 

banking system as a whole by providing greater ability to effectively and efficiently 

manage capital." 

The challenge before the Agencies is to do this while not adding complexity. We do not believe 

the rule as proposed meets these objectives. The proposed rule is not balanced in its treatment 

of exposures and will present undue complexity for the industry. Unfortunately, we must 

recognize that risk-based capital has limited utility for bank management. Bankers have clearly 

communicated to state commissioners that they view this as a regulatory exercise, not a tool 

for risk management. We must question the value of a proposed regulation which provides 

little or no value to the industry. As state and federal supervisors find value in the framework, 

we believe it would be worthwhile to enhance our collective understanding on a framework 

which would prove valuable for the industry and the regulators. 

In order to truly improve the risk sensitivity of the capital rules, the categorization of exposures 

and risk weights need to be supported. The categorization of assets should be aligned with the 

variety of practices of banks for the origination of credit, while accepting that banks have 

2 
219 


79691.134

Exhibit C 

different levels and areas of expertise and appetite for risk. The assigned risk weights must 

have a reasonable correlation with the risk and not be used as a tool for the allocation of credit 

and the creation of an overall more conservative industry. 

In the implementation of Basel II, the Agencies went through a series of "Quantitative Impact 

Studies." This was important to understand the impact on banks and the ability to conform to 

the framework. From this, pUblic policy makers and observers were able to judge and opine on 

the readiness of institutions, the impact on the banks, and the potential changes to the credit 

markets and availability. While a comprehensive impact study would create its own burdens, 

the system and the economy are ill-served by not having a better understanding of the 

desirable and undesirable ramifications of changing the risk weights in the manner proposed. 

Based on industry reactions, the proposal will clearly have a negative impact on credit 

allocation. Policy makers have a responsibility to understand these changes and evaluate the 

potential impact on the banking system and economy. 

RESIDENTIAL MORTGAGE EXPOSURES 

Current risk-based capital requirements generally prescribe a SO% risk-weighting for residential 

mortgage exposures. The proposed rule introduces a complex scheme for risk-weighting 

residential mortgage exposures. This process divides residential mortgage exposures into two 

categories: Category 1 and Category 2. The AgenCies have proposed a detailed set of standards 

that mortgages must meet in order to achieve Category 1 status. Among other criteria, 

Category 1 mortgages must be fully amortizing, without a balloon payment, and meet strict 

underwriting criteria. Any mortgage that does not meet the Category 1 criteria would be 

deemed a Category 2 mortgage. 

Once a mortgage is categorized, its risk-weighting would be assigned based on the Loan-toValue (LTV) ratio of the loan within the eligible risk-weighting range of the category. Category 1 

mortgages would be assigned a risk-weighting between 3S% and 100% based on LTV. Category 

2 mortgages would be assigned a risk-weighting between 100% and 200% based on LTV. 

CSBS believes the proposed treatment of residential mortgage exposures will have a 

detrimental effect on access to mortgage credit. We strongly oppose the proposed scheme for 

risk-weighting residential mortgage exposures, and we urge the AgenCies to re-work or 

abandon the proposed approach. Chief among our concerns is the excessively narrow criteria 

for Category 1 mortgages. In our estimation, traditional products such as adjustable-rate 

mortgages (ARMs) and other products with balloon features would not qualify as Category 1, 

subjecting them to the Category 2 risk weights. Many banks also offer second lien and Home 

Equity Lines of Credit (HELOCs). This is an important source of credit for consumers and small 

businesses. These loans would also be designated as Category 2. The highly punitive riskweightings for all mortgages in Category 2 would effectively discourage institutions from 

engaging in such transactions. Thus, designation of these transactions as Category 2 loans will 

largely eliminate an important source of credit for consumers and small businesses and a 

reliable business line for the institutions, thereby restricting access to credit and negatively 

impacting the safety and soundness of banking institutions, and the overall economy. 

3 
220 


79691.135

Exhibit C 

We are concerned that the rule unnecessarily paints these products with a very broad brush. 

This could have an impact on the availability of certain loan products. There were certainly 

problems with some adjustable rate and balloon products in the financial crisis. However, 

these problems should be addressed in a manner that does not inhibit traditional products that 

banks have managed successfully and that have benefited consumers. The legitimate concerns 

generated from the poor underwriting and risk management practices of a few institutions 

should not be addressed through a capital rule applicable to the entire industry. If the proposal 

is adopted in its current form, the banking industry will enter a counterintuitive phase whereby 

unsecured loans, which receive a 100% risk-weighting under the proposal, will effectively be 

deemed safer than many loans secured by collateral, a concept that contradicts the basic 

principles of banking. Furthermore, the proposed risk-weighting framework will push more 

residential mortgage business into lines that receive government support, as most government 

sponsored mortgage programs receive a low risk-weighting under the proposal. 

It is critical to acknowledge that while the residential mortgage industry is vast, and a large 

portion of mortgage activity takes place off banks' books, the volume of residential mortgage 

exposure held in portfolio at banking organizations is not at all insignificant. Indeed, the 

commercial banking industry holds over $2 trillion in residential mortgage exposure in portfolio. 

Notably, residential mortgage exposures comprise an average of 17% of a bank's assets. While 

the securitization market has become the dominant source of mortgage funding, the 

assumption that this is not an important exposure for banks is incorrect. A bank's ability to 

originate and hold residential mortgage product is an important part of its asset mix and allows 

for a customization of credit beneficial for the consumer. Public policy should not inhibit this 

activity. 

In a period where a coherent plan for addressing broader housing finance reform has not 

emerged, we believe this proposal, which would limit residential mortgage activity at 

institutions that are willing to take on the risk associated with this important class of credit, is 

ill-advised. 

HIGH VOLATILITY COMMERCIAL REAL ESTATE (HVCRE) 

Current risk-based capital requirements prescribe a 100% risk-weighting for acquisition, 

development, and construction (ADC) loans. The Agencies have proposed a new risk-weighting 

for High Volatility Commercial Real Estate (HVCRE) loans. An HVCRE loan would be defined as a 

credit facility that finances or has financed the acquisition, development, or construction of real 

property, unless the facility finances one-to four-family residential properties or commercial 

real estate projects that demonstrate certain LTV or borrower contribution standards. HVCRE 

loans would receive a 150% risk weighting under the proposal. 

The impact of the proposed treatment of HVCRE loans could have negative unintended 

consequences for banks and the broader economy. The proposed approach, with a highly 

punitive risk weight, fails to adequately account for an institution's experience and expertise in 

this type of lending, the adequacy of its policies and procedures, and the level of concentration. 

Issues with development and construction lending should be addressed at the risk management 

4 
221 


79691.136

Exhibit C 

level and through the supervisory process. The proposed 150% risk weighting is effectively 

telling institutions not to engage in this type of lending. 

Strikingly, under the proposed rule, sovereign debt that is in default receives the same riskweighting treatment as the construction and development loans detailed above. Other 

sovereign debt in substantially struggling countries that are not in default receives a potentially 

more attractive risk-weighting than HVCRE loans. Considering these relative risk-weightings, 

the Agencies are effectively signaling to banking organizations that investing in struggling 

countries such as Greece is as sound as investing in real estate projects in their local 

communities. This implied direction will cause many banking institutions, particularly 

community banks, to re-evaluate their asset mix to the detriment of community focused 

business lending. 

We recognize construction and development lending has posed significant risks for many 

community banks over the past few years. However, as discussed above, to the extent a 

construction and development loan poses safety and soundness issues for an institution, those 

issues should be addressed through the supervisory process. The Agencies should not feel 

compelled to penalize broad types of transactions through capital rules rather than addressing 

the concentrations that were problematic during the last crisis. Further, it is important to note 

that while many community banks struggled in their risk assessment of construction and 

development loans, many more were successful and prudent in construction and development 

lending. The successful banks frequently established loan concentration limits that forced them 

to engage in prudent risk selection which recognized the distinct differences within broad loan 

types. CSBS therefore urges the Agencies to re-contemplate the proposed framework for 

HVCRE loans. 

PAST DUE EXPOSURES 

Under current general risk-based capital rules, the risk weighting of an exposure does not 

change if it becomes past due, with the exception of residential mortgage loans. In the NPR, 

the Agencies have proposed to require banking organizations to assign a risk-weight of 150% to 

an exposure that is not guaranteed or not secured if it is 90 days or more past due or on 

nonaccrual. 

This provision will introduce more volatility and potentially sudden shocks into the capital 

planning process. Additionally, we note that levels of past due exposures may change 

frequently from quarter to quarter. We should strive to establish provisions that will not cause 

frequent fluctuations in risk-weighted assets on a quarterly basis. 

CSBS would also like to point out that increasing the risk-weighting for past due loans involves 

some measure of "double-counting." When an exposure becomes past due, there are generally 

allowance provisions that require institutions to reserve capital for those exposures in case they 

default, effectively lowering institutions' capital levels. Therefore, increasing the risk-weighting 

for past due loans will effectively adjust both the numerator and denominator in risk-based 

capital ratios, compounding the negative effect on the ratio. 

5 
222 


79691.137

Exhibit C 

Finally, it is important to note that there exist classes of past due loans that are designated as 

such for administrative reasons. For example, exposures may be past due while institutions are 

waiting on financial statements, appraisals, or other pertinent financial information. In these 

cases, institutions will refrain from renewing the loan until the technical issues are resolved. 

We do not believe institutions should have to hold additional capital against these types of past 

due exposures. 

OFF-BALANCE SHEET ExPOSURES 

Within the context of off-balance sheet exposures, the NPR states that if a banking organization 

provides a credit enhancing representation or warranty on assets it sold or otherwise 

transferred to third parties, including in cases of early default clauses or premium-refund 

clauses, the banking organization would treat such an arrangement as an off-balance sheet 

guarantee and apply a 100% credit conversion factor to the exposure amount. While it appears 

that standard representations and warranties for fraud, misrepresentation, & documentation 

deficiencies that have traditionally accompanied secondary market sales of mortgages to 

investors would be exempted from the risk-based capital requirements, we request the 

Agencies explicitly clarify whether these traditional representations and warranties are indeed 

exempt. We believe that requiring institutions to hold capital against these representations 

and warranties will have detrimental consequences for mortgage banking. 

SECURITIZATIONS 

Dodd-Frank requires financial regulators to strip references to credit ratings from their 

regulations. This clearly has an implication for securitizations, as the risk-weighting framework 

in this area has traditionally referenced credit ratings. Under the proposal, a banking 

organization would generally calculate a risk-weighted asset amount for a securitization 

exposure by applying either: {1} the simplified supervisory formula approach (SSFA), or {2} for 

banking organizations not subject to the market risk rule, a gross-up approach similar to an 

approach provided under the general risk-based capital rules. Alternatively, a banking 

organization may choose to apply a 1,250% risk weight to any of its securitization exposures. 

We acknowledge that the Agencies are required to adjust their regulations in this area to 

account for the Dodd-Frank mandate. We would like to note that the proposed approaches for 

measurement and due diligence requirements, which generally require complex methods of 

evaluating the underlying collateral in securitizations, may be difficult for community banks to 

administer, and the alternative proposed risk-weighting is punitive. CSBS encourages the 

Agencies to explore a simpler method for applying these standards to community banks. We 

are concerned the proposed approach will significantly impair an institution's ability to manage 

its balance sheet through the economic cycle. We believe that in order to have a vibrant and 

diverse banking system, banks of all sizes need the ability to manage the balance sheet with a 

variety of exposures. 

EQUITY EXPOSURES 

Under the proposal, a banking organization would determine the risk-weighted asset amount 

for each equity exposure by multiplying the adjusted carrying value of the equity exposure by 

6 
223 


79691.138

Exhibit C 

the applicable risk weight set out in the Agencies' proposed Simple Risk-weight Approach Table 

for equity exposures. The proposal also permits banking organizations to apply a 100% risk 

weighting to certain equity exposures deemed non-significant. 

The Simple Risk-weight Approach Table is straightforward. However, we believe the scope of 

the 400% equity exposure category applied to non-publicly traded entities should be clarified. 

We would be particularly concerned if this risk-weighting is assigned to equity exposures such 

as stock ownership in bankers' banks. It seems that stock ownership in bankers' banks might 

qualify as a non-significant equity exposure if the ownership meets certain characteristics, 

thereby achieving a lower risk-weighting. Nevertheless, the industry would benefit from clarity 

in this area. The Agencies also inquire as to whether they should explore an alternative 

proposal to simplify the risk-based capital treatment of banking organizations' non-significant 

equity exposures. We support such an effort. 

OTC DERIVATIVES 

CSBS requests clarity on what is meant by "netting" within the context of OTC Derivatives in the 

proposed rule. Netting occurs in many forms. If the proposed rule is simply referring to netting 

within the context of various master netting agreements, we would like to note that the 

definition of netting within those agreements can vary widely. To the extent institutions 

comply with this provision, the Agencies should be aware of the variety of netting 

arrangements that exist under the master agreements. 

MARKET DISCIPLINE AND DISCLOSURE REQUIREMENTS 

The Basel Committee on Banking Supervision (BCBS) introduced additional capital disclosure 

requirements in its 2011 paper entitled, "Definition of Capital Disclosure Requirements." The 

Agencies are proposing to apply these disclosure requirements to banking organizations with 

assets greater than $SO billion. CSBS endorses the Agencies' proposed disclosure requirements 

for large institutions. However, it is important to ensure that these requirements will not flow 

down to community banks in the future. We generally do not believe that the specific 

disclosure requirements would be necessary for smaller banks or beneficial to community bank 

stakeholders. 

REGULATORY FLEXIBILITY ACT ANALYSIS 

The Regulatory Flexibility Act (RFA), S U.S.c. 601 requires an agency to provide an initial 

regulatory flexibility analysis with a proposed rule or to certify that the rule will not have a 

significant economic impact on a substantial number of small entities (defined for purposes of 

the RFA to include banking entities with assets less than or equal to $17S million). 

We are troubled by the inconsistent and, in our view, inadequate approach the Agencies took in 

addressing this requirement. The FDIC and the OCC certify in their analyses that the Basel III 

and Standardized Approach NPRs, taken together, "appear to have a Significant economic 

impact on a substantial number of small entities." The Federal Reserve's analysis is less 

conclusive. 

7 
224 


79691.139

Exhibit C 

CONCLUSION 

The proposed rule provides an important opportunity for the industry and policy makers to 

debate how various rules should apply to a variety of institutions. The Agencies deserve credit 

for the extensive outreach they have conducted to ensure the industry understands the 

proposal. This process should yield the Agencies valuable information on the potential impact 

that this proposed rule will have on banking operations, access to credit and the broader 

economy. We believe this is an important opportunity for the Agencies to consider what is 

realistic and practical for a variety of institutions, appreciating the diversity of the system. 

We believe it is important for the capital rules to take a long-term view of the industry and 

exposures. In this regard, broad risk weights have served regulators reasonably well, with 

specific information about risk exposures supplemented by supervision. While it can be 

tempting to attempt to fine tune the risk identification, there is a fine line between enhanced 

risk sensitivity and credit allocation. 

Most importantly, we believe it is imperative to understand the potential impact not only on 

capital in the banks but also on their behavior in originating credit. An overly conservative 

industry will not be in the position to serve consumers or local economies. We appreciate that 

the Agencies must do certain things to comply with the Basel III international accord and the 

Dodd-Frank Act. The Agencies should pursue a rulemaking with the absolute minimum changes 

required to comply with the law. We strongly encourage the Agencies to undertake a larger 

study to evaluate long-term capital standards under a framework which meets the needs of 

regulators and is consistent with the variety of business models of our banking industry. 

Best regards, 

John W. Ryan 

President & CEO 

8 
225 


79691.140

Exhibit 0 

Banks and Real Estate Exposures 

Banks by Asset Size 

Less than 100MM 

100MM to 500MM 

500MM to 1 Billion 

1B to 10 Billion 

lOB to 50 Billion 

50 Billion + 

Totals 

Banks by Asset Size 

Less than 100M M 

100MM to 500MM 

500MM to 1 Billion 

1B to 10 Billion 

lOB to 50 Billion 

50 Billion + 

Totals 

Source: SNL Financial 

# Banks 

2,375 

3,533 

691 

552 

72 

36 

7,259 

# Banks 

2,375 

3,533 

691 

552 

72 

36 

7,259 

% 

Proportion 

of RE 

Exposures 

33% 1% 

49% 6% 

10% 3% 

8% 10% 

1% 10% 

0% 70% 

100% 100% 

Assets (OOO) 

135,185,376 

795,179,339 

475,620,093 

1,422,243,720 

1,414,753,694 

9,795,843,302 

14,038,825,524 

Allocation of RE Exposures 

1-4 Family C&D CRE Ag 

1% 1% 1% 11% 

6% 14% 14% 38% 

4% 10% 9% 13% 

11% 24% 25% 19% 

14% 10% 13% 7% 

64% 40% 38% 12% 

100% 100% 100% 100% 

1-4 Family Related Loans 

$ (000) % of Assets 

25,048,899 19% 

157,219,937 20% 

94,340,971 20% 

264,904,005 19% 

339,362,507 24% 

1,571,946,188 16% 

2,452,822,507 17% 
226 


79691.141

Marc jarsulic 

Chief Economist 

Better Markets, Inc. 

Testimony on "Examining the Impact of the Proposed Rules to Implement Basel III 

Capital Standards." 

House Subcommittee on Financial Institutions and Consumer Credit, and the 

House Subcommittee on Insurance, Housing and Community Opportunity 

November 29, 2012 

Good afternoon Ms. Chairman Capito, Ms. Chairman Biggert, Ms. Ranking Member Maloney, 

Mr. Ranking Member Gutierrez, and members of the committee. Thank you for the 

invitation to Better Markets to testify today. 

Better Markets is a nonprofit, nonpartisan organization that promotes the public interest in 

the domestic and global capital and commodity markets. It advocates for transparency, 

oversight, and accountability with the goal of a stronger, safer financial system that is less 

prone to crisis and failure, thereby, eliminating or minimizing the need for more taxpayer 

funded bailouts. Better Markets has filed more than 100 comment letters in the U.S. 

rulemaking process related to implementing the financial reform law and has had dozens 

of meetings with regulators. Our website, www.bettermarkets.com. includes information 

on these and the many other activities of Better Markets. 

My name is Marc jarsulic and I am the Chief Economist at Better Markets. I have previously 

served as a Chief Economist of the Senate Banking Committee and Chief Economist and 

Deputy Staff Director of the joint Economic Committee. Prior to that I was an academic 

economist and an attorney specializing in antitrust and securities law. 

1. Introduction 

I will discuss in detail below the impact of the proposed rules to implement Basel III capital 

standards and the balance between ensuring financial institutions are properly capitalized 

and preserving the ability of financial institutions to fulfill their lending and other 

functions. However, I will first address some of the questions raised by the Committees in 

their November 16, 2012 letter inviting us to testify. 

• How well capitalized are U.S. financial institutions? 

In large measure, the 2008 financial crisis happened because the too big to fail banks had 

too much debt and too little equity. Their highly leveraged positions made them vulnerable 

to asset price declines and creditor runs. When the crisis hit, that massive debt and lack of 

1 
227 


79691.142

equity caused them to fail or almost fail. which required government bailouts that were, in 

substance, direct or indirect injections of equity. 

Capital requirements are the mechanism to address this key flaw in the funding practices of 

the too big to fail banks. If they are set at adequate levels, then the likelihood of another 

financial crisis is reduced and, most importantly, the need for taxpayer funded or backed 

bailouts would be reduced even further. 

The crisis also demonstrated that the broker dealers operated by large banks have 

exceptionally high risk of very rapid counterparty runs. Such broker dealer trading is 

heavily reliant on repo funding - which is collateralized short term borrowing, often for 

periods as short as overnight or a single day. These broker dealers with large OTC 

derivatives books are subject to rapid runs, in which counterparties move the contracts to 

other dealers, close them out altogether or make margin calls at the first sign of trouble. 

Because the broker dealers are so highly leveraged, this can create a "cash crunch", forcing 

assets sales (often leading to "fire sales" at any price to raise the needed cash), which 

depresses asset prices which forces more sales and causes more collateral calls. This 

contagion can spread rapidly to other firms, contributing to a systemic event. 

Unfortunately, the proposed capital rules do not adequately address these weaknesses. 

The proposed capital rules do not require too big to fail banks to use sufficient equity 

finance to insure that they will remain solvent in the face of large asset price declines. 

Nor do the proposed capital rules require such banks with large broker dealers to selfinsure against the run risk posed by OTC derivatives books or repo-financed trading 

books. 

Evidence from the financial crisis indicates that banks must finance 20-25 percent of 

their assets with equity if they are to survive large asset price declines. The crisis also 

demonstrated that banks with large broker dealers face run risk that is a function of 

gross repo borrowing and gross OTC derivative exposure. Therefore, equity 

requirements must reflect the risk of these exposures, not some net amount that 

assumes everything is fully and timely paid. 

Are uniform capital standards suitable for the diverse financial system in 

the U.S.? 

The proposed rules do not apply a uniform standard for the diverse U.s. financial system. 

In fact, the capital standards are tailored to different sizes and types of institutions. For 

example, the countercyclical capital buffer and other parts of the "Advanced 

Approaches" rules do not apply to banks with less than $250 billion in assets or $10 

billion in on balance sheet foreign exposure. 

2 
228 


79691.143

However, community banks have raised some legitimate concerns about the application 

of those tailored rules. As discussed below, a few changes to the proposed capital rules 

should help assure continued community bank credit supply for businesses and 

households, without significantly increasing the risks to the overall financial system. 

However, such changes should apply only to genuine community banks, those with 

assets of$10 billion or less. 

• What will be the cost of compliance if proposed rulemakings go into effect? 

Empirical evidence indicates that there would not be a social cost to requiring banks to 

adequately self-insure against large asset price declines or the run risk created by large 

broker dealer operations. That is to say, evidence does not support the claim that the 

cost of bank credit will rise iflarge banks finance their positions with higher proportions 

of equity and lower proportions of debt. 

Historical evidence suggests that industry claims of excessive or burdensome 

compliance costs need to be discounted. Moreover, any actual costs need to be balanced 

against the extraordinary harm inflicted by the financial crisis. 

Do the proposed rulemakings appropriately address the differences in 

business models between financial institutions and insurance companies? 

By applying consolidated capital requirements to insurance holding companies, the 

agencies' Basel III proposal intends to achieve comparable treatment of similar risks across 

banks and insurers. The example of AIG demonstrates that the behavior of the savings and 

loan holding companies that own insurers can easily pose threats to overall financial 

stability. Therefore the proposed treatment of savings and loan holding companies seems 

very reasonable. 

2. The financial crisis revealed important weaknesses ofthe U.S. banking system. 

First, the U.S. banks use far too much debt, and far too little equity, to finance 

their positions and operations. This high leverage makes them vulnerable to 

asset price declines and creditor runs. 

This can be seen by considering developments at four banks - Washington Mutual, 

Wachovia, Citigroup and Bank of America- the failure or near failure of which 

contributed to financial crisis during 2007-2008. The relevant data are presented in 

Table 1 in the Appendix. 

3 
229 


79691.144

Washington Mutual 

Washington Mutual, which failed in the third quarter of 2008 and was acquired by 

JPMorgan Chase, was, from a regulatory capital standpoint, in good shape as of June 30, 

2007. It had total assets of$312 billion, and a ratio of Tier 1 capital to risk-weighted 

assets of 7 percent (giving a leverage ratio of 14.3). But, by another measure - which 

was considered the relevant measure during the crisis - Washington Mutual's capital 

was significantly less robust. The ratio of Washington Mutual's tangible common equity 

to tangible assets was 4.8 percent (making the leverage ratio, the ratio of assets to 

equity, 20.7). 

As the financial crisis got under way, Washington Mutual began to acknowledge some of 

its losses, beginning in the third quarter of 2007. Between the third quarter of 2007 and 

the third quarter of 2008 the cumulative value of Washington Mutual's net charge-offs 

and asset write-offs totaled $5.9 billion, and the ratio of tangible common equity to 

tangible assets fell to 3.6 percent (giving a leverage ratio of 27.8). The bank's stock price 

fell, its borrowing capacity was reduced by the Federal Home Loan Banks and, after 

Lehman collapsed, there were significant deposit outflows.l 

Even after all that, the situation at Washington Mutual was in fact much worse than the 

bank had acknowledged. When JPMorgan Chase acquired the remnants of the bank in 

September 2008, it wrote off an additional $29 billion of Washington Mutual assets. 2 

This brought total write-offs to nearly $35 billion, or 11.5 percent of Washington 

Mutual's tangible assets in June 2007. 

Wachovia 

A similar scenario played out in the case of Wachovia, one of the ten largest bank holding 

companies in 2007 with total assets of $703 billion. In the second quarter of 2007 

Wachovia's Tier 1 capital was 7.5 percent of its risk-weighted assets. However, its ratio 

of tangible common equity to tangible assets was 4.3 percent (giving a leverage ratio of 

23). Between the second quarter of 2007 and the third quarter of 2008 it recognized 

cumulative net charge offs and other asset writedowns of$13.1 billion, only 1.9 percent 

of its second quarter 2007 tangible assets. However, capital markets did not agree with 

Offices of the Inspectors General, u.s. Treasury and Federal Deposit Insurance Corporation (2010). 

Evaluation of Federal Regulatory Oversight of Washington Mutual Bank, Report No. EVAL-10-002, 12-

13. 

JPMorgan Chase (2008). Acquisition of assets, deposits and certain liabilities of Washington Mutual's 

banks by JPMorgan Chase, September 25, investor presentation. 

4 
230 


79691.145

Wachovia's sunny view of its positions, and in the third quarter of 200S the bank could 

no longer borrow in the capital markets and was about to fail.3 

Wachovia was acquired by Wells Fargo, which wrote off an additional $47.3 billion in 

assets in 200SQ4. This brought total losses to $60.2 billion, nearly 9 percent of 2007Q2 

tangible assets. 

Citigroup 

Citigroup was on a similar path before it was rescued by massive federal aid. Between 

the second quarter of 2007 and end of 200S, its ratio of tangible common equity to 

tangible assets fell from 3 percent (for a leverage ratio of 33) to 1.3 percent (for a 

leverage ratio of 7S.S). This occurred while its regulatory capital ratio was increasing 

from 7.9 percent to 11.9 percent. Citigroup's cumulative charge offs and writedowns 

were 3.7 percent of its second quarter 2007 tangible assets over this period. 

However, in the fourth quarter of 200S Citigroup had a massive injection of what was in 

essence government equity. Treasury purchased $45 billion in preferred stock, and the 

FDIC guaranteed $31.S billion of Citigroup debt. 4 It clearly needed these public equity 

injections to survive.s Hence, by the fourth quarter of 200S the total of Citigroup's 

recognized losses and public equity injections totaled $156 billion, or 7.2 percent of 

second quarter 2007 tangible assets. 

Bank of America 

Bank of America had a tangible common equity to tangible assets ratio of 4 percent (and 

a leverage ratio of 25) in the second quarter of 2007. By the fourth quarter of 200S the 

ratio was down to 2.S percent (for a leverage ratio of 35.3). Cumulative losses amounted 

to 5.6 percent of it second quarter 2007 tangible assets. By the fourth quarter of200S 

Treasury had purchased $45 billion of Bank of America preferred stock, and FDIC 

guaranteed $10 billion ofthe bank's debt. So in the fourth quarter of200S, the sum of 

Bank of America's recognized losses and public equity injections totaled 9.3 percent of 

second quarter 2007 tangible assets. 

*** 

Wachovia 10-Q, for the period ended September 30, 2008, 2. 

By 2009Q2 debt guarantees rose to more than $72 hillion. 

The Treasury, Federal Reserve, and FDIC also guaranteed $301 billion ofCitigroup assets, and the 

bank was a large user of Federal Reserve emergency lending facilities. The Congressional Oversight 

Panel put total federal government exposure to Citigroup at $476.2 billion. See, Congressional 

Oversight Panel (2011)' March Oversight Report, Figure 7, available at 

http://cybercemetery.unt.edu larchive 1 cop 120110401232213 Ihttp:((cop.senate.goY/documents/co 

p-031611-report.pdf. 

5 
231 


79691.146

Taken together, these four examples of Washington Mutual, Wachovia, Citigroup and 

Bank of America clearly demonstrate that banks require equity well in excess of 10 

percent of their tangible assets to survive financial crises of the severity we have just 

witnessed. Losses alone can exceed this amount. And to assure counterparties that they 

are still viable after such a loss, the bank needs to demonstrate that it will remain viable 

if it experiences additional losses. Given the fact that assets may devalue rapidly during 

a crisis, equity equal to 20-25 percent of assets appear necessary for a bank to be selfinsured against failure. 

Second, the broker dealers operated by large bank holding companies are highly 

exposed to risk of very rapid counterparty runs. 

Large bank broker dealer trading is heavily reliant on repo funding - which is 

collateralized short term borrowing, often for periods as short as overnight or a single 

day. It was estimated that in 2007 the 5 largest investment banks funded 42 percent of 

their assets with repo borrowing. These broker dealers are therefore vulnerable to 

literal overnight runs when there is severe financial market stress or even the mere 

threat of stress. 6 

In early 2008 there was a general "run on repo" as firms and asset classes became suspect, 

even for overnight loans. By the end of the 2008 outstanding repo debt held by primary 

dealers contracted from a peak value of $4.6 trillion to $2.4 trillion. It is estimated that 

during the crisis Merrill Lynch, Goldman Sachs, Morgan Stanley and Citigroup lost about 50 

percent of their tri-party repo funding, which supported non-agency mortgage backed 

securities, asset-backed securities and corporate debt. 

The collapse of the repo market prompted the Federal Reserve to intervene with the 

Primary Dealer Credit Facility, Term Securities Lending Facility, and to expand its own repo 

lending. At its peak, outstanding Federal Reserve lending from these three sources 

amounted to more than $450 billion. 

Broker dealers with large OTC derivatives books are subject to rapid runs, in which 

counterparties have other dealers step in as counterparties in contracts, close out contracts 

altogether, or make margin calls. 7 Runs of this kind materialized during the financial crisis 

at Bear Stearns and Lehman Brothers, contributing to the collapse of those firms. Other 

For a description of the run on repo, see the Better Markets comment letter on Voleker Rule, available at 

http:{ {www.bettermarkets.com {sjtes {defau It/files {SEC-%2 OCL·%2 OVo I cker%2 0 Ru le-%2 0 2 -13 -12.pdf; 

for a data on Federal Reserve efforts to aid repo borrowers, see 

http://bettermarkets.com/blogs I another-reason -we-need-stro ng-vo Ie ker· rule. 

Financial Crisis Inquiry Commission (2011). The Financial Crjsis Inquiry Report, U.S. Government 

Printing Office, Washington, D.C., 287-288; and D. Duffie (2010). The Failure Mechanics of Dealer 

Banks, fournal of Economic Perspectives Volume24,Number 1, 51-72. 

6 
232 


79691.147

large bank broker dealers faced similar risk, which is what necessitated such massive 

bailouts and rescue programs. 

3. The proposed capital rules do not adequately address these weaknesses. 

The proposed capital rules do not require banks to use nearly enough equity 

finance and will allow continued excessively high debt financing, which will 

continue to pose serious risks of runs that will almost certainly result in the need 

for bailouts in the future. For example, the proposed rules require banks to hold 

common equity equal to just 4 percent of on balance sheet assets.B But evidence clearly 

indicates that banks require common equity equal to at least 20-25 percent of their 

tangible assets to survive a financial crisis of the severity we have just witnessed. 9 

The proposed capital rules do not require banks to self-insure against the run risk 

posed by OTe derivatives trading or repo borrowing, which means that taxpayers 

will- again - have to provide the equity for bank bailouts when the next financial 

crisis happens. For example, the proposed rules allow banks to calculate repo 

exposures net of the collateral used to borrow, and to calculate derivatives exposures 

net of counterparty exposures (with a small "potential future exposure" add-on). These 

net calculations do not reflect the fact that runs on repo finance will mean a loss of gross 

repo financing. And, a run by OTe derivatives counterparties will mean an attempt to 

eliminate gross exposure to the weakened dealer. With a financial crisis looming or 

unfolding, no lender is going to wait until a counterparty nets all its gross positions and 

exposures to determine if, on a net basis, they are financially sound or not. Any lender is 

going to call the debt, get their cash and eliminate their exposure as fast as possible. 

Instead, equity requirements should rise as trading operations increase their use of repo 

borrowing or securities lending to fund long maturity assets. They should also rise with 

gross derivatives exposures. This would require banks to effectively self-insure against 

runs, and provide some protection against the funding runs that brought down Lehman 

and Bear Stearns and threatened all the large dealers. It is also a key method to reduce 

the risk of and need for taxpayer funded or backed bailouts, which were required last 

time because the too big to fail banks simply did not have enough equity to avoid failure 

and bankruptcy. 

Federal Register, Vol. 77, No. 169, 52792, Subpart B, §§ _.10(a)(4) and _.10(b)(1). 

See the Better Markets comment letter on the recently proposed rule changes for more detail, available at 

http://www.bettermarkets.CQm/sites/defaultlfiles/FRS%2C%20QCC%2C%20FDIC-%20CL-3nprs-

%2010-22-12.pdf. 

7 
233 


79691.148

4. The social cost of adequate self-insurance against large asset price declines, or 

the run risk created by large broker dealer operations, is limited. 

Empirical evidence indicates that there would not be a social cost to requiring banks to 

adequately self-insure against large asset price declines or the run risk created by large 

broker dealer operations. If there were, then we should be able to observe a historical 

correlation between bank equity levels and the cost of bank credit. That is, as bank 

leverage rises, the markup that banks charge on loans should decline. But as Hanson, 

Kashyup, and Stein have pointed out, there is no observable correlation between overall 

bank leverage and bank credit spreads. IO Therefore there is little reason to expect that 

the cost of credit for businesses and households would increase ifbanks were required 

to finance a larger proportion of their positions and operations with equity. 

5. The banking industry has overstated the costs of complying with more 

stringent standards governing equity finance and controls on run risk. In any 

event, these heightened requirements are an essential component of reforms 

designed to prevent another financial crisis. 

• History proves that industry claims of excessive compliance costs from financial 

reform are false 

Since the emergence of financial market regulation, the financial services industry has 

claimed that new regulatory requirements will have a devastating impact by imposing 

excessive compliance costs or prohibiting profitable activities. Yet the industry has always 

absorbed the cost of those new regulations and has consistently remained one of the most 

profitable sectors in our economy. For example, a century ago, when securities regulation 

first emerged at the state level, Wall Street staunchly opposed it as an "unwarranted" and 

"revolutionary" attack upon legitimate business that would cause nothing but harm.II 

However, in the years following this early appearance of financial regulation, banks and 

their profits grew handsomely.12 

10 S. Hanson et al. (2011). A Macroprudential Approach to Financial Regulation. lournal of Economic 

Perspectives. Volume 25. Number 1, 3-28. See also A. Admati and M. Helliwig (2013). The Bankers' New 

Clothes forthcoming, for a thorough explanation of why, on the basis of established economic theory, we 

should expect the liability structure of banks to have very limited impact on the cost of credit 

11 See Marcus Baram, The Bankers Who Cried Wolf Wall Street's History 0/ Hyperbole About Regulation, THE 

WATCHDOG, HUFFINGTON POST, June 21, 2011, http://www.huffingtonpost.comf2011f06/21/wall-street· 

historyhyperbole-regulation n 881775.html. 

12 Paul G. Mahoney, The Origins a/the Blue-Sky Laws: A Test a/Competing Hypotheses, 46 J.L. & ECON. 229, 

249 (2003) ("In the 5 years following adoption of a merit review statute [the most stringent type of blue 

sky law statute], bank profits increased on average by nearly 5 percentage points ... "). 

8 
234 


79691.149

The same pattern has been repeated with each new effort to strengthen financial 

regulation, including passage of the federal securities laws, deposit insurance, the GlassSteagall Act, mutual fund reform, and the national market initiatives of the mid-1970s.13 It 

continues with full force today, as banks and other financial institutions argue strenuously 

that many of the reforms in the Dodd-Frank Act will hamper capital formation and credit 

availability, thus stifling economic recovery. And typically, the industry provides little or 

no credible data or substantive support for their assertion that regulatory costs will prove 

to be excessive and unmanageable.14 

For example, a frequent industry claim is that financial reform rules will "reduce market 

liquidity, capital formation and credit availability, and thereby hamper economic growth 

and job creation." Yet the industry fails to mention that the financial crisis did more 

damage to those concerns than any rule or reform possibly could: Starting in September 

2008 and continuing into 2009, there was no "market liquidity, capital formation [or] 

credit availability" and, since then, there has been little "economic growth" and even less 

"job creation" due to the financial collapse and economic crisis. 

The lesson to be learned from this history is that when faced with new regulations, 

members of the regulated industry routinely argue that the costs and burdens are too 

heavy-but then they invariably adapt and thrive. 1s Thus, to the extent that banks resist 

the imposition of more stringent equity ratios and run risk controls on the basis of 

compliance costs, those arguments must be appropriately discounted. 16 

13 Marcus Baram, supra note 82; see also Nicholas Economides et aI., The Political Economy a/Branching 

Restrictions and Deposit Insurance: A Model a/Monopolistic Competition Among Small and Large Banks, 39 

J. L. & EcaN. 667, 698 (1996) ("The American Bankers Association fights to the last ditch deposit 

guarantee provisions of GlaSS-Steagall Bill as unsound, unscientific, unjust and dangerous. 

Overwhelmingly, opinion of experienced bankers is emphatically opposed to deposit guarantee which 

compels strong and well-managed banks to pay losses of the weak .. The guarantee of bank deposits has 

been tried in a number of states and resulted invariably in confusion and disaster ... and would drive the 

stronger bank, from the Federal Reserve System.") (quoting Francis H. Sisson, president of the American 

Bankers Association). 

14 Those seeking to block reform are not only exaggerating the impact of regulation, but also submitting 

incomplete, misleading, or inaccurate cost estimates. See, e.g., John E. Parsons & Antonio S. Mello, Nera 

Doubles Down, Betting Against the Business, Mar. 19, 2012, 

http://bettingthebusiness.com/2012j03j19jnera-doubles·downj (challenging industry estimates of the 

cost of margin requirements in derivatives transactions) 

15 For more analysis of the financial industry's resistance to financial reform, see Better Markets, Setting 

The Record Straight On Cost-Benefit Analysis And Financial Reform At The SEC (July 30, 2012), available 

at http://bettermarkets.com/sites/default/files/CBA%20Report.pdf. incorporated hy reference as if fully 

set forth herein. 

16 Bradley Keoun & Jonathan D. Salant, Obama Plan Gets Wary Reception from Banks, Lawmakers 

(Update 1), BLOOMBERG, June 18,2009, 

http://www.bloomberg.com/apps/news?pjd-2060 1 087 &sid-ae85nCexFOvO ("The brewing legislative 

battle recalls the industry's reluctance to accept reforms after the 1929 stock-market crash. I don't think 

9 
235 


79691.150

Even if more stringent equity ratios and run risk controls were to impose increased 

compliance costs on banks, those costs would be warranted to help protect the 

banking system and the entire economy from another financial crisis. 

Over a three-year period beginning in 2007 and culminating in the passage of the DoddFrank Act on July 21, 2010, Congress and the President witnessed the financial and 

economic destruction caused by the financial crisis, implemented emergency measures to 

contain it, and then made the judgment that comprehensive reforms were essential to 

protect the financial system and the economy from another financial crisis. The Legislative 

and Executive Branches determined that the industry would have to bear substantial 

regulatory burdens to achieve this overriding objective. Those burdens include initial and 

ongoing compliance costs as well as the elimination of some profitable but high-risk 

business activities. Congress and the President recognized these consequences but 

nevertheless imposed them to re-regulate the recently de-regulated financial industry, to 

close regulatory gaps, and to strengthen existing requirements for the benefit of investors, 

the public, and the entire economy.17 

Illustrating this approach, the Dodd-Frank Act imposes a broad set of regulatory reforms 

on bank holding companies and nonbank financial institutions, with the focus on 

systemically important institutions. They will pay compliance costs from new 

requirements relating to registration, reporting, record keeping, public disclosures, risk 

committees, examinations, fees, capital and leverage requirements, and other enhanced 

supervisory and prudential standards.1s Key provisions of the statute will also eliminate 

some immensely profitable trading activities. 19 These statutory bans on profitable 

anyone can buy the argument that by regulating too tightly, we'll choke off capitalism. .. That argument is 

as shallow now as it was then.") (citing Charles Geisst, Professor, Manhattan College). 

17 For an analysis of the enormous cost and scale of the financial crisis, see Better Markets, The Cost of The 

Wall Street-Caused Financial Collapse And Ongoing Economic Crisis is More Than $12.8 Trillion (Sept 15, 

2012), available at http://bettermarkets.com/sites I defa ult/files/Cost%200fDiil20The%20Crisis O.pdf. 

18 §§ 112(d) (reporting by Bank Holding Companies & Nonbank Financial Institutions); 114 (registration of 

Covered Nonbank Companies); 116(a) (Bank Holding Companies with consolidated assets of$50 billion, 

or Covered Nonbank Companies to submit certified information reports); 161 (reporting by and 

government examinations of Covered Nonbank Companies); 165(b) (enhanced prudential standards for 

Covered Bank Holding Companies and Covered Nonbank Companies); 165(d) (reporting by Covered 

Bank Holding Companies and Covered Nonbank Companies); 165(1) (public disclosures by Covered Bank 

Holding Companies and Covered Nonbank Companies); 165(h) (risk committee requirements for Publicly 

Traded Covered Nonbank Companies and Publicly Traded Bank Holding Companies); 165(i) (stress tests 

to be performed on Bank Holding Companies with consolidated assets of $50 billion, or Covered Nonbank 

Companies); 210(0) (Orderly Liquidation Fund fees from Bank Holding Companies with consolidated 

assets of $50 billion, or Covered Nonbank Companies); 619 (Insured Depository Institutions, Bank 

Holding Companies, and Covered Nonbank Companies to keep records to comply with Voleker Rule). 

]9 See, e.g" Provisions on capital requirements for Covered Nonbank Companies, §§ 165(b)-(c), 171; 

Covered Bank Holding Companies, § 165(b)-(c); Depository Institutions and Depository Institution 

10 
236 


79691.151

activities will effectively eliminate billions of dollars in annual revenue for the largest 

banks. 

These reforms are necessary to bring integrity and stability to the financial markets. It is 

clear that these reforms would be impossible to implement without imposing compliance 

costs on market participants, who will be required to pay filing fees, hire new staff, upgrade 

and maintain information technologies, reallocate capital, and alter their business 

procedures. In passing the Dodd-Frank Act, both Congress and the President decided that 

the enormous collective benefits of the law far exceeded any costs or lost profits that 

industry would have to absorb. Similarly, the imposition of heightened standards 

governing equity finance and run risk controls on banks is clearly warranted as a key 

component of the reforms that must be implemented to more effectively safeguard our 

markets and our economy from another crisis. 

6. Any adjustments to the capital requirements for "community banks" should be 

restricted to a properly defined set of banks. 

The banking agencies have indicated that the capital rules may need some changes to 

account for issues that are specific to community banks. For example, in a speech on 

October 23, Comptroller Thomas Curry cited two issues that might merit additional 

consideration,zo The Comptroller noted that "some aspects of provisions pertaining to 

mortgages could impose a serious burden on community banks and thrifts, particularly 

when applied to existing mortgages or if phased in too quickly." He also said that the 

proposed treatment of unrealized gains and losses on available for sale securities could 

create volatility in regulatory capital that would be difficult to manage for banks that " ... do 

not regularly access the short term capital markets." Also, Federal Reserve Governor 

Elizabeth A. Duke argued on November 9 for providing a separate set of rules for mortgage 

lending by community banks.21 

Some rule changes may help assure continued community bank credit supply for 

businesses and households without significantly increasing the risks to the overall financial 

system. For example, it may be reasonable to grandfather existing portfolios of mortgages 

from proposed new risk weights for mortgages outside "category 1." It may also make 

sense to phase in the requirement that fair value changes in "available for sale securities" 

holdings are reflected in calculations of Tier 1 capital. That would give community banks 

Holding Companies, § 171; Bank Holding Companies, Savings and Loan Holding Companies, & DepositOlY 

Institutions, § 616; Supervised Securities Holding Companies, § 618(d); and Covered Nonbank Companies 

engaging in activities covered by Voleker Rule, § 619. 

20 Remarks by Thomas J. Curry, before the Florida Bankers Association, October 23, 2012, available at 

http://www.occ.gov I news-issua nces Ispeech es 12 0 12 Ipu b-speech -2 012 -lSl.pdf 

21 Community Banks and Mortgage Lending, Remarks by Elizabeth A. Duke, Member Board of Governors of 

the Federal Reserve System, at the Community Bankers Symposium, November 9, 2012, available at 

http://wwwfederalreserve.gov/newsevents/speech/duke20121109a.htm 

11 
237 


79691.152

time to adjust their securities holdings and to reduce potential regulatory capital volatility. 

And there may be circumstances where the definition of qualified mortgages can be 

adjusted to meet the special circumstances faced by community banks. For example, the 

Dodd-Frank Act allows, under certain circumstances, "balloon" mortgages made by banks 

operating in rural or underserved areas to be treated as qualified mortgages. 22 

However, such changes should apply only to genuine community banks. To prevent toobig-to-fail banks that pose systemic risks from avoiding regulation appropriate to them 

by hiding behind community bank concerns, it is essential to properly define a 

community bank,23If community banks are defined as those with assets less than $1 

billion, then community banks comprise 91 percent of all FDIC insured institutions. If 

the asset threshold for a community bank were to be generously raised to $10 billion, 

then community banks comprise more than 98 percent of all banks. 24 

For present purposes, Better Markets would suggest that individual banks or bank 

holding companies with assets of $1 0 billion or less should be considered community 

banks. Such a definition would mean that, with the exception of some small banks in 

multiple-bank holding companies, 98 percent of all individual banks would be 

considered community banks.25 

Thus, 98 percent of all individual banks would have the impact of implementing Basel III 

addressed as discussed above. 

7. Consolidated capital requirements for insurance holding companies will enhance 

overall financial stability 

By applying consolidated capital requirements to insurance holding companies, the 

agencies' Basel III proposal intends to achieve comparable treatment of similar risks across 

banks and insurers. This is an important goal. Even if major subsidiaries in a holding 

Z2 Dodd-Frank Act, section 1412(2)(E). 

23 Researchers often define community banks as those that serve limited geographical markets, depend on 

retail deposits for much of their funding, and have assets of $1 billion or less. See, e.g., G. Kahn et aL 

(2003). The Role of Community Banks in the U.S. Economy. Economic Review Federal Reserve Bank of 

Kansas City, Second Quarter, 17; T. Critchfield et aL (2004). Community Banks: Their Recent Past, 

Current Performance, and Future Prospects, FDIC Banking Review. 2. 

24 See the data in Tahle 2, attached. The data in the Tahle cover individual banks. Some banks may be 

subsidiaries of holding companies that control more than one bank. Hence the number of holding 

companies would be somewhat smaller than the number of individual banks, and the distribution of 

holding company assets will differ somewhat from the data presented here. Data on smaller bank 

holding companies are not readily available. 

25 ld.; see also, Remarks by Elizabeth A Duke, Member Board of Governors of the Federal Reserve System, at 

the Community Bankers Symposium, Novemher 9,2012, available at 

http://www.(ederalreserye.goyinewseyentsispeechiduke20121109a.htm (using an asset threshold of 

$10 billion to identify community banks). 

12 
238 


79691.153

company engage in property casualty insurance or asset management, they can also engage 

in securities trading, OTC derivatives transactions, and securities lending at the holding 

company level. 

The example of AIG where high risk investments financed with securities lending, and a 

huge portfolio of CDS unsupported by equity both contributed to a systemically damaging 

failure demonstrates that the behavior of such holding companies can easily pose threats 

to overall financial stability. 

The proposed regulations do take account of the differences between insurers and others. 

Separate accounts that do not guarantee results to investors have a zero risk weights for 

regulatory capital purposes, and policy loans receive a low risk weight. 

Therefore, the proposed treatment of savings and loan holding companies seems very 

reasonable. 

13 
239 


79691.154

Table 1 

Washington Mutual 

I, I, I. .I:"'''ib'' I: I: l~cE I: Common Common Tangible Assets TC£jTA leverage TIer 1 

Intangibles Equity Preferred Stock Equity{TCE) !TA) (percent) ratio capital 

20071.12 312.2 9.1 24.2 3032 207 21 

2007-q3 0.5 3210 448 22J 10 

2007q4 327.0 24.6 3.4 3197 4},) 230 

2OO8q1 7.' 22.4 1118 HI) 278 " 2008q2 309.7 26.1 3.4 3024 510 196 " 21 

I

: Net Loan .I~ Other Asset .I~ Total ,I: Cumulative j;,m,' Writedowns •• " I quarter Cha!];e-Offs Write downs Writedowns Write downs (percent)" 

20071.12 

2oo7q3 0.206 1.' e. 0.5 

2007q4 0.461 10 1.0 

2_' 0-165 2.1 10 3 .. 1.3 

,-, 1.31)9 3.7 2.0 1.9 

200",,3 34.4 11.5 

*",100"(cl.lmulativewritedilwns/tangibleassets2007q2) 

Data from SEC loa. ~nd 10K's, and. FR Y9-C's. Unless otherwise noted, data in current $ billions. 

Table 1, contd. 

Bank of America 

quarter 

20071.1 2 1,534.4 1,459.8 25.0 92.4 

20071.13 1,578.8 57.4 58.0 1.501.7 25,9 924 

20071.14 1,715.7 77.S 146.8 ".5 1,627.9 

2_' 1,736.5 77.9 ,8 156.3 17.3 51.3 1,548.8 32.1 99.1 

,-, 1,716.9 n8 ,s 1627 2" 51.2 1.629.5 3.1 

2_3 1,831.2 81.8 9.2 161.0 242 1,740.3 37.9 137.4 

2_4 1,817.9 8.5 37.7 1,727.5 35.3 118.8 

quarter 

2007q3 

2007q4 3.8 1at 21.9 30.7 

200Sql 

2_2 <A 7.2 11,6 

2008q3 '.7 112 '" 581 " '.7 ,_4 812 5.6 10 136.2 

~ '" l00~{cumulati\le writedowns/tangible assets 2007q2) 

u '" lOO~Hcumulat!ve wntedowns+TARP+TLGP)/tangible assets 2007q2) 

Data from SEC 10Cl.and 10K's, and FR Y9-C's. Unless othelWise noted, data in current $ billions. 

14 

1

:""111

0

'" I Weighted 

Assets} 

(percent) 

7.0 

7.5 

'.3 

54 

5' 

7.5 

7.S 8, 
240 


79691.155

Table 1, contd. 

Citigroup 

2007q2 22209 no 0.6 21'>8.7 30 332 ". 2007q3 235a.3 39.9 23.7 127.1 02 '7947 28 92-4 73 

2007q4 2187.5 41.2 12 •. 0 2123.7 366 "., 200Bq1 ]3.9 128.2 19.4 2132.3 517 77 

200Bq2 43.3 24.5 136..4 27.4 ." 8.7 

2oo8q3 2050,1 '" 126.1 1987.0 18 56.0 137,4 

200Sq' 1938.5 141.6 707 1891.5 7<8 " 

200/q3 76 '.6 0.3 

2007q4 3.6 21.9 13 

200",1 " 10.8 43.1 10 

200.,7 72 IV; 54.7 

]OOSq3 47 65 112 659 31 " ""." 6.7 155.8 7.2 

* ~ l00~(C\Jmulativ<') wflt<')dowrls/tangib-Je a~s<')u 7IXl7q2) 

*. ~ lOO·((cumulative wril<')downSfTAFtP+-TlGP)/tanglblC' assets 2007q2) 

Data fram SEC lOQand 10K's, and FR Y9---C's Unless otherwIse noted, data ill curr<')nt Sbilliom 

Table 1, contd. 

Wachovia 

2007q1 702.7 38.8 16 69.8 " 662.3 

2oo7q2 7154 388 15 69.3 29 675.2 00 )B 41.9 

2007q3 388 14 70.1 4.19 23.9 43.S 

2(l(l7q4 43.1 21 " 737.7 

200Sq1 27 763.5 " '" 45' 7.4 

2008q2 37.0 19 7'd 3.93 25.5 495 '_3 1M 19 "" 

quarter 

2007q2 

)007q3 07 0.7 00 

2007q4 0.5 3.2 0.5 

2008ql 08 31 

lOO8q2 " 2.7 87 

lOOSq3 • .4 13.1 1.' 

""". 47.3 " • '" lOO*(wmuJative wriferlown5/tangible ~5sets 2007q2) 

Data from SEC 1lXl. and 10K's, and FR Y9--C'~, UnieH ott1erwis", noted, data in current $ blilions. 

15 
241 


79691.156

number of institutions 

reporting 

total assets (in billions) 

percent of all banks 

percent of total assets 

Table 2 

All FDIC Insured Less than $100 $100 Million to $1 $1 Billion to $10 

Institutions Million 8illion Billion 

7,246 2,342 4,244 

14,031 135.4 1274.7 

32.3 58.6 

LO 9.1 

553 

1425.9 

7.6 

10.2 

Greater than $10 

Billion 

107 

11,195.0 

15 

79.9 

Banks with assets of $1 billion or less comprise 91 percent of all banks and hold 10 percent of total assets 

Banks with assets of $10 billion or less comprise 98.6 percent of all banks and hold 20.3 percent of total assets 

Source: Fmc Quarterly Banking Profite, Second Quarter 2012 

16 
242 


79691.157

~~NDENT COMMUNITY 

BANKERS of AMERICA 

Testimony of 

William A. Loving 

President and CEO of Pendleton Community Bank 

Franklin, WV 

On behalf of the 

Independent Community Bankers of America 

Before the 

United States House of Representatives 

Committee of Financial Services 

Subcommittee on Financial Institutions and Consumer Credit 

and 

Subcommittee on Insurance, Housing, and Community Opportunity 

Hearing on 

"Examining the Impact of the Proposed Rules to Implement Basel III 

Capital Standards" 

November 29,2012 

Washington, D.C. 
243 


79691.158

Opening 

Chairman Capito, Chairman Biggert, Ranking Member Maloney, Ranking Member Gutierrez 

and members of the subcommittees, my name is William A. Loving, Jr., and I am President and 

CEO of Pendleton Community Bank, a $260 million asset bank in Franklin, West Virginia that 

serves four rural markets in West Virginia and one Virginia community. I am also Chairmanelect of the Independent Community Bankers of America and I testifY today on behalf of its 

nearly 5,000 members. Thank you for convening this hearing on a topic of existential 

importance to the community banking industry, the Basel III proposed capital rules. 

We are grateful to the many members of the Financial Services Committee who have sent letters 

to the banking regulators expressing their serious concerns about the impact of Basel III and the 

standardized approach on community banks. It is no exaggeration to say that these rules could 

bring about the demise of the community banking industry within a decade. No topic has caused 

such alarm among community bankers in recent memory - as demonstrated by their estimated 

2,000 individually-written comment letters on the proposed rules and their potential impact on 

their communities. In addition, nearly 15,000 individuals have signed an ICBA petition urging 

the banking regulators to provide an exemption for banks with assets ofless than $50 billion. 

Today, we urge Congress to support such an exemption and protect the community bank modclone essential to communities all across our great nation. 

In this testimony I will detail community banks' concerns with Basel III and the standardized 

approach, but let me snmmarize those concerns here. The proposed rules penalize customized 

lending without regard to asset quality. This strikes at the community bank competitive 

advantage - customized, relationship-based lending in an industry that is increasingly 

dominated by a small number of large banks offering commoditized lending. A second broad 

objection is this: New, unnecessarily high capital requirements are simply not viable for 

community banks because we have extremely limited options for raising new capital, unlikc our 

larger competitors. Without access to the public markets, community banks must rely on other 

limited means to raise new capital. In partiCUlar, mutual community banks, which are among the 

safest institutions, must rely exclusively on retained earnings to raise capitaL With historically 

low interest rates, compressed interest margins make it very difficult to accumulate retained 

earnings. Finally, the proposed rules will introduce volatility into regulatory capital where 

stability is an important indicator of fmancial health. 

Basel III was meant to apply to the largest, interconnected, internationally active and 

systemically important institutions. Community banks, with their simple capital structures and 

conservative funding and lending practices, have nothing in common with these larger 

institutions. Applying the same regulatory capital standards to community banks - in a one-sizefits-all fashion - in addition to the many other new regulations that are becoming effective, will 

simply make community banking a losing proposition for many, triggering thousands of bank 

sales. Mass consolidation will make the banking industry less competitive for consumers and 

businesses. The small towns and rural areas currently served by community banks for credit will 

face curtailed access to credit and cconomic stagnation. 

2 
244 


79691.159

Let's not take a step that will fundamentally alter the nature of the financial services industry. 

Our national economy needs a diverse, competitive fmancial services sector with large and 

regional banks as well as thriving community banks offering real choice, including customized 

products, to consumers and small businesses alike. An economy dominated by a small number 

of large banks wielding undue market power and offering commodity products would not 

provide the same level of competitive pricing and choice. Promoting and sustaining a vibrant 

community banking sector is an important public policy goal. Basel III and the standardized 

approach contravene this goal, posing an existential threat to community banks. 

The case for a total exemption for community banks from Basel III and the standardized 

approach is illustrated by two particularly troubling provisions. 

Standardized Approach Risk Weights 

New risk weights on certain residential mortgages will impose punitive capital charges on all but 

standardized, "plain vanilla" loans. What's more, because of their complexity - there are eight 

different risk weightings for residential mortgages - the new risk weights will be exceedingly 

difficult to comply with without incurring significant software upgrades and other operational 

costs. Mutual banks will be disproportionately impacted because, as thrifts, they hold more 

mortgage loans than other community banks. Customized home loans like balloon loans a 

staple of community banking - as well as second liens will be severely penalized with new 

capital constraints during a fragile housing recovery. Under the proposed standardized approach, 

balloon loans would move from their current 50% risk weight to a potential mind-boggling 200% 

risk weight all while being fully secured by real estate. Balloon loans are the best mortgage 

option for many community banks and their customers for any number of sound reasons. For 

example, a loan may be ineligible for sale into the secondary market because it's collateralized 

by an irregular, rural property without adequate comparables. I'm happy to hold such loans in 

my portfolio but the only way I can protect my bank against interest rate risk is to structure the 

transaction as a balloon loan with a five to seven year maturity or an Adjustable Rate Mortgage 

(ARM), a product which carries its own set of customer concerns and regulatory reporting issues. 

Without the balloon loan option, many rural customers will be unable to finance home purchases 

or home improvements. I and other community bankers have safely offered balloon loans for 

decades. Because I retain these loans as well as other loan types in portfolio, I have a vested 

interest in their performance and I take care to ensure that they are underwritten to the highest 

standards. I am not aware of any data whatsoever that dcmonstrates that balloon loans are more 

risky than other types of credit. 

Second liens like home equity loans and home equity lines of credit help to provide borrowers 

with the flexibility they need and are a major contributor to economic growth throughout the 

country. Although these loan products are often cited as an example of the past economic 

excesses of reckless homeowner leverage, prudently underwritten second liens serve a very 

important and vital role in the lives of homeowners and the overall economy. These loan 

products are frequently used by homeowners to finance property improvements, send a child to 

college, and start a small business. 

3 
245 


79691.160

The new proposed risk weights strike right at the heart of the community banking modeL Our 

direct knowledge of the community and the borrower aJlows us to underwrite loans tailored to 

their unique needs loans that larger lenders are unwilling to make. 

Treatment of Accumulated Other Comprehensive Income 

The Basel III proposal requiring banks to include in regulatory capital accumulated other 

comprehensive income (AOCI) wiJl significantly misrepresent community banks' capital 

positions. AOCI, a component of shareholders' equity that for most community banks represents 

unrealized gains and losses on certain investment securities, is currently excluded from 

regulatory capital and its inclusion wiJl introduce unnecessary volatility into a community bank's 

capital position. Most community banks, including Pendleton Community Bank, have large 

positive AOCI balances as a result ofhistoricaJly low interest rates. Today's low interest rate 

environment, coupled with the "flight to quality" on u.s. gove=ent debt by risk adverse 

investors, has driven up the value of debt securities and increased unrealized gains in many 

portfolios. These sources of unrealized gains are not sustainable. When economic growth 

accelerates and interest rates inevitably rise, debt securities will drop in value and AOCI will 

quickly tum negative. This pending shift in AOCI says nothing about a bank's ability to absorb 

losses and should not be reflected in its regulatory capital. To use my bank as an example, a 300 

basis points increase in interest rates (a reasonable scenario given the maguitude of the fall in 

rates since 2007) would cause my bank's bond portfolio to show a net paper loss of $2 million. 

My bank's tier one capital would drop 11.03 pcrcent and the bank's tier one risk based capital 

ratio would decrease 9.92 percent- from 14.01 percent to 12.62 percent if AOCI was included. 

While the ratio would remain above minimum regulatory levels, both now and proposed, many 

other conununity banks would experience much larger paper losses and sharper drops in capital 

and ratios. Even banks such as mine that would not become undercapitalized will be forced to 

reassess their business strategies and plans for growth to preserve capital. The expected rise in 

interest rates is just one source of fair value change that will cause capital volatility. Changes in 

credit spreads and other market developments will have a similar impact. To avoid becoming 

undercapitalized, banks will need to maintain an additional capital cushion of 2 to 3 percent, 

depending on the economic environment. 

Larger banks have tools at their disposal, such as interest rate derivatives, to minimize the impact 

of AOCI on regulatory capital. This gives the larger banks a competitive advantage over 

conununity banks because they can more readily absorb the overhead necessary to engage in 

derivatives trading. Community banks have limited ability to carry interest rate derivatives on 

their balance sheets due to the increased resources needed to maintain these risk mitigation 

activities. Because of this disadvantage, conununity banks are disproportionately impacted by 

the inclusion of AOCI in regulatory capital. 

The inclusion of AOCI in regulatory capital will undenninc community bankers' ability to 

maintain capital levels that are not only adequate but stable - an important indicator of bank 

health to the public, depositors, borrowers, investors, counterparties, and regulators. 

I've highlighted the impact of just two provisions - risk weights and the inclusion of AOCI in 

regulatory capital to illustrate why community banks must be exempt from Basel III and the 

standardized approach. Many additional provisions are nearly as troubling, and the cumulative 

impact, as I have stated, would effectively bring about the end of the conununity banking 

4 
246 


79691.161

industry within a decade. There's just too much wrong with this rule for it to be adequately 

addressed with a few discreet amendments. Only a full exemption will adequately address our 

concerns and ensure the 10ng-teI11/- viability of our industry. 

leBA Recommended Modifications 

Absent a total exemption for banks with less than $50 billion in assets, lCBA strongly favors the 

following modifications to Basel III to simplifY the rule and better align the proposed capital 

standards to the unique strengths and risks of community banking: 

Banks under $50 billion in assets should be exempt from the standardized approach for risk 

weighted assets. The standardized approach's complex and punitive risk weighting for 

residential mortgages could force community banks out of this line of business. 

• Unless it can be empirically shown that these assets are risky, the proposed substantially 

higher risk weights for balloon mortgages and second mortgages should be reduced to their 

current Basel I levels. Basel I risk weighting better reflects the high-quality nature of this 

asset class. 

AOCl should continue to bc excluded from the calculation of regulatory capital for banks 

lU1der $50 billion in assets to avoid harmful and urmeeessary volatility in capital adequacy. 

If AOCl is not excluded from the calculation of regulatory capital for community banks, then 

changes in the fair value of all obligations of the U.S. government, mortgage-backed 

securities issued by Fannie Mae and Freddie Mac, and all municipal securities should be 

exempt. These securities are deemed to be risk free and are essential to maintaining a 

healthy housing market. For community banks, this change would greatly simplifY the 

process of computing AOCl and significantly reduce capital volatility. 

Consistent with the Collins Amendment of tlle Dodd-Frank Act, bank regulators should 

continue the current Tier I regulatory capital treatment of TruPS issued by bank holding 

companies with consolidated assets between $500 million and $15 billion. This change 

would reflect Congressional intent and reduce the capital burden for community banks. 

Many community banks have based their long-term capital planning on the permanent 

grandfather provisions ofthe Collins Amendment. Four hundred eighty five institutions with 

between $500 million and $10 billion in asset~ depend on TmPS for 13.33 percent of Tier I 

capitaL 

Consistent with the proposal for bank holding companies, the Federal Reserve should exempt 

all thrift holding companies with assets of $500 million or less from Basel III and the 

standardized approach or provide a policy rationale for why they are not exempt. 

The allowance for loan and lease losses (ALLL) should be included in Tier I capital in an 

amount up to 1.25 % of risk weighted assets and the remaining balance of ALLL should 

qualifY for inclusion in Tier 2 capital so that the entirc ALLL will be included in a 

conununity bank's total capitaL Delinquent loans are essentially "double reserved," taking 

into account bofu ALLL and the proposed IUles' significantly higher capital requirements for 

such loans. Our recommended change will at least give proper recognition to the lossabsorbing capacity of the ALLL. 

• Mortgage servicing assets should be subject to the current higher deduction thresholds 

because they do not pose a risk to community bank capitaL The punitive deduction 

thresholds set forth in the proposed IUlc will discourage community banks from retaining 

5 
247 


79691.162

servicing rights and will accelerate consolidation in the servicing industry. Community 

banks provide high quality, personalized servicing that reduces foreclosures. They should be 

encouraged to remain in the business. 

Community banks should be exempt from the provisions of the capital conservation buffer 

because they have no vehicle, such as the equity markets, for raising capital quickly. This is 

particularly important for the 2300 Subchapter S community banks. Subchapter S owners 

owe tax on the bank's earnings and they rely on distributions, which would be put at risk by 

the provision of the capital conservation buffer, to pay these tax bills. Alternatively, the 

phase-in period for the capital conservation buffer should be extended by at least three years 

to January 1, 2022 to provide community banks with enough time to meet the new regulatory 

minimums. 

The proposed risk weights for equity investments should be substantially simplified so 

community banks will not be discouraged from investing in other financial institutions such 

as banker's banks, which are key business partners in community bank lending. 

In the absence of a full exemption from the standardized approach, any changes to thc risk 

weights should be applied prospectively to give community banks enough time to comply. 

Regulators should make accommodations to ensure Basel III and the standardized approach 

do not negatively impact the nation's minority banks and the diverse and somctimes 

economically stressed and underserved communities they serve. Minority banks should be 

preserved and promoted. 

If Basel III and the standardized approach are to apply to community banks, then they should 

also apply to credit unions. The credit union tax exemption already gives them a significant 

competitive advantage over tax-paying banks. That advantage should not be exacerbated by 

allowing credit unions to comply with much less rigorous capital standards that will allow 

them to offer low rates on loans and rates on deposits. 

Again, the most sensible and prudent policy, the policy that would avoid severe unintended 

consequences, would be an outright exemption for financial institutions with assets of less than 

$50 billion. Basel III was originally intended to apply only to large, complex, and 

internationally-active institutions. Applying Basel III more broadly in a one-size-fits-all manner 

would harm all consumers and businesses that rely on credit and the impact would be especially 

harsh in small communities and rural areas not served by larger institutions. 

ICBA encourages this committee to consult our October 22 comment letter to the banking 

regulators for more detail substantiating the above views. (The ICBA letter is available at: 

http;//www-icba.org/files/ICBASitesIPDFs/clI02212.pdf.) 

Closing 

Thank you again for convening this important hearing and helping to raise the profile of a 

significant economic policy issue with far reaching and perhaps unappreciated implications. 

Your letters to the bank regulators, both in their thoughtful quality and their sheer number, have 

made a significant impression. We look forward to working with this committee to obtain a full 

exemption from Basel III and the standardized approach for banks with less than $50 billion in 

assets. 

6 
248 


79691.163

For Release Upon Delivery 

10:00 a.m., November 29,2012 

TESTIMONY OF 

JOHN C. LYONS 

SENIOR DEPUTY COMPTROLLER BANK SUPERVISION POLICY 

and 

CHIEF NATIONAL BANK EXAMINER 

OFFICE OF THE COMPTROLLER OF THE CURRENCY 

Before the 

SUBCOMMITTEE ON FINANCIAL INSTITUTIONS AND CONSUMER CREDIT 

And the 

SUnCOMMITTE ON INSURANCE, HOUSING AND COMMUNITY OPPORTUNITY 

U.S. HOUSE OF REPRESENTATIVES 

November 29, 2012 

Statement Required by 12 U.S.C. § 250: 

The views expressed herein arc those of the Office of the Comptroller of the Currency and do not 

necessarily represent the views of the President. 
249 


79691.164

Chailman Capito, Ranking Member Maloney, Chainnan Biggert and Ranking Member 

Gutierrez, and members of the Subcommittees, thank you for your invitation to testify. I 

appreciate the opportunity to appear before you today to discuss the three proposed capital rules 

released by the federal banking agencies (the Office of the Comptroller of the Currency (Ocq, 

the Federal Reserve Board, and the Federal Deposit Insurance Corporation) in June, and in 

particular, the impact of those proposed rules on national banks and federal savings associations 

and the stability of the U.S. financial system. 

During the public comment period for these proposals that ended on October 22, 2012, 

the OCC and the other federal banking agencies received approximately 1,500 comment letters 

from banks and federal savings associations of all sizes. In light of the number of comments 

received and the important issues raised, the agencies announced earlier this month that we do 

not expect to finalize the proposals by January 1,2013. While we are still in the process of 

reading and assessing the comments, it appears that the most fundamental issues have been 

raised by small banks and federal savings associations (collectively, community banks) who 

have raised concerns about the applicability of the standards to them. Large banks have raised 

some of the same concerns as the community banks in tenns of specific provisions contained in 

the proposals as well as additional concerns that are more technical in nature. Since our 

comment review process is in early stages, there are some limitations on the views I can express 

to avoid prejudging the outcome of the rulemaking process. 

We are committed to carefully considering all the comments we received; however, my 

testimony today will focus on some of the overarching concerns raised, and in particular, those 

raised by community bankers. In this regard. [ want to assure you that we are very cognizant of 

the special role that smaller banks play in our communities and in providing financing of our 

country's small businesses and families. 

It's important to start by noting that the key reason that we issued the proposals was to 

improve the safety and soundness of our nation's banking system. Strong capital standards have 

played an important role in moderating downturns and positioning the banking system to serve as 

a catalyst for recovery by ensuring that financial institutions stand ready to lend throughout the 

2 
250 


79691.165

economic cycle. Access to credit by businesses and consumers is critically important to 

promoting and achieving financial stability. The recent crisis demonstrated the consequences of 

having insufficient capital in the banking system of the U.S. and around the world. 

The international Basel III agreements embraced many of the lessons learned during the 

crisis relating to regulatory capital. As members of the Basel Committee on Banking 

Supervision, the agencies worked to develop these enhanced capital standards, and the elements 

contained in the Basel III international framework are reflected in much of what we have 

proposed to apply in the U.S. As the acc has previously testified, many of the key provisions 

and objectives of Basel J[J complement key capital provisions ofthe Dodd-Frank Act. l 

However, in developing the U.S. capital proposals, we did not adopt a "onc-sizc fits all 

approach." We carefully evaluated each element ofthe Basel 1II framework and assessed to 

which banks it should be applied. In making these assessments, the agencies strove to calibrate 

the requirements to reflect the nature and complexity of the financial institutions involved. As a 

result, and consistent with thc higher standards for larger banks required by section 165 of the 

Dodd-Frank Act, many of the provisions in the proposed rules are only for larger banks and 

those that engage in complex or risky activities; community banks with more basic balance 

sheets are largely or completely exempted. While the international BasellIl agreements 

incorporate many ofthe lessons learned from the crisis, there were other key concerns that were 

not addressed in those standards, but which are important for promoting the resiliency and 

stability ofthe U.S. banking system - for example, the importance of better differentiating risks 

in mortgage lending. The U.S. proposed rules attempt to address these additional elements as 

well. 

We recognize that the proposed changes represent a comprehensive reform of regulatory 

capital standards and that the burden of reviewing and assessing the impact of new regulatory 

proposals can weigh especially heavily on community banks. This is why we have taken several 

measures to reduce the burden of this rulemaking process for these banks - in the way we 

1 Testimony of John Walsh, Acting Comptroller of the Currency, before the Committee on Banking, Housing, and 

Urban Affairs, United States Senate (March 22, 2012). 
251 


79691.166

organized the proposals, in outreach we have conducted, and by distributing a tool to help 

bankers assess the potential impact of the proposals on their capital requirements, 

We also appreciate that the burden for community banks lies not only in reviewing and 

understanding the proposals, but also in complying with them. In this context, it is important to 

remember that these are proposed rules, not final rules, and we are very interested in feedback on 

all aspects of these proposals. We posed over 80 specific questions in the proposals, including 

questions related to regulatory burden, to elicit comments on all aspects of the proposals. 

In my testimony today, I will review briefly the proposed capital rules and then discuss 

three of the major issues raised in the comments we have received. These issues are: (I) the 

overall complexity of the proposals and questions about their applicability to, and 

appropriateness for, community banks; (2) the proposed treatment of unrealized losses (and 

gains) in regulatory capital; and (3) the treatment of real estate lending, particularly residential 

mortgages. 

The Proposed Capital Rules 

In June, the agencies published three notices of proposed rulemaking (NPRs)·- the Basel 

III NPR, the Standardized Approach NPR, and the Advanced Approaches NPR. 2 Many, but not 

all, of the provisions contained in two of these three NPRs - the Basel III NPR and the 

Standardized Approach NPR -- would apply to all banks, including community banks. 

The Basel III NPR would raise the quantity and quality of capital required to meet 

minimum regulatory standards. The Standardized Approach NPR seeks to address shortcomings 

in the way capital is aligned with risks in our current rules. The Advanced Approaches NPR 

would require the largest banks, when calculating regulatory capital, to take a more complete and 

accurate account of their risks, both on- and off-balance sheet. The Basel III and Advanced 

2 "Regulatory Capital Rules: Regulatory Capital, Implementation of Base I III. Minimum Regulatory Capital Ratios, 

Capital Adequacy. Transition Provisions, and Prompt Corrective Action" (Basel III NPR), 77 Fed. Reg. 52792; 

"Regulatory Capital Rules: Standardized Approach for Risk-weighted Assets; Market Discipline and Disclosure 

Requirements" (Standardized Approach NPR), 77 Fed. Reg. 52888; and "'Regulatory Capital Rules: Advanced 

Approaches Risk-based Capital Rule; Market Risk Capital Rule" (Advanced Approaches NPR) 77 Fed. Reg. 52978. 

4 
252 


79691.167

Approaches NPRs would significantly raise capital standards for large banks. Taken together, 

the three NPRs address the risks that contributed to the recent financial crisis and aim to enhance 

the safety and soundness ofthe U.S. banking system. 

Turning to the first ofthe three NPRs, the Basel 1II NPR concentrates largely on 

improving the reliability with which banks of all sizcs can absorb future losses. It covers both 

the definition and the minimum required levels of capital. The NPR proposes a new measure for 

regulatory capital called Common Equity Tier I (CEIl). This measure was introduced because 

some of the instruments that qualified under the broader existing definitions of regulatory capital 

did not dependably absorb losses during the crisis and the subsequent economic downturn. 

The proposed minimum standard for CEIl is 4.5 percent of risk-weighted assets. On top 

of this, the NPR introduces two new capital butTers - the capital conservation buffer and the 

countercyclical buffer. 

The proposed capital conservation buffer is 2.5 percent of risk-weighted assets, which 

would bring the effective CETl requirement up to 7 percent of risk-weighted assets. If a bank's 

CET! ratio were to fall below that level, capital distributions and discretionary bonus payments 

would be restricted. This buffer would apply to banks of all sizes. During the recent financial 

crisis and economic downturn, some banks continued to pay dividends and substantial 

discretionary bonuses even as their financial condition weakened; the capital conservation buffer 

is intended to limit such practices and conserve capital at individual banks and for the banking 

system as a whole. 

The countercyclical capital buffer would apply only to the largest internationally-active 

banks with assets in excess of $250 billion or foreign exposures of more than $10 billion. If 

activated by the agencies during the expansionary stage of a credit cycle, it could increase the 

minimum CEIl buffer by as much as another 2.5 percent of risk-weighted assets. The intent of 

the countercyclical capital buffer is to increase capital requirements during periods of rapid 

economic growth to reduce the excesses in lending and to protect against the effects of weakened 

underwriting standards during subsequent contractions. 
253 


79691.168

A separate surcharge on systemically important banks (the so-called "SIFI surcharge"), 

which is to be the subject of a separate rulemaking, could potentially add another 3.5 percent of 

risk-weighted assets to the risk-based capital requirements of the largest banks. The cumulative 

effect of the countercyclical buffer and the potential SIFI requirement is that during an upswing 

in the credit cycle, some large U.S. banks may be required to hold eET! equal to as much as 13 

percent of their risk-weighted assets. This difference in potential capital requirements - i.e., as 

much as 13 percent for large banks compared with 7 percent for small banks is intended to 

appropriately distinguish between their relative riskiness. 

In addition to risk-based capital standards, all U.S. financial institutions are subject to a 

leverage ratio that is designed to limit the overall amount that a bank can leverage its capital. In 

this regard, another way in which the proposals differentiate between banks of different sizes is 

the new supplementary leverage ratio introduced in the Basel III NPR. This ratio would be set at 

3 pcrcent of adjusted assets and would apply only to large internationally active banks. It is a 

more demanding standard than the existing 4 percent levcrage requirement that already applies to 

all banks because it would include certain off-balance-sheet exposures. If this proposed change 

is implemented, small banks would be subject to only one leverage ratio requirement whereas 

large banks would have to meet two requirements. 

While the Basel III NPR focuses on raising the quality and quantity of capital, the 

Standardized Approach NPR seeks to ensure that riskier activities require more capital. To 

accomplish this, the Standardized Approach NPR would revise the capital treatment for 

exposures to non-U.S. sovereigns, residential mortgages, commercial real estate, securitizations, 

and equities, and revise and expand the recognition of credit risk mitigation through collateral 

and guarantees. It also would introduce new disclosure requirements for banks over $50 billion 

in assets, as a means to impose additional market discipline. This disclosure requirement would 

not apply to community banks. Finally, the Standardized Approach NPR would remove external 

credit ratings from the capital standards in accordance with section 939A of the Dodd-Frank Act. 

The Advanced Approaches NPR applies only to the largest, internationally active banks. 

This NPR includes several changes to the calculation of risk-weighted assets for counterparty 

6 
254 


79691.169

cxposures so that sufficient capital will be required for this source of risk that was found to be 

significant during the recent financial crisis. 

In developing the June proposals, we were kcenly aware of their potential impact, 

particularly on smaller banks throughout the country. The proposals include lengthy transition 

provisions and delayed effective dates to reduce the likelihood of adverse effects from increases 

in minimum required regulatory capital. For example, the revised risk weights included in the 

Standardized Approach NPR would not go into effect until 2015, and some of the transitional 

provisions related to capital instruments in the Basel IT! NPR extend out to 2022. 

We assessed the potential effects of the proposed rules on banks by using regulatory 

repOlting data and certain key assumptions, which we noted in the preamble to the proposals. 3 

Our assessments indicate that many community banks hold capital well above both the existing 

and the proposed regulatory minimums. Many of the largest. internationally active banks 

already have strengthened their regulatory capital levels to mcet the proposed minimum 

standards, particularly the new CETI standard, in order to meet market participants' 

expectations. Establishing higher minimum standards for all banks would reinforce the financial 

strength ofthe banking sector in the future and the stability of the U.S. financial system. 

While we did consider the potential impact ofthe proposals on banks and the banking 

system as we were developing them, one of the key purposes of the notice and comment process 

is to gain a better understanding of the potential impact of the proposals on banks of all sizes. As 

previously noted, to foster feedback from community banks on potential effects of the proposals, 

the agencies developed and posted on their respective Web sites an estimator tool that allowed 

smaller banks to use bank-specific infonnation to assess the likely impact on their individual 

institution. 

3 See the attached impact assessment on OCC-regulated banks and thrifts pursuant to the Unfunded Mandates 

Reform Act. 

7 
255 


79691.170

Issues Raised in Comment Letters 

1. Complexity and Applicability 

Commenters have raised an overarching concern about the complexity of the rules. More 

specifically, many comments have stated that the residential mortgage provisions in the 

Standardized Approach NPR are too complex. The NPR would separate mortgages into two risk 

categories based on product and underwriting characteristics and then, within each category, 

assign several new risk weights based on loan-to-value ratios (L TVs). Commenters were 

concern cd about the costs associated with reviewing the existing book of mortgages and creating 

new systems to accommodate the more granular treatment of risks under the proposed approach. 

Under today's standards, all mortgages are assigned just one oftwo weights based on criteria that 

are relatively simple to administer. 

Commenters also raised concerns about complexities resulting from these capital 

proposals in combination with other regulatory initiatives. For example, banks of all sizes have 

raised concerns about the interactions between some ofthe provisions of the proposals and 

certain aspects of the Dodd-Frank Act. In particular, some commenters raised concerns about 

the interplay and overall effect that the proposed treatment for residential mortgages will have on 

the housing sector and availability of mortgage loans when combined with the pending 

regulations related to the definitions of "qualified mortgage" (QM) and "qualified residential 

mortgage" (QRM).4 In developing the treatment for residential mortgages, the agencies were 

mindful of the proposed definitions of QM and QRM and specifically requested comment on 

whether mortgages that meet the QM definition should be included in the lower risk category of 

residential mortgage. 

Some commenters suggested that, given the complexity of the proposals, the best way to 

reduce regulatory burden on community banks would be to delay the implementation of the 

4 Proposed regulations relate to the definition of "qualified mortgage" under regulations to be issued by the 

Consumer Financial Protection Bureau pursuant to the Truth in Lending Act <as revised by section 1412 of the 

Dodd-Frank Act), as well as the definition of "qualified residential mortgage" under the securitization risk retention 

regulations to be issued jointly by the federal banking agencies, FHF A, SEC, and HUD pursuant to section 941 of 

the Dodd-Frank Act. 
256 


79691.171

Standardized Approach NPR or to exempt community banks altogether from any new capital 

rules. In this vein, many commenters observed that community banks did not cause the crisis, 

and therefore should be exempted. We will carefully consider these comments as well as 

suggestions for improving the NPR. 

As noted earlier, we have taken steps to try to ease the burden of understanding the 

proposed set of rules for community banks. Nevertheless, we recognize that understanding and 

complying with the proposed rules could still be difficult for community banks. However, it is 

also important to recognize that the proposed rules are lengthy, in part, because they address 

banks of all shapes and sizes including banks involved in complex or risky activities, 

instruments, or lines of business. Banks engaged in these activities are not necessarily only the 

largest banks in the country but also can include smaller banks that engage in one or two 

complex or riskier activities. The proposed rules are comprehensive in their coverage and would 

therefore address such instances. The vast majority of community banks, however, will not need 

to consider many of these provisions. 

Finally, it is important to remember that over 460 smaller banks have failed in the 

aftermath of the financial crisis for a variety of reasons but, ultimately, because they did not have 

enough capital in relation to the risks that they took. The future safety and soundness of 

community banks will depend on their having sufficient capital going forward. 

2. Unrealized Losses 

Another major issue raised by commenters is the inclusion of unrealized losses (and 

gains) on available-for-sale (AFS) debt securities in regulatory capital. Under our existing 

standards, such unrealized losses generally do not affect a bank's regulatory capital. 5 In contrast, 

5 Under the existing standards for national banks in 12 CFR Part 3, Appendix A, section 2, and for federal savings 

associations in 12 CFR 167.5, Tier 1 capital (national banks) and core capital (federal savings associations) include 

"common stockholders' equity." The definition of "common stockholders' equity" (listed at 12 CFR Part 3, 

Appendix A, section I for national banks and 12 CFR 167.1 for federal savings associations) does not include 

unrealized gains or losses on AFS debt securities, but it does include unrealized losses on AFS equity securities with 

readily determinable fair values. Additionally, at 12 CFR Part 3, Appendix A, section 2(b)(5) (national banks) and 

12 CFR 167.5(b)(5) (federal savings associations), the current rules also provide that up to 45 percent of pretax net 

unrealized gains on AFS equity securities can be included in Tier 2 capital. 

9 
257 


79691.172

under the Basel III NPR, unrealized losses on AFS debt securities would directly impact a bank's 

regulatory capital. 6 The rationale for the proposal is that ignoring unrealized losses has the 

potential to mask the true financial position of a bank. This is particularly true when a bank is 

under stress and when creditors arc most likely to be concerned about unrealized losses that 

could inhibit a bank's ability to meet its obligations. 

Many bankers have commented that the inclusion of unrealized gains and losses on AFS 

debt securities could result in large and volatile changes in capitallevcls and other measures tied 

to regulatory capital, such as legal lending limits, especially when interest rates rise from the 

current low levels. Because these gains and losses often result from changes in interest rates 

rather than changes in credit risk, commenters also noted that the value of these assets on any 

particular day might not be a good indicator of the value of a security to a bank, given that the 

bank could hold the security until its maturity and realize the amount due in full (assuming no 

credit related issues). 

There are strategies available to banks to minimize some ofthese potential adverse 

effects on regulatory capital. Banks could increase their capital, hedge or reduce the maturities 

oftheir AFS securities, or shift securities into the held-to-maturity portfolio at the cost of 

reducing liquidity. However, commenters have stated that these strategies are all expensive and 

some strategies, such as hedging or raising additional capital, may be especially expensive and 

difficult for community banks. Commentcrs also have noted that undcr the proposed approach, 

12 CFR Part 3, Appendix A, seclion 2(b)(5) (national banks) and 12 CFR 167.5(b)(5) (federal savings associations), 

further provide that unrealized gains and losses on other assets, including AFS debt securities~ may be taken into 

account when considering a bank's overall caphal adequacy, however, those gains and losses are not specifically 

included in the determination ofa bank's regulatory capital ratios, 

'Section 20(a)(1) oflhe proposal defines the elements that make up common equity tier I capital. Those elements 

include accumulated other comprehensive income (AOCI). Under U.S. GAAP, AOCI is comprised offour 

elements: (I) unrealized gains and losses on AFS securities (ASC Topic 320, Investments-Debt and Equity 

Securities); (2) gains and losses on derivatives held as effective cash flow hedges (ASC Topic 815, Derivatives and 

Hedging); (3) recognized actuarial gains and losses on defined benefit plans (ASC Topic 715, CompensationRetirement Benefits); and (4) gains and losses resulting from currency translation offoreign subsidiaries financial 

statements (ASC Topic 830, Foreign Currency Matters). Under the existing capital standards, items one through 

three of AOCI are not included in regulatory capital. 

10 
258 


79691.173

offsetting changes in the value of other items on a bank's balance sheet would not be recognized 

for regulatory capital purposes when interest rates change. As a result, they stated that the 

proposed treatment could greatly overstate the real impact of interest rate changes on the safety 

and soundness of the bank. 

The agencies anticipated many of the concerns raised by commenters on this issue and 

included a discussion within the BascllIl NPR requesting comment on potentially excluding 

from regulatory capital unrealized gains and losses associated with U.S. Treasury and GSE debt 

that can be expected to be driven solely by interest rates. Under such an approach, other 

unrealized losses and gains -- for example, those associated with a corporate bond -- would be 

recognized in regulatory capital. The aee recognizes the importance of this issue and the 

challenges the proposed treatment could present to banks, particularly community banks, in 

managing their capital, liquidity, and interest rate risk positions and in affecting their ability to 

lend to their communities. We are committed to reviewing this issue carefully. 

3. Real Estate Lending 

Another major concern of commenters relates to the proposed treatment for residential 

mortgages, and, to a lesser extent, commercial real estate. These provisions in the Standardized 

Approach NPR attempt to address some of the causes of the crisis - the collapse in residential 

mortgage underwriting standards and the prevalence of higher risk commercial real estate loans 

in some banks. Under our current rules, residential mortgages within a broad spectrum of risk 

attributes receive identical capital treatment. The treatment of commercial real estate loans is 

even less risk sensitive in that all such loans receive the same capital treatment. The proposed 

standard would raise the capital requirement for the riskiest mortgages and commercial real 

estate loans while actually lowering the charge on relatively safer residential mortgage loans. 

Some of the major issues that commenters have raised relate to: the treatment of 

residential balloon mortgages; recordkeeping issues associated with the proposed use of LTV 

ratios; the treatment of second liens and commercial real estate; and the potential impact on the 

housing market. With respect to residential balloon mortgages, the concentration of credit risk in 

11 
259 


79691.174

the final balloon payment presents more risk to the lender than a loan that is fully amortized over 

a number of years - especially in situations where housing prices are not increasing. Therefore, 

the NPR proposes a relatively high capital charge. 7 Many community bankers have questioned 

this assumption and noted their good experience with balloons and their wide use in managing 

interest rate risk and providing credit to established customers. 

On the rccordkeeping that would be required for LTVs, while higher LTV ratios are 

closely associated with higher risks of default, many community bankers have stated that going 

back through their existing portfolios to determine each loan's LTV at origination would be a 

burdensome task. For this reason, some have suggested applying the proposed treatment 

prospectively. 

Commenters have also raised concerns with the proposed treatments for second lien 

residential mortgages, such as home equity loans. and for certain commercial real estate loans. 

Similar to issues raised with balloon mortgages, commenters have expressed concern that the 

proposed rules do not adequately distinguish between prudent and more risky lending in such 

products. 

With respect to broader implications for the housing market, while the proposal would 

actually lower capital requirements for the safest mortgages, it would also raise capital 

requirements for riskier mortgages, which could raise the incremental costs of such mortgages. 

Commenters have raised concerns about the impact this might have on recovery ofthe housing 

sector. 

The OCC will pay attention to the unique and intimate knowledge that community banks 

possess of their customers and their lending relationships as we review the range of issues raised 

by commenters on our proposed treatment ofreal estate lending. 

7 Under the proposals, balloon mortgages would receive risk weights between 100 and 200 percent, depending on 

the loan's LTV. 

12 
260 


79691.175

Conclusion 

Given the attention that the regulatory capital proposals have received recently, let me 

conclude by taking a moment to put these proposals in a broader perspective. Specifically, 

regulatory capital standards are an important component in a larger and more comprehensive 

process of bank supervision. They cannot and should not be viewed as a substitute for other 

assessments of a bank's financial position, including banks' internal capital adequacy 

assessments. They should be viewed as complementary to strong supervision of institutions, 

which requires in-depth and bank-specific analysis. 

With this as the context, I want to reemphasize that we are still in the process of 

reviewing the many comment letters that we have received. We will carefully assess the 

advantages and disadvantages of the alternatives suggested, including assessing regulatory 

burden against the value of more and better quality capital that is better aligned to actual risks. 

As the Comptroller said last month, "As we finalize the rules, we will be thinking broadly about 

ways to reduce regulatory burden. As well as considering the substance of each provision, we 

will be taking a fresh look at the possible scope for transition arrangements, including the 

potential for grandfathering, to evaluate what we can do to lighten burden without compromising 

our two key principles of raising the quantity and quality of capital and setting minimum 

standards that generally require more capital for more risk.,·8 

Given the vital role that banks serve in our national economy and local communities, we 

are committed to helping ensure that the business model of banks, both large and small, remains 

vibrant and viable. But, as a foundation for their future success, their capital has to stay strong 

too. If we can help ensure that, then we will be well along the road in ensuring that there is a 

stable and competitive banking system meeting household and business credit needs across 

America in the years ahead. 

, Remarks by Thomas J. Curry, Comptroller of the Currency, before the American Bankers Association in San 

Diego, California, October 15, 2012. 

13 
261 


79691.176

() 

Comptroller of the Currency Administrator of National Banks 

Washington, DC 20219 

To: Carl Kaminski, Legislative and Regulatory Activities 

Thru: Gary Whalen, Director, Policy Analysis Division 

MEMORANDUM 

From: Douglas Robertson, Senior Financial Economist, Policy Analysis Division 

Date: May 30, 2012 

Subject: Impact Assessment for the Basel III Rule: General Capital Rules, NPR I 

This memorandum provides our assessment of the economic impact of the proposed rules that 

would implement the Basel III framework developed by the Basel committee on Banking 

Supervision. The Basel III framework would revise current general risk-based capital rules and 

would be applicable to all banking organizations. The federal banking agencies are 

implcmenting Basel III through three separate rules. The first rule would apply Basel III 

minimum capital requirements to all banking organizations (NPR I). The second rule would 

implement new alternative measures of creditworthiness for general banking organizations 

(NPR2). The third rule would apply Basel III enhancements to institutions subject to the 

advanced approaches capital rules (NPR3). Advanced approaches banking organizations are 

those institutions with total assets of at least $250 billion or foreign exposures of at least $10 

billion, or institutions that have elected to adopt the advanced approaches. 

J) Basel III NPR (NPRI) 

This will include the changes to the numerator orthe risk-based eapital ratio, the new ratio 

requirements (common equity Tier 1 and the higher minimums), as well as the conservation and 

countercyclical buffers. It also will include the changes to the treatment of mortgage servicing 

assets and deferred tax assets (DTAs). 

2) Standardized Approach NPR (NPR2) 

This will include the changes to the calculation of risk-weighted assets (the denominator of the 

risk-based capital ratio), except for the treatment of mortgage servicing assets and DTAs 

discussed in the Basel III NPR). 

3) Advanced Approaches NPR (NPR3) 

The advanced approaches NPR will introduce enhancements to the advanced approaches rule, 

and it will include a proposal to expand the scope of the market risk rule to include thrifts. 
262 


79691.177

We cstimatc that the first-year cost associated with highcr minimum capital requirements in 

NPRI will be approximately $5.1 million. We estimate that the first-ycar cost associated with 

changcs in risk-weighted assets and implementation of alternative measures of creditworthiness 

in NPR2 will be approximately $93.2 million. We estimate that the first-year cost associated 

with changes in risk-weighted assets and simultaneously mceting ncw market risk capital 

requirements in NPR3 will be approximately $46.8 million. Togethcr, we estimate that the 

overall cost ofthe three Basel III rules will be approximately $145.1 million in the first ycar. 

After introducing new systems for determining risk weighted assets in the first year, we estimate 

that the overall cost of !3asellll in subsequent years will decrease to approximately $98.6 million 

per year. 

I. The Proposed Rule: Minimum Regulatory Capital Ratios (NPRl) 

The proposed rule would implement Basel [II and has the following major elements. The 

proposed rule would: 

I. Introduce a new common cquity Tier 1 capital ratio 

2. Introduce a higher minimum Tier I capital ratio 

3. Introduce a supplementary leverage ratio for advanced approaches banks 

4. Introduce new capital conservation buffer 

5. Introduce a countercyclical capital buffer for advanced approaches banks 

6. Prompt Corrective Action thresholds: Introduce common equity Tier J thresholds and 

increase Tier J thresholds 

7. Apply the proposed capital rules to savings and loan holding companies on a 

consolidated basis 

The proposed rule also contains a reservation of authority that authorizes a banking 

organization's primary federal supervisor to require the banking organization to hold additional 

capital relative to what would be required under the proposed rule. 

Section 1. Minimum Capital Requirements 

Under the proposed rule, changes to minimum capital requirements include a new common 

equity Tier I capital ratio, a higher minimum Tier I capital ratio, a supplemental leverage ratio 

for advanced approaches banks, new thresholds for prompt corrective action purposes, a new 

capital conservation bufTer, and a new countercyclical capital buffer for advanced approaches 

banks. All banking organizations would transition to the new minimum capital requirements 

between January 1,2013, and January 1,2019. Table I shows the transition table for minimum 

capital requirements under the proposed rule. 

Although the proposed rule would also increase several prompt corrective action (PCA) 

thresholds, with the exception of the leverage ratio, the minimum capital conservation buffer in 

the proposal effectively requires all banking organizations in the United States to be well 

capitalized for PCA purposes by 2019. Adding the capital conservation buffer to minimum 

required capital ratios elevates the capital ratios above PCA well-capitalized thresholds 

beginning January 1,2019. 

-2-
263 


79691.178

Table 1.- Transition Schedule for Minimum Capital Requirements 

Jan. 1,2013 Jan.1, Jan. I, Jan. I, Jan. I. Jan. I, Jan. J, PCA 

2014 2015 2016 2017 2018 2019 Adq. Well 

Common Equity 3.5% 4.0% 4.5% 4.5% 4.5% 4.5% 4.5% 4.5% .5% 

to Risk-Weighted 

Assets 

Tier I to Risk- 4.5% 5.5% 6.0% 6.0% 6.0% 6.0% 6.0% 6% 8% 

Weighted Assets 

Total Capital to 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8% 10% 

Risk-Weighted 

Assets 

Conservation 0.625% 1.25% 1.875% 2.5% 

Buffer to RiskWeighted Assets 

Maximum 0.625% 1.25% 1.875% 2.5% 

Advanced 

Approaches 

Countercyclical 

Buffer 

Minimum 3.5% 4.0% 4.5% 5.125% 5.75% 6.375% 7.0% 

Common Equity + 

Conservation 

Buffer 

Minimum Tier 1 + 4.5% 5.5% 6.0% 6.625% 7.25% 7.875% 8.5% 

Conservation 

Buffer 

Minimum Total 8.0% 8.0% 8.0% 8.625% 9.125% 9.875% 10.5% 

Capital + 

Conservation 

Buffer 

Leverage Ratio 4.0% 4.0% 4.0% 4.0% 4.0% 4.0% 4.0% 4% 5% 

Advanced Start to 3.Q% 3.0% 

Approaches Report 

Supplemental 

Leverage Ratio 

Section 2. Eligibility Requirements for Regulatory Capital Instruments 

In addition to changing minimum required capital ratios, the proposed rule would also change 

what counts as capital. For instance, the proposed rule would increase deductions from 

regulatory capital for deferred tax assets, it would limit the inclusion of minority interests in 

capital, and unrealized gains and losses on all available-for-sale securities would flow through to 

common equity tier one capital. 

-3-
264 


79691.179

A. Common Equity Tier 1 Capital Ratio 

The proposed rule would require banking organizations to maintain a minimum 4.5 percent ratio 

of common equity Tier I capital to total risk-weighted assets. To be a well-capitalized institution 

under Prompt Corrective Action (PCA) regulations, banking organizations would need to 

maintain a minimum ratio of 6.5 percent. 

Under the proposed rule, common equity Tier 1 capital would equal the sum of common stock 

and related surplus (net of any Treasury stock), retained earnings, accumulated other 

comprehensive income (AGCI), and common equity Tier I minority interest subject to limits 

minus regulatory adjustments and deductions. Qualifying common stock instruments would 

have to satisfy certain criteria. The banking agencies expect that the vast majority of existing 

common stock will fully satisfy these criteria. 

New deductions from common equity Tier I capital include the following: 

a. Mortgage Servicing Assets (MSAs) 

b. Deferred tax assets (DT As) 

c. Investments in the capital of an unconsolidated financial institution above a threshold 

d. Changes in accumulated other comprehensive income (AGCI) without adjustments for 

gains and losses in available-for-sale debt securities 

e. Investments in hedge funds and private equity funds consistent with the Volcker Rule l 

B. Tier 1 Capital: Additional Tier I 

Under the proposed rule, total Tier I capital would equal the sum of common equity Tier 1 

capital and additional Tier I capital. Additional Tier 1 capital equals the sum of noncumulative 

perpetual preferred, related surplus, other Tier I minority interest, and various SBLF and EESA 

qualifying instruments less certain adjustments and deductions. Trust preferred securities would 

no longer be eligible for inclusion in Tier 1 capital. Additional Tier 1 capital instruments must 

also satisfy certain criteria. In essence, thesc instruments must be subordinated, have fully 

discretionary non-cumulative dividends, have no maturity date, have no incentives to redeem, 

and must be able to absorb losses. Instruments currently included in Tier 1 capital that do not 

meet the new criteria will be phased out of the Tier 1 regulatory capital calculation beginning in 

January 1,2014 and will be 100 percent phased out beginning January 1,2018, except for trustpreferred securities, which must be phased out according to a different timeline set forth in 

section 171 of the Dodd-Frank Act. 

C. Tier 2 Capital 

I This deduction is consistent with the proposed Voleker Rule. In our impact assessment for that rule, we estimated 

that banking organizations could invest in hedge funds and private equity funds up to as much as three percent of 

Tier 1 capital. As this deduction depends on the still pending final Voleker Rule, we defer assessment ofthe cost of 

this deduction until we conduct our economic impact analysis ofthe final Voleker Rule. 

-4-
265 


79691.180

The proposed rule will also adjust Tier 2 capital elements. Tier 2 capital instruments must 

satisfy eligibility criteria as well. [n particular, the instrument must have an original maturity of 

at least 5 years. Under the proposed rule, banking organizations may include limited amounts of 

common equity of a consolidated depository institution subsidiary. 

D. Leverage Ratio 

The proposed rule would require advanced approaches banks to maintain a three percent 

minimum Basel 3 leverage ratio in addition to the current U.S. leverage ratio. The Basel 3 

leverage ratio is defined as a ratio of Tier I capital to a sum of on-balance sheet and certain offbalance sheet assets. The Basel 3 leverage ratio would supplement the currcnt U.S. leverage 

ratio, which only includes on-balance sheet items in the ratio's denominator. 

E. Capital Conservation and Countercyclical Buffers 

The proposed rule would require all banking organizations to hold common equity Tier I capital 

in the form of a capital conservation buffer. The capital conservation buffer would begin to 

phase-in on January 1, 2016 and be fully phased-in at 2.5 percent of risk-weighted assets on 

January 1,2019. Combined with other minimum capital requirements, the capital conservation 

buffer effectively requires banks to maintain a 7 percent common equity Tier I ratio, an 8.5 

percent Tier I ratio. and a 10.5 percent total risk-based capital ratio. 

The proposed rule would also require advanced approaches banking organizations to hold 

additional common equity Tier I capital in a countercyclical buffer, which would range between 

zero and 2.5 percent of risk-weighted assets. The countercyclical buffer would apply when the 

primary federal regulator determines (using various guide variables) that a period of excessive 

credit growth is contributing to an increase in systemic risk. The regulator would generally 

announce the level of the buffer 12 months in advance of its implementation, but may give 

shorter notice if necessary. 

Institutions that do not meet the capital conservation buffer or the countercyclical capital buffer 

requirements would be subject to limitations on capital distributions and incentive compensation 

payments proportional to the shortfall in the buffer. A banking organization that operates in 

multiple jurisdictions would have to calculate its countercyclical capital buffer as the weighted 

average of the countercyclical capital buffer for cachjurisdiction. 

II. Institutions Affected By the Proposed Rule 

The proposed minimum capital requirements will apply to all banking organizations. According 

to December 31,20 II Call Report data, there are 7,432 FDIC-insured institutions. After 

aggregating to the highest holding company, there are 6,744 bank holding companies, of which, 

-5-
266 


79691.181

1,213 are national banking organizations.2 Excluding several thrifts that are includcd as 

subsidiaries of national banking organizations, the proposed rule would also apply to 612 

federally chartered private savings institutions. Thus, the proposed rule would apply to 1,825 

financial institutions regulated by the acc. 

III. Estimated Costs and Benefits ofthe Proposed Rule 

The various elements of the proposed rule will affect costs in three ways: (l) the cost of capital 

institutions will need to meet the higher minimum capital ratios and the new eligibility standards 

for capital, (2) compliance costs associated with establishing the infrastructure to determine 

correct risk weights using the new alternative measures of creditworthiness, and (3) compliance 

costs associated with new disclosure requirements. Some institutions will also incur costs 

associated with new capital requirements for exposures to central counterparties and changes to 

recognized collateral and eligible guarantors, but we subsume these expenses into our general 

cost of capital estimates. In this analysis of the proposed rule covering minimum capital 

requirements, we only estimate the cost of capital necessary to make up any projected shortfall 

between current capital levels and the proposed rule's new minimum capital requirements. 

Benefits of the Proposed Rule 

The proposed rule would produce the following benefits: 

I. Improves the quality of regulatory capital by introducing a common equity Tier I 

regulatory capital requirement and tightening the standards for including non-common 

equity instruments in regulatory capital 

2. Increases risk sensitivity of capital requirements and risk-weighted assets 

3. Improves loss absorbency of regulatory capital 

4. Improve transparency and market discipline through disclosure requirements. 

5. Enhanced supervisory review process through the establishment of Pillar 2-based 

expectations for banking organizations 

6. Enhances counterparty credit risk capital requirements that proved inadequate during the 

financial crisis 

Costs of the Proposed Rule 

To estimate the impact of the proposed rule on bank capital needs, we estimate the amount of 

capital banks will need to amass to meet the new minimum standards relative to the amount of 

capital they currently hold. To estimate new capital ratios and requirements, we use currently 

available data from banks' quarterly Consolidated Report of Condition and Income (Call 

Reports) to approximate capital under the proposed rule. We arrive at our estimates ofthe new 

numerators ofthe capital ratios by combining various Call Report items to reflect definitional 

changes to common equity capital, Tier 1 capital, and total capital as described in the proposed 

2 A national banking organization is any bank holding company with a subsidiary national bank. Two of the 16 

organizations also include a federally chartered private savings institution, but both ofthese organizations also 

contain a national bank and are included in the 16 national banking organizations. 

-6-
267 


79691.182

rule. The capital ratio denominator, risk-weighted assets, will also change under the proposed 

rule. However, because the idiosyncratic nature of each institution's asset portfolio will cause 

the direction and extent of the change in the denominator to vary from institution to institution, 

we are unable to estimate risk-weighted assets under the proposed rule. Instead, we use the 

current definition of risk-weighted assets and thus the amount reported by institutions in their 

most recent Call Report. 

Using our estimates of the proposed capital ratio numerators and holding these capital levels 

constant through 2019, we estimate the capital shortfall each institution would encounter as the 

new capital ratios come into effect according to the schedule shown in table I. Table 2 shows 

our estimates of the number of institutions that would not meet the transition schedule for 

minimum capital requirements using data as of December 31, 2011. Table 3 shows our estimates 

of the aggregate amount of capital shortfall over the transition period ending in 2019. While 

institutions must simultaneously meet all of the minimum capital requirements, the largest 

shortfall amount in any given year shows the most binding minimum capital requirement. The 

number of institutions and the capital shortfall amounts shown in the 2016 column reflect those 

institutions that show a shortfall with regard to the new PCA standards relative to current capital 

levels. 

As shown in table 3, our estimate ofthc largest capital shortfall would be a $1,111 million 

shortfall in total capital plus the capital conservation bufter in 2019. However, a slightly smaller 

shortfall of$I,088 million arrives four years earlier when the new Tier I PCA standard for wellcapitalized institutions takes effect on January 1,2015. We view this new PCA Tier I standard 

as the earliest significant capital constraint in the proposed rule. 

Because banks confronting a capital shortfall under the proposed rule will need to gradually 

increase their capital levels to meet the proposed transition schedule, the aggregate cost of 

increasing capital will be spread out over several years. We estimate that the largest shortfall for 

any given year will be approximately $900 million to meet the new PCA Tier I standard for 

well-capitalized institutions when it takes effect in 2015. This estimate combines the capital 

needs for national banking organizations and federally chartered private savings institutions 

(together, acc institutions). 

To estimate the cost to banks of the new capital requirement, we examine the effect of this 

requirement on capital structure and the overall cost of capital. 3 The cost of financing a bank 

or any firm is the weighted average cost of its various financing sources, which amounts to a 

weighted average cost of capital reflecting many different types of debt and equity financing. 

Because interest payments on debt are tax deductible, a more leveraged capital structure reduces 

corporate taxes, thereby lowering funding costs, and the weighted average cost of financing 

tends to decline as leverage increases. Thus, an increase in required equity capital would force a 

bank to deleverage and - all else equal - would increase the cost of capital for that bank. 

3 See Merton H. Miller, (1995), "Do the M & M propositions apply to banks?" Journal ~rBanking & Finance, Vol. 

19, pp. 483-489. 

-7-
268 


79691.183

This increased cost would be tax benefits foregone: the capital requirement ($900 million), 

multiplied by the interest rate on the debt displaced and by the effective marginal tax rate for the 

banks affected by the proposed rule. The effective marginal corporate tax rate is affected not 

only by the statutory federal and state rates, but also by the probability of positive earnings (since 

there is no tax benefit when earnings are negative), and for the offsetting effects of personal 

taxes on required bond yields. Graham (2000) considers these factors and estimates a median 

marginal tax benefit of$9.40 per $100 of interest. So, using an estimated interest rate on debt of 

6 percent, we estimate that the annual tax benefits foregone on $900 million of capital switching 

from debt to equity is approximately $900 million * 0.06 (interest rate) * 0.094 (median marginal 

tax savings) = $5.1 million per year.4 

The banking agencies will also incur some modest costs associated with macro-prudential 

monitoring. Under the proposed rule, the agencies would need to monitor credit growth through 

the use of various guide variables such as credit default swap spreads, funding spreads, and asset 

prices. We estimate that this macro-prudential monitoring will involve approximately 192 hours 

per year per agency. This estimate assumes that the monitoring and reporting will involve two 

individuals for eight hours a month (2 x 8 x 12 192). Applying our wage estimate of $85 per 

hour, we estimate that the total cost of macro-prudential monitoring and reporting will be 

approximately $48,960 per year for all three banking agencies ($85 x 192 x 3 = $48,960). 

Our overall estimate for this segment ofthe Basel III proposal is $5.1 million per year. 

4 See John R. Graham, (2000), How Big Are the Tax Benefits ofOebtO, Journal of Finance, Vol. 55, No.5, pp. 

1901-1941. Graham points out that ignoring the offsetting effects of personal taxes would increase the median 

marginal tax rate to $31.5 per $1 00 of interest. 

-8-
269 


79691.184

Table 2. - Cumulative Number of OCC-Regulated Banking Organizations Short oflhe 

Transition Schedule for Minimum Capital Requirements, December 31, 2011 

Dec.31" Jan. 1, Jan. 1, Jan.l, Jan.l, Jan. 1, Jan. 1, 2016 2011 2013 2014 2015 (PCA) 2017 2018 

Common Equity NBOs 5 8 12 13 25 

to Risk-Weighted FCPSIs 7 12 12 12 18 

Assets Tolal 12 20 24 25 43 

NBOs 10 10 12 16 30 Tier I to Risk- FCPSIs 10 11 13 16 21 Weighted Assets 

Total 20 21 25 32 51 

Minimum Total NBOs 22 27 27 31 Capital + FCPSIs 17 18 22 27 Conservation 

Buffer Total 39 45 49 58 

Advanced NBOs Approaches FCPSls Countercyclical Total 

~ Buffer 

Advanced NBOs 0 Approaches FCPSls 0 Leverage Ratio Total 0 

-9-

Jan. l, 

2019 

39 

28 

67 

0 

0 

0 
270 


79691.185

Table 3. - Capital Shortfall for Scheduled Minimum Capital Requirements, ($ in millions) 

Decem ber 31 , 20 II 

Dec. 31, Jan. I, Jan.l, lan.l, Jan.l, Jan. 1, 

2011 2013 2014 2015 2016 J;~i~' (PCA) 2017 2 

Common Equity NBGs $18 $42 $54 $67 $357 

to Risk-Weighted FCPSls $51 $83 $100 $117 $202 Assets Total $69 $125 $154 $184 $559 

NEGs $25 $32 $62 $79 $849 Tier I to Risk- FCPS!s $49 $62 $88 $1l0 $239 Weighted Assets 

Total $74 $94 $150 $189 $1,088 

Minimum Total NBGs $169 $271 $355 $498 

Capitai-l' FCPSls $152 $189 $228 $342 Conservation 

Buffer Total $321 $460 $583 $840 

Advanced NEOs 

Approaches FCPSls Countercyclical 

Buffer Total 

Advanced NBGs 

Approaches FCPSls I 

Leverage Ratio Total 

Regulatory Flexibility Act (RF A) Analysis 

As part of our analysis, we considered whether the proposed rule is likely to have a significant 

impact on a substantial number of small entities, pursuant to the RFA. The size threshold for 

small banks is $175 million. Tables 4 and 5 show our estimates of the number and capital 

shortfall for small institutions under the proposed rule. We estimate that the cost of lost tax 

benefits associated with increasing total capital by $82 million as shown in table 5 will be 

approximately $0.5 million per year. Averaged across the 28 affected institutions. the cost is 

approximately $18,000 per institution per year. Among the small institutions facing a potential 

capital shortfall over the transition period, this cost would only be significant for three of these 

institutions when measured against total non interest expenses. Thus, we believe that this 

proposed rule will not have a significant impact on a substantial number of small entities. 

Hl 

0 

0 

0 

Jan. I, 

2019 

$670 

$441 

$1,111 

0 

0 

0 
271 


79691.186

Table 4. - Cumulative Number of Small OCC-Regulated Banking Organizations Short of 

the Transition Schedule for Minimum Capital Requirements, December 31, 2011 

Dec.31, Jan. 1, Jan. I, Jan. 1, Jan. 1, Ian. I, Jan. J, 2016 2011 2013 2014 2015 (PCA) 2017 2018 

Common Equity NBOs 4 6 8 9 12 

to Risk-Weighted FCPSIs 2 3 3 3 6 Assets Total 6 9 II 12 18 

NBOs 7 7 8 10 14 Tier 1 to Risk- FCPSIs 2 3 3 4 6 Weighted Assets 

Total 9 10 II 14 20 

Minimum Total NBOs II 14 14 15 Capital + FCPSls 4 4 5 9 Conservation 

Buffer Total 15 18 19 24 

Table 5. Capital Shortfall for Small OCC-Regulated Banking Organizations for 

Scheduled Minimum Capital Re uirements, ($ in millions) December 31, 2011 

Dec.31, Jan. I, Jan. 1, Jan. 1. Jan, I, Jan. 1, Jan. J, 2016 2011 2013 2014 2015 (PCA) 2017 2018 

Common Equity NBOs $9 $17 $20 $23 $39 

to Risk-Weighted FCPSls $1 $2 $2 Assets Total $10 $19 $~~I~ l NBOs $21 $24 Tier 1 to Risk- FCPSls $1 $1 $2 =mt Weighted Assets 

Total $22 $25 $35 

Minimum Total NBOs $40 $4 $52 $61 

Capita! + FCPSls $3 $5 $6 $10 Conservation 

Buffer Total $43 $51 $58 $71 

H 

Jan, 1, 

2019 

19 

9 

28 

Jan. 1, 

2019 

$69 

$13 

$82 
272 


79691.187

() 

Comptroller of the Currency 

Administrator of National Banks 

Washington, DC 20219 

To: Carl Kaminski, Legislative and Regulatory Activities 

Thru: Gary Whalen, Director, Policy Analysis Division 

MEMORANDUM 

From: Douglas Robertson, Senior Financial Economist, Policy Analysis Division 

Date: May 30, 2012 

Subject: Impact Assessment for Baseillf: Standardized Approaches to Risk-weighted Assets, NPR2 

This memorandum provides our assessment of the economic impact oflhe proposed rules that 

would implement the Basel III framework developed by the Basel Committee on Banking 

Supervision. The Basel III framework would revise current general risk-based capital rules and 

would be applicable to all banking organizations. The federal banking agencies are 

implementing Bascl III through three separate rules. The first rule would apply Basel III 

minimum capital requirements to all banking organizations (NPRI). The second rule would 

implement new alternative measures of creditworthiness for all banking organizations (NPR2).1 

The third rule would apply Basel III enhancements to the risk-weighted assets of institutions 

subject to the advanced approaches capital rules (NPR3). 

I) Basel III NPR (NPRI) 

This will include the changes to the numerator of the risk-based capital ratio, the new ratio 

requirements (common equity Tier I and the higher minimums), as well as the conservation and 

countercyclical buffers. It also will include the changes to the treatment of mortgage servicing 

assets and deferred tax assets (DT As). 

2) Standardized Approach NPR (NPR2) 

This will include the changes to the calculation of risk-weighted assets (the denominator of the 

risk-based capital ratio), except for the treatment of mortgage servicing assets and DTAs 

discussed in the Basel III NPR. 

3) Advanced Approaches NPR (NPR3) 

The advanced approaches NPR will introduce enhancements to the advanced approaches rule, 

and it will include a proposal to expand the scope of the market risk rule to include thrifts. 

1 These rules would serve as the generally applicable capital rules and therefore would be a floor for the risk-based 

capital requirement for advanced approaches banks under Section 171 of the Dodd Frank Act. 
273 


79691.188

We estimate that the first-year cost associated with higher minimum capital requirements in 

NPRI will be approximately $5.1 million. We estimate that the first-year cost associated with 

changes in risk-weighted assets and implementation of alternative measures of creditworthiness 

in NPR2 will be approximately $93.2 million. We estimate that the first-year cost associated 

with changes in risk-weighted assets and simultaneously meeting new market risk capital 

requirements in NPR3 will be approximately $46.8 million. Togethcr, we estimate that the 

overall cost of the three Basel III rules will be approximately $145.1 million in the first year. 

After introducing new systems for determining risk weighted assets in the first year, we estimate 

that the overall cost of Basel III in subsequent years will decrease to approximately $98.6 million 

per year. 

I. The Proposed Rule: Standardized Approach for Risk-weighted Assets (NPR2) 

The proposed rule (NPR 2) includes changes to the general risk-based capital requirements that 

address the calculation of risk-weighted assets. The proposed rule would: 

I. Revise the treatment of I -4 family residential mortgages 

2. Introduces a higher risk weight for certain past due exposures and acquisition and 

development real estate loans 

3. Provides a more risk sensitive approach to exposures to non- U.S. sovereigns and nonU.S. public sector entities 

4. Replace references to credit ratings with alternative measures of creditworthiness 

5. Provides more comprehensive recognition of collateral and guarantees 

6. Provides a more favorable capital treatment for transactions cleared through qualifying 

central counterparties 

7. Introduces disclosure requirements for banking organizations with assets of $50 billion or 

more 

Calculating Risk-Weighted Assets 

Section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act (DoddFrank) requires federal agencies to remove references to credit ratings from regulations and 

replace credit ratings with appropriate alternatives. The proposed rule would introduce 

alternative measures of creditworthiness for securitization positions and re-securitization 

positions. Table I summarizes changes in the proposed rule. 

-2-
274 


79691.189

Table 1: Key Provisions of the Proposed Rule for Calculating Risk-weighted Assets 

Aspect of Proposed Rule Proposed Treatment 

Risk-weighted Assets 

Credit exposures to: Unchanged. 

U.S. government and its agencies 

U.S. government-sponsored entities 

U.S. depository institutions and credit unions 

U.S. public sector entities, such as states and 

municipalities 

Credit exposures to: Introduces a more risk-sensitive treatment 

Foreign sovereigns using the Country Risk Classification measure 

Foreign banks produced by the Organization for Economic 

Foreign public sector entities Cooperation and Development. 

Corporate exposures Assigns a 100 percent risk weight to corporate 

exposures, including exposures to securities 

firms. 

Residential mortgage exposures Introduces a more risk-sensitive treatment 

based on several criteria, including the loan-tovalue-ratio of the exposure. 

High volatility commercial real estate Applies a 150 percent risk weight to certain 

exposures credit facilities that finance the acquisition, 

development or construction of real property. 

Past due exposures Applies a 150 percent risk weight to exposures 

that are not sovereign exposures or residential 

mortgage exposures and that are more than 90 

days past due or on nonaccrual. 

Securitization exposures Maintains the gross-up approach for 

securitization exposures. 

Replaces the current ratings-based approach 

with a formula-based approach for determining 

a securitization exposure's risk weight based 

on the underlying assets and exposure's 

relative position in the securitization's 

structure. 

Equity exposures Introduces more risk-sensitive treatment for 

equity exposures. 

Off-balance Sheet Items Revises the measure of the counterparty credit 

risk of repo-style transactions. 

Raises the credit conversion factor for most 

short-term commitments from zero percent to 

20 percent. 

Derivative Contracts Removes the 50 percent risk weight cap for 

-3-
275 


79691.190

Aspect of Proposed Rule Proposed Treatment 

derivative contracts. 

Cleared Transactions Provides preferential capital requirements for 

cleared derivative and repo-style transactions 

(as compared to requirements for non-cleared 

transactions) with central counterparties that 

meet specified standards. Also requires that a 

clearing member of a central counterparty 

calculate a capital requirement for its default 

fund contributions to that central counterparty. 

Credit Risk Mitigation Provides a more comprehensive recognition of 

collateral and guarantees. 

Disclosure Requirements Introduces qualitative and quantitative 

disclosure requirements, including regarding 

regulatory capital instruments, for banking 

organizations with total consolidated assets of 

$50 billion or more that are not subject to the 

separate advanced approaches disclosure 

requirements. 

Alternative Measure for Securitization Positions 

The alternative measure for securitization positions is a simplified version of the Basel II 

advanced approaches supervisory formula approach. The simplified supervisory formula 

approach (SSF A) applies a 100 percent risk-weighting factor to the junior most portion of a 

securitization structure equal to the amount of capital a bank would have to hold if it retained the 

entire pool on its balance sheet. For the remaining portions of the securitization pool, the SSFA 

uses an exponential decay function to assign a marginal capital charge per dollar of a tranche. 

Securitization positions for which a bank does not use the SSFA would be subject to a 100 

percent risk-weighting factor. The proposed rule would also apply minimum risk weights to 

securitization tranches that would increase as cumulative losses to the pool increase. The 

proposed rule would allow institutions other than advanced approaches banking organizations to 

use the gross-up approach, which is similar to an approach provided for under current risk-based 

capital rules. 

Alternative Measure for Exposures to Sovereign Entities 

The proposed rule would assign capital requirements to sovereign exposures based on OECD 

Country Risk Classifications (CRCs). Risk weights would range from zero percent to 150 

percent based on CRCs, and sovereigns that have defaulted on any exposure during the previous 

five years would have a 150 percent risk weight. Default would include a restructure that results 

in a sovereign entity not servicing an obligation according to its terms prior to the restructuring. 

-4-
276 


79691.191

Exposures to the United States government and its agencies would always carry a zero percent 

risk weight. Sovereign entities that have no CRC would carry a ! 00 percent risk weight. 

The proposed rule would apply a zero percent risk weight 10 exposures to supranational entities 

and multilateral development banks. International organizations that would receive a zero 

percent risk weight include the Bank for International Settlements, the European Central Bank, 

the European Commission, and the International Monetary Fund. The proposed rule would also 

apply a zero percent risk weight to exposures to 13 named multilateral development banks and 

any multilateral lending institution or regional development bank in which the U.S. govenunent 

is a shareholder or member, or if thc bank's primary federal supervisor detennines that the entity 

poses comparable credit risk. 

Other Positions 

Corporate Exposures: The propcsed rule would maintain current practice under general riskbased capital rules and assign a 100 percent risk weight to all corporate exposures. 

Government Sponsored Entities (GSEs): The proposal would apply a risk weight of20 percent to 

non-equity exposures and a 100 percent risk weight to preferred stock issued by a GSE. 

Depository Institutions, Foreign Banks, and Credit Unions: Generally, the proposal would link 

depository institution risk weights to the sovereign entity risk weight. Under the proposal, 

sovcreign entity risk weights may take one of the following percentage values: (0,20,50,100, 

150). Generally, exposures to foreign depository institutions would receive a risk weight one 

category higher than the risk weight assigned to the home sovereign. For instance, a bank based 

in a country that carries a zero percent risk weight would carry a 20 percent risk weight. If a 

country does not have a CRC, a bank based in that country also carries a 100 percent risk weight. 

Banks in countries with 150 percent risk weights would also carry 150 percent risk weights. 

Residential Mortgage Exposures: The proposed rule would maintain the current risk-based 

capital treatment for residential mortgage exposures that are guaranteed by the U.S. government 

or its agency. Residential mortgage exposures that are unconditionally guaranteed by the U.S. 

government or a U.S. agency would receive a zero percent risk weight, and residential mortgage 

exposures that are conditionally guaranteed by the U.S. government or a U.S. agency would 

receive a 20 percent risk weight. A banking organization would divide other residential 

mortgages into one of two categories based on various loan characteristics such as duration, 

amortization, perfonnance, and underwriting standards. These loans would then receive risk 

weights based on the loan-to-value ratio at the origination of the loan or at the time of 

restructuring. Table 2 shows the risk weights for residential mortgages. 

-5-
277 


79691.192

Table 2 - Risk Weights for Residential Mortgage Exposures 

Loan-to-value ratio Category I residential Category 2 residential 

(in percent) mortgage exposure mortgage exposure 

(in percent) (in percent) 

Less than or equal to 60 35 100 

Greater than 60 and less than or equal 50 100 to 80 

Greater than 80 and less than or equal 75 150 to 90 

Greater than 90 100 200 

High Volatility Commercial Real Estate Exposures: The proposed rule would assign a 150 

percent risk weight to any high volatility commercial real estate exposure. The proposed rule 

would generally define such an exposure as a loan that finances the acquisition, development, or 

construction of real property that is not a one- to four-family residential property or certain 

commercial real estate projects. 

Publie Sector Entities (PSEs): A PSE is a state, local authority, or other governmental 

subdivision below the level of a sovereign entity. The proposed rule would apply the same risk 

weights to exposures for U.S. states and municipalities as current general risk-based capital rules. 

Under the proposal, a banking organization would assign a 20 percent risk weight to a general 

obligation exposure to a U.S. PSE and a 50 percent risk weight to a revenue obligation exposure 

to such a PSE. For non-U.S. PSEs, the proposed rule would assign a risk weights based on the 

sovereign's CRG. One risk weight schedule would apply to general obligation claims and 

another schedule would apply to revenue obligations. Table 3 shows the risk-weight linkage for 

sovereigns and non-U .S. PSEs. 

Tabl e 3 R· IS k W . h elg ts f, or E xposures to S overelgns an d P u bI" IC S E .. ector "ntItles 

Sovereign CRC Sovereign Non-U.S. PSE Non-U.S. PSE 

Entity General Obligation Revenue Obligation 

Risk Weights Claim Risk Weights 

(in percent) Risk Weights (in percent) 

(in percent) 

0-1 0 20 50 

2 20 50 100 

3 50 100 100 

4-6 100 150 150 

7 150 150 150 

NoCRC ]00 100 100 

Sovereign Default 150 150 150 

Disclosure Requirements 

-6-
278 


79691.193

The proposed rule would also introduce new disclosure requirements for banking organizations 

with $50 billion or more in total assets. The proposed rule would also introduce a Pillar 2 

supervisory review process for all banking organizations. 

II. Institutions Affected By the Proposed Rule 

According to December 31. 2011 Call Rcport data, there are 7,432 FDIC-insured institutions. 

After aggregating to the highest holding compan~, there are 6,744 bank holding companies, of 

which, 1,213 are national banking organizations. Excluding several thrifts that are included as 

subsidiaries of national banking organizations, the proposed rule would also apply to 612 

federally chartered private savings institutions. Thus, the proposed rule would apply to 1,825 

financial institutions regulated by the acc. Banking organizations using the advanced 

approaches would not be affected by major portions of the proposed rule. 

III. Estimated Costs and Benefits of the Proposed Rule 

The various elements of the proposed rule will affect costs in three ways: (l) the cost of capital 

institutions will need to meet the higher minimum capital ratios and the new eligibility standards 

for capital, (2) compliance costs associatcd with establishing the infrastructure to determine 

correct risk weights using the new alternative measures of creditworthiness, and (3) compliance 

costs associated with new disclosure requirements. 

Benefits of the Proposed Rule 

The proposed rule would produce the following benefits: 

I. Improves the quality of regulatory capital by introducing a common equity Tier I 

regulatory capital requirement and tightening the standards for including non-common 

equity instruments in regulatory capital 

2. Increases risk sensitivity of capital requirements and risk-weighted assets 

3. Improves loss absorbency ofregulatory capital 

4. Improve transparency and market discipline through disclosure requirements. 

5. Expanded list of eligible third-party guarantors (page 143) 

6. Expanded array of collateral types 

7. Enhanced supervisory review process through the establishment of Pillar 2-based 

expectations for banking organizations 

8. Enhances counterparty credit risk capital requirements that proved inadequate during the 

financial crisis 

2 A national banking organization is any bank holding company with a subsidiary national bank. Two of the 16 

organizations also include a federally chartered private savings institution, but both of these organizations also 

contain a national bank and are included in the 16 national banking organizations. 

-7-
279 


79691.194

Costs of the Proposed Rule 

I. Impact of Risk-weighted Assets on Capital Requirements 

Minimum required capital levels are likely to change under the proposed rule. The increased risk 

sensitivity of the alternative measures of creditworthiness implies that capital requirements may 

go down for some assets and up for others. For those assets with a higher capital charge under 

the proposed rule, however, that increase may be large in some instances, e.g., requiring a dollarfor-dollar capital charge for some securitization exposures. 

The Basel Committee on Banking Supervision has been conducting periodic reviews of the 

potential quantitative impact of the BasellTl framework. The quantitative impact study working 

group reported that the average change in risk-weighted assets for a global sample oflarger 

banks (including some U.S. banks) was approximately 20 percent.) Although these reviews 

monitor the impact of implementing the Basel TIl framework rather than the provisions of the 

proposed rule, for the purposes of this analysis we consider the results of the Basel working 

group to be a best estimate and thus we increase risk-weighted assets by 20 percent to estimate 

the impact of the proposed rule on risk-weighted assets. 

To estimate the impact of the proposed rule on bank capital needs, we estimate the amount of 

capital banks will need to amass to meet the new minimum standards described in our analysis of 

NPRJ. As with that analysis, we estimate new capital ratios and requirements by combining 

various Call Report itcms to reflect definitional changes to common equity capital, Tier I capital, 

and total capital as described in NPRI. Because this proposed rule, NPR2, will change the 

capital ratio denominator, risk-weighted assets, we increase current risk-weighted assets by 20 

percent. We use this 20 percent adjustment while recognizing that the idiosyncratic nature of 

each institution's asset portfolio will undoubtedly cause the direction and extent of the change in 

the denominator to vary considerably from institution to institution. 

We thus construct new capital ratios reflecting the requirements of the proposed rules (NPR I and 

NPR2) and estimate capital shortfalls as the difference between current capitalleveJs and capital 

levels necessary to meet the new minimum standards. We estimate the capital shortfall each 

institution would encounter as the new capital ratios come into effect during the transition period 

from 2013 through 2019. Table 4 shows our estimates of the number of institutions that would 

not meet the transition schedule for proposed minimum capital requirements using data as of 

December 31, 20 II. Table 5 shows our estimates of the aggregate amount of capital shortfall 

over the transition period ending in 2019. While institutions must simultaneously meet all ofthe 

minimum capital requirements, the largest shortfall amount in any given year shows the most 

binding minimum capital requirement. The number of institutions and the capital shortfall 

amounts shown in the 2016 column reflect those institutions that show a shortfall with regard to 

the new PCA standards relative to current capital levels. 

J The working group also reported an average change in risk-weighted assets for a global sample of smaller banks 

(those with Tier I capital less than €3 billion), but no U.S. banks participated in this sample. The reported average 

increase for this group was less than 10 percent, which suggests that our use of a 20 percent increase in riskweighted assets for all institutions may overestimate the impact of the proposed rule. 

-8-
280 


79691.195

As shown in table 4, our estimate of the largest capital shortfall would be an approximately $27 

billion shortfall in 2015 when the new Tier I PCA standard for well-capitalized institutions takes 

effect. We vicw this new PCA Tier I standard as the major capital constraint in the proposed 

rule. 

Because banks confronting a capital shortfall under the proposed rule will need to at least 

increase their capital levels gradually to meet the transition schedule, we assume that the 

aggregate cost of increasing capital will be spread out over several years. We estimate that the 

largest shortfall for any given year will be approximately $9.0 billion, or one third of the amount 

needed to meet the new PCA Tier I standard for well-capitalized institutions when it takes effect. 

This estimate combines the capital needs for national banking organizations and federally 

chartered private savings institutions (together, OCC institutions). 

To estimate the cost to banks of the new capital requirement, we examine the effect of this 

requirement on capital structure and the overall cost of capital.4 As with our estimate in NPRI, 

we estimate that the cost of the increase in capital would be tax benefits foregone: the capital 

requirement ($9.0 billion), multiplied by the interest rate on the debt displaced and by the effective 

marginal tax rate for the banks affected by the proposed rule. Graham (2000) estimates a median 

marginal tax benefit of$9.40 per $100 of interest. So, using an estimated interest rate on debt of6 

percent, we estimate that the annual tax benefits foregone on $9.0 billion of capital switching from 

debt to equity is approximately $9.0 billion * 0.06 (interest rate) * 0.094 (median marginal tax 

savings) = $50.8 million per year.' Approximately $5.1 million per year is attributable to NPRl, 

leaving $45.7 million per year as the capital cost ofNPR2. 

4 See Merton H. Miller, (I 995), "Do the M & M propositions apply to banks?" Journal of Banking & Finance, Vol. 

19, pp. 483-489. 

5 See John R. Graham, (2000), "How Big Are the Tax Benefits ofOebt?" Journal of Finance, Vol. 55, No.5, pp. 

1901-1941. Gmham points out that ignoring the offsetting effects of personal taxes would increase the median 

marginal tax rate to $31.5 per $100 of interest. 

-9-
281 


79691.196

Table 4. - Cumulative Number of OCC-Regulated Banking Organizations Short ofthe 

Transition Schedule for Minimum Capital Requirements and Estimated Risk-weighted 

Assets .. December 31 , 2011 

Dec.31, Jan. l, Jan.l, Jan. 1, Jan.l, Jan. 1, Jan. 1, 2016 2011 2013 2014 2015 (PCA) 2017 2018 

Common Equity NBOs 7 12 15 16 32 

to Risk~Weighted FCPS!s 8 12 12 14 22 

Assets Total 15 24 27 30 54 

NBOs 11 12 22 26 53 Tier 1 to Risk- FCPSls 11 13 18 18 33 Weighted Assets 

Total 22 25 40 44 86 

Minimum Total NEOs 30 34 47 82 Capital + FCPS!s 26 28 37 51 Conservation To(al Buffer 56 62 84 133 

Advanced NBOs Approaches FCPSls Countercyclical 

Butler Total 

Advanced NBOs 0 Approaches FCPSIs 0 Leverage Ratio Total 0 

Jan. I, 

2019 

130 

60 

190 

0 

0 

0 
282 


79691.197

Table 5. - Capital Shortfall for Scheduled Minimum Capital Requirements and Estimated 

Risk-weighted Assets, $ in millions) Oecember 31, 2011 

Dec.31, Jan. 1, Jan. 1, Jan. 1, Jan. 1, Jan. 1, Jan.l, 20J6 20J] 2013 20]4 20]5 (PCA) 20]7 2018 

Common Equity NBOs $17 $59 $96 $186 $924 

to Risk-Weighted FCPS]s $51 $106 $127 $148 $288 Assets Total $68 $165 $223 $334 $1212 

NBOs $41 $59 $107 $142 $26,192 Tier 1 to Risk- rCPSls $70 $85 $144 $180 $490 Weighted Assets 

Total $1I1 $144 $251 $322 $26,682 

Minimum Total NBOs $437 $623 $1,172 $5,755 

Capital + FCPS]s $300 $417 $531 $810 Conservation 

Buffer Total $ 737 $1040 $1,703 $6,565 

Advanced NBOs 

Approaches FCPSls Countercyclical 

Buffer Total 

Advanced NBOs 

Approaches FCPSls 

Leverage Ratio Total 

2. Alternative Measures of Creditworthiness 

The proposed rulc would require institutions to (I) establish systems to determine risk weights 

using the allernative measures of creditworthiness described in the proposal, and (2) apply these 

alternative measures to the bank's assets. We believe that this element ofthe proposed rule will 

involve costs associated with gathering and updating the information necessary to calculate the 

relevant risk weights, establishing procedures, and maintaining the programs that perform the 

calculations. 

In particular, the proposed rule would require institutions with assets in each affected asset 

category to: 

1. Establish and maintain a system to apply the gross-up approach or implement the 

simplified supervisory formula approach (SSFA) for securitization positions. 

2. Establish and maintain a system to assign risk weights to sovereign exposures. 

3. Establish and maintain systems to assign risk weights to non-U.S. public sector entities, 

depository institutions, and other foreign positions. 

4. Assign 1-4 family residential mortgage exposures to one of two categories. 

Listed below are the variables banks will need to gather to calculate risk weights under the 

proposed rule: 

0 

0 

0 

Jan. 1, 

20]9 

$24,630 

$1.122 

$25,752 

0 

0 

0 
283 


79691.198

Securitization Positions: 

1. Weighted average risk weight of assets in the securitized pool as determined under 

generally applicable risk-based capital rules 

2. The attachment point of the relevant tranche 

3. The detachment point of the relevant tranche 

4. Cumulative losses 

Residential Mortgage Exposures: 

1. Mortgage category 1 or 2 determination 

2. Loan-to-value ratio 

Sovereign Entity Debt Positions: 

1. Organization for Economic Co-operation and Development Country Risk Classifications 

(CRC) Score 

Table 6 shows our estimate of the number of hours it will take small and large institutions to 

perform the activities necessary to meet the requirements of the proposed rule. We base these 

estimates on the scope of work required by the proposed rule and the extent to which these 

requirements extend current business practices. We have also taken into consideration 

observations from comment letters regarding the burden of similar measures in a proposed 

amendment to the market risk rule. These observations suggest that the securitization element of 

the proposed rule may involve some additional data gatbering before an institution is able to 

accurately calculate risk weights using the SSFA approach. 

Although the total cost of gathering the new variables will depend on the size of the institution's 

portfolio, we believe that the costs of establishing systems to match creditworthiness variables 

with exposures and calculate the appropriate risk weight will account for most of the expenses 

associated with the credit rating alternatives. Once a bank establishes a system, we expect the 

marginal cost of calculating the risk weight for each additional asset in a particular asset class 

will be relatively small. We also note that it is likely that a third-party will eventually emerge to 

provide risk weights for these assets. Our estimates do not reflect this cost-saving innovation, 

however, as we cannot be sure such a provider will emerge or be retained by institutions subject 

to the rule. 

We estimate that large financial institutions, those with assets of$10 billion or more, covered by 

the proposed rule will spend approximately 1,300 hours during the first year the rule is in effect. 

In subsequent years, we estimate that all financial institutions will spend approximately 180 

hours per year on activities related to determining risk weights using the alternative measures of 

creditworthiness. For smaller institutions, those with total assets less than $10 billion, we 

estimate that they will spend approximately 425 hours during the first year the rule is in effect. 

Most smaller institutions do not lend to foreign governments or banks in foreign countries, and 

they do not hold foreign debt securities. Thus, for smaller institutions, we include system and 

compliance costs related to sovereign debt in the system and compliance costs for other 

positions. 
284 


79691.199

Table 7 shows our overall cost estimate related to the detennination of risk weights using the 

measures of creditworthiness in the proposed rule. Our estimate of the compliance cost ofthe 

proposed rule is the product of our estimate of the hours required per institution, our estimate of 

the number of institutions aftixted by the rule, and an estimate of hourly wages. To estimate 

hours necessary per activity, we estimate the number of employees each activity is likely to need 

and the number of days necessary to assess, implement, and perfect the required activity. To 

estimate hourly wages, we reviewed data from May 20 I 0 for wages (by industry and occupation) 

from the U.S. Bureau of Labor Statistics (BLS) for depository credit intennediation (NArCS 

522100). To estimate compensation costs associated with the proposed rule, we use $85 per 

hour, which is based on the average of the 90th percentile for seven occupations (i.e., accountants 

and auditors, compliance officers, financial analysts, lawyers, management occupations, software 

developers, and statisticians) plus an additional 33 percent to cover inflation and private sector 

benetits.6 As shown in table 7, we estimate that the cost of introducing alternative measures of 

creditworthiness is approximately $46.5 million. 

2. Disclosure Requirements 

The proposed rule requires institutions with total assets of $50 billion or more to disclose 

information on a somewhat lengthy list of structural and financial variables. We estimate that 

meeting the disclosure requirements will entail approximately 520 hours during the first year the 

proposed rule applies, and this will cost the affected institutions approximately $44,200 in the 

first year. We estimate that the time necessary to meet the disclosure requirements in subsequent 

years will diminish substantially, to roughly 25 hours per quarter or 100 hours per year. We 

estimate that approximately 23 OCC-regulated institutions will be subject to the disclosure 

requirements in the proposed rule, resulting in a cost of $1.0 million. 

3. Overall Cost Estimate for Standardized Approaches for Risk-weighted Assets 

Combining our estimates of capital costs ($45.7 million), the cost of applying alternative 

measures of creditworthiness ($46.5 million), and disclosure requirements ($1.0 million), our 

overall estimate ofthe cost of the proposed rule (NPR2) is $93.2 million. 

6 According to the BLS' employer costs of employee benefits data, thirty percent represents the average private 

sector costs of employee benefits. 
285 


79691.200

Table 6 Estimated Annual Hours for Creditworthiness Measurement Activities 

Asset Activity Estimated hours Estimated hours 

per institution per institution with 

with total assets < total assets:::: $10 

$10bil. bi!. 

Securitization System 

development 120 480 

Data acquisition 

& Due Diligence 80 240 

Calculation, 

verification, and 

training 60 120 

Residential System 

Mortgages development 60 60 

Data acquisition 30 50 

Calculation, 

verification, and 

training 10 10 

Sovereign Debt System 

development 80 

Data acquisition 30 

Calculation, 

verification, and 

training 60 

Other Positions System 

Combined7 development 40 80 

Data acquisition 20 30 

Calculation, 

verification, and 

training 5 60 

Total Hours 425 1,300 

7 Includes sovereign debt implementation costs for institutions with less than $10 billion in assets. 

-14 
286 


79691.201

Table 7. 

Estimated Costs of Creditworthiness Measurement Activities December 31 20 It 

Institution Number of Estimated hours Estimated cost Estimated cost 

institutions per institution per institution 

Small banking 

organizations 

(assets < $10 bi!.) 1,177 425 $36,125 $42,519,125 

Large banking 

organizations 

(assets> $10 bi!.) 36 1,300 $110,500 $3,978,000 

Total 1,213 $46,49},l?5 

Regulatory Flexibility Act (RFA) Analysis 

As part of our analysis, we considered whether the proposed rule is likely to have a significant 

impact on a substantial number of small entities, pursuant to the RF A. The size threshold for 

small banks is $175 million. Tables 8 and 9 show our estimates of the number and capital 

shortfall for small institutions under the proposed rules (NPR I and NPR2). We estimate that the 

cost oflost tax benefits associated with increasing total capital by $143 million as shown in table 

9 will be approximately $0.8 million per year. Averaged across the 56 affected institutions, the 

cost is approximately $14,000 per institution per year. From table 7, we estimate that the cost of 

implementing the alternative measures of creditworthiness will be approximately $36,125 per 

institution. For the 56 institutions with a projected capital shortfall, we estimate that the cost of 

the standardized approaches for risk-weighted assets will be slightly more costly at 

approximately $50,000 per institution. 

To determine if the proposed rule has a significant economic impact on small entities we 

compared the estimated annual cost with annual non interest expense and annual salaries and 

employee benefits for each small entity. If the estimated annual cost was greater than or equal to 

2.5 percent of total noninterest expense or 5 percent of annual salaries and employee benefits we 

classified the impact as significant. The proposed rule will have a significant economic impact 

on 500 small national banks and 253 small federally chartered private savings institutions. 

Accordingly, the proposed rule appears to have a significant economic impact on a substantial 

number of small entities. 

-Is. 
287 


79691.202

Table 8. - Cumulative Number of Small OCC-Regulated Banking Organizations Short of 

the Transition Schedule for Minimum Capital Requirements and Estimated Risk-weighted 

Assets, December 31, 2011 

Dec.31, lan.l, Jan.l, Jan.l, Jan.l, Jan. 1, 2016 2011 2013 2014 2015 (PCA) 2017 

Common Equity NBOs 6 8 9 10 16 

to Risk-Weighted FCPSls 2 3 3 3 7 

Assets Total 8 II 12 13 23 

NBOs 7 8 11 13 22 Tier 1 to Risk- FCPSIs 3 3 5 5 13 Weighted Assets 

Total 10 11 16 18 35 

Minimum Total NBOs 15 17 22 Capita! + FCPSIs 10 11 13 Conservation Total Buffer 25 28 35 

Table 9. Capital Shortfall for Small OCC-Regulated Banking Organizations for 

Scheduled Minimum Capital Requirements and Estimated Risk-weighted Assets, ($ in 

millions) December 31,2011 

Dec.31, Jan. 1, Jan.l, Jan.l, Jan. 1, Jan.l, 2016 201] 2013 2014 20]5 (PCA) 2017 

Common Equity NBOs $8 $21 $25 $30 $54 

to Risk-Weighted FCPSls $1 $2 $3 $3 $10 

Assets Total $9 $23 $28 $33 $64 

NBOs $25 $29 $39 $45 $75 Tier 1 to Risk- FCPSls $1 $2 $4 $5 $16 Weighted Assets 

Total $26 $31 $43 $50 $91 

Minimum Total N130s $58 $67 $76 

Capital + FCPSls $9 $13 $17 Conservation 

Buffer Total $67 $80 $93 

-16 

Jan. 1, 

2018 

27 

17 

44 

Jan. 1, 

2018 

$94 

$25 

$119 

Jan. 1, 

2019 

37 

19 

56 

Ian. t, 

20]9 

$111 

$32 

$143 
288 


79691.203

c) 

Comptroller of the Currency Administrator of National Banks 

Washington, DC 20219 

To: Carl Kaminski, Legislative and Regulatory Activities 

Thru: Gary Whalen, Director, Policy Analysis Division 

MEMORANDUM 

From: Douglas Robertson, Senior Financial Economist, Policy Analysis Division 

Date: May 30, 2012 

Subject: Impact Assessment for the Basel [ll Rule: Advanced Approaches, NPR3 

This memorandum provides our assessment of the economic impact of the proposed rules that 

would implement the Basel III framework developed by the Basel Committee on Banking 

Supervision, The Basellll framework would revisc current general risk-based capital rules and 

would be applicable to all banking organizations, The federal banking agencies are 

implementing Basel III through three separatc rules. The first rule would apply Basel III 

minimum capital requirements to all banking organizations (NPR I). The second rule would 

implement new alternative measures of creditworthiness for all banking organizations (NPR2).1 

The third rule would apply Basel III enhancements to the risk-weighted assets of institutions 

subject to the advanced approaches capital rules (NPR3). Advanced approaches banking 

organizations are those institutions with total assets of at least $250 billion or foreign exposures 

of at least $10 billion, or institutions that have elected to adopt the advanced approaches. 

1) BasellI! NPR (NPRI) 

This will include the changes to the numerator of the risk-based capital ratio, the new ratio 

requirements (common equity Tier I and the higher minimums), as well as the conservation and 

countercyclical butters. It also will include the changes to the treatment of mortgage servicing 

assets and deferred tax assets (DTAs). 

2) Standardized Approach NPR (NPR2) 

This will include the changes to the calculation of risk-weighted assets (the denominator of the 

risk-based capital ratio), except for the treatment of mortgage servicing assets and DTAs 

discussed in the Basel III NPR. 

1 These rules would serve as the generally applicable capital rules and therefore would be a floor for the risk-based 

capital requirement for advanced approaches banks under Section 171 of the Dodd Frank Act. 
289 


79691.204

3) Advanced Approaches NPR (NPR3) 

The advanced approaches NPR will introduce cnhancements to the advanced approaches rule, 

and it will include a proposal to expand the scope of the market risk rule to include thrifts. 

We estimate that the first-year cost associated with higher minimum capital requirements in 

NPRI will be approximately $5.1 million. We estimate that the first-year cost associated with 

changes in risk-weighted assets and implementation of alternative measures of creditworthiness 

in NPR2 will be approximately $93.2 million. We estimate that thc first-year cost associated 

with changes in risk-weighted assets and simultaneously meeting new market risk capital 

requirements in NPR3 will be approximately $46.8 million. Together, we estimate that the 

overall cost of the three Basel 111 rules will be approximately $145.1 million in the first year. 

After introducing new systems for determining risk weighted assets in thc first year, we estimate 

that the overall cost of13asellll in subsequent years will decrease to approximately $98.6 million 

per year. 

L The Proposed Rule: Advanced Approaches Risk-based Capital (NPR3) 

The proposed rule would incorporate Basel Committee on Bank Supervision revisions to the 

Basel capital framework into the banking agencies' advanced approaches capital rules and 

remove references to credit ratings consistent with section 939A ofthe Dodd-Frank Act. The 

proposed rule would apply the market risk capital rule to certain savings associations. 

The proposed rule would modify various elements of the advanced approachcd risk-based capital 

rules regarding the determination of risk-weighted assets. These changes would (I) modify 

treatment of counterparty credit risk, (2) remove references to credit ratings, (3) modify the 

treatment of securitization exposures, and (4) modify thc treatment of exposures subject to 

deduction from capitaL The proposed rule would also enhance disclosure requirements, 

especially with regard to securitizations. 

The proposed rule would amend the advanced approaches so that capital requirements using the 

internal models methodology takes into consideration stress in calibration data, stress testing, 

initial validation, collateral management, and annual model review. The proposcd rule would 

also require a banking organization to identify, monitor, and control wrong-way risk, which the 

proposed rule defines as the risk that arises when an exposure to a particular counterparty is 

positively correlated with the probability of default of such counterparty itself. 

The proposed rule would also remove the ratings-based approach and the internal assessment 

approach for securitization exposures from the advanccd approaches rule and require advanccd 

approaches banking organizations to use either the supervisory formula approach (SF A) or a 

simplified version of the SF A when calculating capital requirements for sccuritization exposures. 

Advanced approaches banking organizations would be required to calculate their risk-based and 

leverage capital requirements under the standardized approach (using the numerator and 

denominator in NPR I and NPR 2), as well as the under thc revised advanced approaches, 

outlined in this proposal (NPR 3). Advanced approaches banking organizations would apply thc 

-2-
290 


79691.205

lower risk-based capital and leverage ratios for purposes of determining compliance with the 

proposed minimum regulatory capital requirements. 

II. Institutions Affected By the Proposed Rule 

The proposed rule (NPR3) will apply to advanced approaches banking organizations, i.e., 

banking organizations with total assets of at least $250 billion or foreign exposures of at least 

$10 billion, other banking organizations that have elected to adopt the advanced approaches, and 

banking organizations that are subsidiaries of banking organizations that must use the advanced 

approaches rules. The NPR also proposes to expand the scope ofthe market risk rule to apply to 

savings associations and savings and loan holding companies that meet the relevant trading 

activity thresholds - $1 billion or more in trading activity or trading activity equal to 10 percent 

or more of the banking organization's total assets. 

III. Estimated Costs and Benefits of the Proposed Rule 

Benefits ofthe Proposed Rule 

The proposed rule would produce the following benefits: 

I. Increases risk sensitivity of risk-weighted assets 

2. Improves transparency and market discipline through disclosure requirements. 

3. Enhances counterparty credit risk capital requirements that proved inadequate during the 

financial crisis 

Costs of the Proposed Rule 

I. Impact of Risk-weighted Assets on Capital Requirements 

The modifications to risk-weighted assets in the proposed rule will affect overall risk-weighted 

assets and hence risk-based capital ratios for advanced approaches banks. Applying new risk 

weights implies that capital requirements may go down for some assets and up for others. As 

with NPR2, securitization exposures in particular may face higher capital charges under the 

proposed rule. 

As with NPR2, we estimate the proposed rule's impact on risk-weighted assets by applying the 

average change in risk-weighted assets reported by the Basel Committee on Banking Supervision 

quantitative impact study working group. For the analysis ofNPR3, we first estimate the effect 

of increasing risk-weighted assets of advanced approaches banks by 20 percent. We also 

incorporate estimates of the effect of the market risk rule on institutions that are subject to both 

the advanced approaches rule and the market risk rule. 

To estimate the impact of the proposed rule (NPR3) on bank capital needs, we estimate the 

amount of capital banks will need to gather to meet the new minimum standards described in our 

analyses ofNPRI and NPR2. As with those analyses, we estimate new capital ratios and 

-3-
291 


79691.206

requirements by combining various Call Report items to reflect definitional changes to common 

equity capital, Tier I capital, and total capital as described in NPR I. We also increase current 

risk-weighted assets by 20 percent as described in NPR2. 

We thus construct new capital ratios for advanced approaches banking organizations reflecting 

the requirements ofthe proposed rules (NPR I and NPR2) and estimate capital shortfalls as the 

difference bctween current capital levels and capitallevcls necessary to meet the new minimum 

standards. We estimate the capital shortfall each institution would encounter as the new capital 

ratios come into effect during the transition period from 2013 through 2019. Table 1 shows our 

estimates of the number of advanced approaches institutions that would not meet the transition 

schedule for proposed minimum capital requirements using data as of December 31,2011. Table 

2 shows our estimates of the aggregate amount of capital shortfall over the transition period 

ending in 2019. While institutions must simultaneously meet all of the minimum capital 

requirements, the largest shortfall amount in any given year shows the most binding minimum 

capital requirement. The number of institutions and the capital shortfall amounts shown in the 

2016 column reflect those institutions that show a shortfall with regard to the new PCA standards 

relative to current capital levels. 

Table 2 shows that $22 billion of our NPR2 estimate of a $27 hill ion capital shortfall is 

attributahle to 3 advanced approaches hanks that would encounter a capital shortfall in 2015 

whcn the new Tier I PCA standard for well-capitalized institutions takes effect. 

Because many advanced approaches banks are also subject to the market risk rule, we repeat our 

capital shortfall estimate by adding estimated markct risk assets to the capital ratios for these 

institutions. Table 3 shows our estimate of the number of institutions that would need to increase 

capital levels to meet new minimum capital requirements. Table 4 shows our estimate of the 

amount of capital needed (0 meet those capital requirements. 

We assumc that the aggregate cost of increasing capital will be spread out over several years. 

Table 2 reflects capital amounts already included in our analysis ofNPR2. To estimate the 

amount of required capital not accounted for in NPR2, we subtract the capital amounts shown in 

table 2 from thosc shown in table 4. This comparison suggests that the earliest significant capital 

requirement for advanced approaches hanks will he raising $24.8 billion in capital to meet the 

new PCA Tier I standard for well-capitalized institutions when it takes effect. We estimate that 

the largest shortfall for any given year will be approximately $8.3 billion, or one third orthe 

amount necded to meet this new PCA Tier I standard. 

To estimate the cost to hanks ofthc new capital requirement, we examine the effect of this 

requirement on capital structure and the overall cost of capital? As with our estimates in NPRI 

and NPR2, we estimate that the cost of the increase in capital would be tax benefits foregone: the 

capital requirement ($8.3 billion), multiplied by the interest rate on the debt displaced and by the 

effective marginal tax rate for the banks affected by the proposed rule. Graham (2000) estimates a 

median marginal tax benefit of $9.40 per $100 of interest. So, using an estimated interest rate on 

2 Sec Merton H. Miller, (1995), "Do the M & M propositions apply to banks?" Journal a/Banking & Finance, Vol. 

19, pp. 483-489. 

-4-
292 


79691.207

debt of 6 percent, we estimate that the annual tax benefits foregone on $8.J billion of capital 

switching from debt to equity is approximately $8.3 billion * 0.06 (interest rate) * 0.094 (median 

marginal tax savings) ~ $46.8 million per ycar3 

Table 1. - Cumulative Number of OCC-Regulated Advanced Approaches Banking 

Organizations Short of the Transition Schedule for Minimum Capital Requirements and 

E' -,shmate dR' IS k . h d A t D b -weIgl te sse s, ecem er 31 , 2011 

Dec.31, ~ Jan. I, Jan. I, Jan.l, Jan. 1, Jan. 1, 2016 2011 2014 2015 (PCA) 2017 2018 

Common Equity to Risk- O 0 0 0 I 0 Weighted Assets 

Tier I to Risk-Weighted Assets 0 0 0 0 3 

Minimum Total Capital + 0 0 0 Conservation Buffer 

Advanced Approaches 

Countercyclical Buffer 

Advanced Approaches 

Leveraoe Ratio 

3 See John R. Graham. (2000), "How Big Arc the Tax Benefits of Dcht?" Journal a/Finance, Vol. 55, No.5, pp. 

1901-1941. Graham points out that ignoring the offsetting effects of personal taxes would increase the median 

marginal taX rate to $31.5 per $100 ofinteresL 

-5-

1 

0 

Jan. I, 

2019 

3 

I 
293 


79691.208

Table 2. - OCC-Regulated Advanced Approaches Banking Organizations Cumulative 

Capital Shortfall for Scheduled Minimum Capital Requirements and Estimated Riskweighted Assets, ($ in millions) December 31, 2011 

Jan. I, Jan.l, Jan. I, 1ao.1,2016 Jan. 1, Jan. l, Jan. I, 

2013 2014 2015 (PCA) 2017 2018 2019 

Common Equity to Risk~ 0 0 0 0 Wei 'hted Assets 

Tier 1 to Risk~Weighted Assets 0 0 0 $22,175 

Minimum Total Capital-t 0 0 $2,501 $18,586 Conservation Buffer 

Advanced Approacbes 

Countercyclical Bulfer 

Advanced Approaches 0 Leverage Ratio 

Table 3. - Cumulative Number of OCC-Regulated Advanced Approaches Banking 

Organizations Short of the Transition Schedule for Minimum Capital Requiremcnts 

Includin~ Estimated Risk-wei~hted & Market Risk Assets, December 31, 2011 

Dec. 31. Jan.l, Jan. 1, Jan.1, Jan. l, Jan.l, 2016 2011 2013 2014 2015 (PCA) 2017 

Common Equity to Risk- O 0 0 0 I Weighted Assets 

Tier I to Risk-Weighted Assets 0 0 0 1 3 

Minimum Total Capital + 0 I 1 Conservation Buffer 

Advanced Approaches 

Countercvclical Buffer 

Advanced Approaches 

Lcver!l:ge Ratio 

-6-

$3,918 

Jan.l, 

2018 

2 

0 

Jan. 1, 

2019 

4 

1 
294 


79691.209

Table 4. - aCC-Regulated Advanced Approaches Banking Organizations Cumulative 

Capital Shortfall for Scheduled Minimum Capital Requirements Including Estimated 

Risk-weie:hted & Market Risk Assets, ($ in millions December 31, 2011 

Jan. I, Jan. 1, Jan. I, Jan. I, Jan. I, Jan. 1, 2016 2013 2014 2015 (PCA) 2017 2018 

Common Equity to RiskWeighted O 0 .0 $15,061 Assets 

Tier 1 to Risk-Weighted Assets 0 0 $6,689 $46,937 

Jan. I, 

2019 

Minimum Total Capital + $9,101 $17,473 $31,516 $57,430 Conservation Buffer 

Advanced Approaches $23,432 Countercyclical Buffer 

Advanced Approaches 0 Leverage Ratio 

2. Cost of Disclosure Requirements 

The proposed rule requires advanced approaches banking organizations to amend disclosures 

regarding securitizations to include the following: 

The nature of the risks inherent in a banking organization's securitized assets, 

A description of the bank's policies for monitoring changes in the credit and 

market risk of the organization's securitization exposures, 

A description of a banking organization's policy regarding the use of credit risk 

mitigation for securitization exposures, 

A list of the special purpose entities a banking organization uses to securitize 

exposures and the affiliated entities that a bank manages or advises and that invest 

in securitization exposures or the referenced SPEs, and 

A summary of the banking organization's accounting policies for securitization 

activities. 

As described in our analysis ofNPR2, we estimate that meeting all disclosure requirements will 

entail approximately 520 hours during the first year the proposed rule applies, and this will cost 

the affected institutions approximately $44,200 in the first year. We estimate that the time 

necessary to meet the disclosure requirements in subsequent years will diminish substantially, to 

roughly 25 hours per quartcr or 100 hours per year. 

Because we included these disclosure costs along with system implementation costs in our 

analysis ofNPR2, we do not include these expenses in this analysis. Thus, our overall estimate 

of the cost of the proposed rule (NPR3) is $46.8 million per year. This cost estimate reflects the 

-7-
295 


79691.210

added capital burden of institutions that will be subject to both the advanced approaches capital 

rules and the revised market risk rule. 

Regulatory Flexibility Act (RFA) Analysis 

The proposed rule (NPR3) will apply to advanced approaches banking organizations, i.e., 

banking organizations with total assets of at least $250 billion or foreign exposures of at least 

$10 billion, other banking organizations that have elected to adopt the advanced approaches, and 

banking organizations that are subsidiaries of banking organizations that must use the advanced 

approaches rules. Our size threshold for small banks for RfA purposes is $175 million in assets. 

The proposed rule will affect six small subsidiaries of advanced approaches organizations. We 

do not consider this a substantial number of small institutions, and thus we believe that the 

proposed rule will not have a significant effect on a substantial number of small entities. 

-8-
296 


79691.211

Testimony of the 

National Association of Insurance Commissioners 

Before the 

Subcommittees on Financial Institutions and Consumer Credit 

and Insurance, Housing, and Community Opportunity 

Committee on Financial Services 

United States House of Representatives 

Regarding: 

Examining the Impact of the Proposed Rules To Implement 

Basel III Capital Standards 

November 29,2012 

Kevin M. McCarty 

Commissioner, Florida Office of Insurance Regulation 

and 

President of the National Association ofInsurance Commissioners 
297 


79691.212

Introduction 

Chairman Capito, Chairman Biggert, Ranking Member Maloney, Ranking Member Gutierrez, 

and members of both Subcommittees, thank you for the opportunity to testify today. My name is 

Kevin McCarty, and I am the Commissioner of Insurance for the State of Florida. I am here as 

President ofthc National Association of Insurance Commissioners (NAIC), and I present this 

written testimony on behalf of that organization. The NAIC is the United States standard-setting 

and regulatory support organization created and governed by the chief insurance regulators from 

the 50 states, the District of Columbia, and five U.S. territories. Through the NArC, we establish 

standards and best practices, conduct peer review, and coordinate our regulatory oversight. 

NAIC members, together with the central resources of the NAIC, form the national system of 

state-based insurance regulation in the U.S. 

As financial institutions have evolved over time, many have become larger, more diverse, and 

increasingly international. More often than not, these institutions are subject to a myriad of 

regulatory requirements designed to protect consumers of different financial products. The 

challenge for policymakers and regulators alike is to ensure that these regulatory requirements, 

designed to address different products and the different types of institutions that offer them, 

provide consumers with the appropriate level of protection given the unique risks each firm faces 

while not conflicting or otherwise being unduly burdensome to the companies subject to them. 

The NArC recognizes that certain insurance groups have made business decisions to engage in 

non-insurance activities, particularly banking activities, which could subject such companies to 

consolidated holding company supervision by the Federal Reserve. Unfortunately, in applying 

such consolidated supervision, the natural tendency is to eschew nuance for a seemingly simpler 

"one size tits all" approach. It is our long-held belief and experience that the "one size fits all" 

approach to regulation does a disservice to consumers and companies alike by putting in place 

requirements that are not appropriately sized to the risks facing the institution and its customers. 

In this regard, the prospect of bank-centric regulatory rules being imposed on or impacting 

insurance legal entities that have very different business models is quite problematic, and it is 

critical that the regulatory walls around legal entity insurers that have successfully protected 

policyholders for decades not be displaced or disrupted. 

Today, I will provide the Committee with the differences between insurance and banking 

products, an overview of the current financial solvency framework and risk-based capital regime 

for U.S. insurers, discuss the NAIC's suggestions for the proposed rules relating to Basel III 

Capital Standards issued by the Federal Reserve, the Federal Deposit Insurance Corporation, and 

the Office ofthe Comptroller of the Currency, and finally address the related concept of global 

capital standards. 

1 
298 


79691.213

Differences Between Insurance and Banking Products 

Insurance products are fundamentally different from banking products. Banking products 

involve money deposited by customers and are subject to withdrawal on demand, which the bank 

is liable for at any time. Insurance policies involve up-front payment in exchange for a legal 

promise to pay benefits upon a specified loss-triggering evcnt in the future. The very nature of 

insurance significantly rcduces the potential of a run-on-the-bank scenario for property/casualty, 

health and most life insurance products. For those limited products sold by insurers that could be 

subject to some level of run risk, mitigating factors exist such as policy loan limitations, 

surrender/withdrawal penalties, and additional taxes. Additionally, insurers typically maintain a 

diverse product mix so only a portion of the company's products would be subject to the already 

reduced level of run risk. 

Importantly, insurance products unlike other financial products, do not transform short term 

liabilities into longer term assets. Insurance has shorter duration liabilities in many of the 

property/casualty and health product lines, and the assets held are similarly short term. Insurance 

has longer duration liabilities in life and annuity product lines, and these liabilities are matched 

against similarly longer term assets. This is a critical distinction from banking and other 

financial products. The reason many other financial firms suffered during the financial crisis 

was that the duration of their assets and liabilities were not matched in a way that enabled them 

to fund their liabilities when they came due. 

Insurance Regulation's Financial Solvency Framework 

Importantly, the national state-based system of insurance regulation was specifically designed to 

address the unique nature of insurance products. The system's fundamental tenet is to protect 

policyholders by ensuring the solvency of the insurer and its ability to pay insurance claims. 

Strict standards and keen financial oversight are the hallmarks of our solvency framework. Such 

regulatory oversight begins with the premise that insurance companies are different from other 

financial institutions and the products they sell are differcnt. It is for this reason that insurance 

regulators purposely avoid "one size fits all" approaches and, instead, opt for company and 

product specific analysis and examination. In this regard, while insurer capital requirements are 

important, such requirements are not a substitute for the other tools in the regulatory tool chest 

and, if imposed incorrectly, can be unnecessarily onerous to the company and ultimately harmful 

to the policyholder. 

State laws and regulations provide the structure ofthe financial solvency framework, requiring 

insurers to be licensed before selling their products or services. All U.S. insurers are subject to 

regulation in their state of domicile and in all other states where they are licensed to sell 

insurance. Such licenses are unique to the types of products that an insurer wishes to sell. 

Regulators assess the license application, which includes a review of the ownership structure, 

2 
299 


79691.214

quality and history of management, internal controls, and projected financial condition. Insurers 

who fail to comply with regulatory requirements are subject to license suspension or revocation, 

and states may exact fines for regulatory violations. 

Detailed and transparent insurer reporting and disclosure requirements are equally critical 

components of our solvency framework. Insurers are required to prepare comprehensive 

financial statements using the NAIC's Statutory Accounting Principles (SAP). SAP utilizes the 

framework established by Generally Accepted Accounting Principles (GAAp), but unlike GAAp 

which is primarily designed to provide key information to investors of public companies and 

looks at ongoing-concerns, SAP is specifically designed to assist regulators in monitoring the 

solvency of an insurer by using more of a winding up approach.l Thus, the assets, liabilities and 

surplus reported in statutory financial statements are typically much more conservative. The 

NATC's Accounting Practices and Procedures Manual includes the entire codification of SAP 

and serves as the consistent baseline accounting requirement for all states. Unlike GAAp which 

provides for consolidated financial statements for an entire holding company, the financial 

statements filed with the NAIC are prepared using SAP at the legal entity insurer level. 

Quarterly and annually, each insurer must file financial statements with the NAIC, including a 

balance sheet, an income statement, and numerous schedules and exhibits showing financial 

conditions. The NAIC serves as the central repository for this data, including running automated 

prioritization indicators and sophisticated analysis techniques enabling regulators around the 

country to have access to national-level data without the redundancy of reproducing this resource 

in every state. This centralized data and analysis capability was cited by the International 

Monetary Fund as "world-leading" in its most recent assessment of U.S. insurance regulation. 2 

Insurance regulators utilize the financial statements and other information as part of their 

continuous, intensive financial analysis to identify issues that could impact solvency. At least 

cvery quarter, regulators assess a company's reserve adequacy, leverage, liquidity, surplus, asset 

quality, investment concentration, or other trends reflected in the filings. Every 3-5 years, 

regulators engage in full scope on-site examinations. Such exams are risk-focused and are used 

as a means of validating that the insurer's systems are performing as claimed in their financial 

statements and regulatory filings. On an ongoing basis, insurance regulators assess business 

plans, material transactions, and any reputational or contagion risk posed by such transactions to 

determine whether to approve, deny, or require additional solvency protections. They analyze 

impacts of major economic and insurance events through the use of special data rcquests and 

stress testing. 

1 A detailed presentation on differences between SAP and GAAP was appended to the NAIC's October 22 Comment 

letter on proposed Federal Regulatory Capital Standards, available at: 

http:{/www.naic.org/documents/cipr testimonies 121022 baseI3.pdf. 

2 2010 International Monetary Fund Country report No. 10/126, "United States: Publication of Financial Sector 

Assessment Program Documentation Detailed Assessment of Observance of IAIS Insurance Core Principles." 

3 
300 


79691.215

As part of our solvency system's "Windows and Walls" approach to group supervision, insurers 

are required to report on any reputationai or other contagion risks posed by non-insurance 

affiliates, the "windows" into the rest orthe group. In the event ofthe insolvency of an at1iliate 

of an insurer, regulators have the authority to "ring-fence" the insurance company, thereby 

preventing the affiliate from endangering the solvency of the insurer and protecting 

policyholders. These are the "walls" in the "Windows and Walls" approach. 

Insurers are required to have a certain amount of capital and surplus to establish and continue 

operations. The NAIC risk-based capital (RBC) system3

, which is embedded in statute in all 50 

states, was created to provide a capital adequacy standard that is related to risk, raises a safety 

net for insurers, is uniform among the states, and provides regulatory authority for timely action. 

It requires an insurer to hold a minimum amount of capital based on analysis of risks on the 

insurer's balance sheet before regulatory action is triggered, but it is a regulatory tool not 

intended to be used as a target capital amount. 

The RBC system has two main components: I) the RBC formula, that establishes a hypothetical 

minimum capital level that is compared to a company's actual capital level, and 2) statutory 

authority granting successive levels of regulatory intervention power, based upon risks assessed 

in the formula compared to the insurer's capital amount. A separate RBC formula exists for each 

of the primary insurance types: Life, Property/Casualty, and Health. The formula focuses on the 

material risks that are common for the particular insurance type. For example, interest rate risk is 

included in the Life RBC formula because the risk of losses due to changes in interest rate levels 

is a material risk for many life insurance products. Investment and other asset risks, on the other 

hand, are experienced by all insurers and so are included in all three formulas. Investment risk 

includes: default of principal and/or interest for bonds and mortgage loans, default and passed 

dividends for preferred stock, decrease in fair value for common stock and real estate. Other 

asset risks included in the formulas cover credit risk and concentration risk. 

There are five outcomes to the RBC calculations, which are determined by comparing a 

company's Total Adjusted Capital to its Authorized Control Level RBC. The level of required 

RBC is calculated and reported annually. Depending on the level of reported RBC, a number of 

remedial actions, if necessary, are available as follows: (1) No action; (2) Company action level; 

(3) Regulatory action level; (4) Authorized control level; (5) Mandatory control level. 

The Proposed Federal Capital Rules 

The NAIC provided its official comments to the rules proposed by the Federal Reserve, the 

OCC, and the FDIC on October 22, 2012. While our focus in the written comment was to 

provide technical clarifications on the specific insurance related questions set forth in the 

3 A more detailed overview of the RBC system is available at: 

http://www.naic.org/documents/committees e capad RBCoverview.pdf. 

4 
301 


79691.216

proposed rules, we want to emphasize our interest in promoting an open dialogue that will help 

these agencies better understand the insurance business model and regulatory regime in order to 

develop an approach that best captures the risk involved in supervising the consolidated entities, 

while respecting the existing regulation of the insurance entity. 

We believe it is imperative that in their efforts to appropriately regulate thrift and bank holding 

companies, Federal regulators have the information necessary to craft rules appropriate to the 

risk profiles of the enterprises being regulated. We remain concerned with the bank-centric 

approach the proposed rules appear to take, and continue to emphasize that the regulatory walls 

around legal entity insurers should not be displaced or disrupted. 

To that end, we provided input on the proposed definitions of separate accounts and policy loans, 

which may be in conflict with state law and may need to be re-evaluated for risk-weighting 

purposes, respectively. We also discussed the use of RBC for managing underwriting risk, the 

requirements for surplus note reporting, and laid out the differences between SAP and GAAP 

accounting, all of which I described to you earlier. Of particular concern is the proposal's 

treatment ofRBC as a minimum capital requirement for insurers, rather than as a regulatory 

trigger for intervention. Given that insurers typically hold significantly more capital than the 

RBC trigger levels, the proposed rule suggests either a misunderstanding of insurer capital or an 

implication that capital above the minimum RBC levels is "excess" and therefore available to 

support capital deficicncies created by actions of the holding company or other affiliates. We 

would strongly object to policyholder dollars being used without insurance regulator approval to 

subsidize losses of the holding company. 

We fully recognize the need for capital transfers within groups. However, state insurance 

regulators have statutory authority, laid out above, to restrict extraordinary dividend amounts 

used to accomplish such transfers to other group entities to maintain an adequate level of capital 

and surplus in the legal entity insurer to protect policyholders - considering current and 

prospective risks. This adequate level of capital is an amount much higher than the minimum 

RBC amount. 

We further indicated to the Board that insurers typically have different liquidity needs and rely 

more on unassigned funds than other financial institutions and, therefore, have less of a need to 

issue various types of capital instruments. Finally, we provided the agencies with data regarding 

the total amount of outstanding surplus notes and the significance of that amount relative to 

industry capital and surplus. 

While the focus of the proposed rules and this hearing is the implementation of the Basel III 

capital requirements, even more important than a capital requirement, minimum or otherwise, is 

ensuring appropriate regulatory requirements for risky activities and active solvency oversight. 

Capital requirements alone cannot enhance the safety and soundness of complex financial 

institutions - they are just one tool in a bigger toolbox. For instance, the Basel III capital 

5 
302 


79691.217

requirement would not have prevented the AIG meltdown. Regulatory requirements need to be 

applied to unregulated financial risks, e.g., requiring reserves for risks written or limiting the 

ability to write derivatives for a certain threshold of covered positions. Frequent solvency 

monitoring, otf-site and on, must be performed; and risks of unregulated entities within the group 

must be a part of this monitoring. As the Federal Reserve develops its consolidated supervision 

regime for bank and thrift holding companies that are engaged in insurance activities, we 

welcome the opportunity to discuss our regulation of insurance entities as well as approaches to 

supervision that takes into account the unique nature of insurance companies and products. 

Global Capital Standard 

In addition to the regulatory changes occurring domestically, it is important to recognize that 

changes are, at the same time, occurring internationally as well. Insurance markets have evolved 

over the years to become increasingly global, interconnected, and convergent - a trend that will 

undoubtedly continue in years to come. Indeed, we recently welcomed nearly 600 of our 

regulator colleagues from across the globe to Washington, DC for the lAIS annual conference. 

At that forum and others, state regulators continue to show that we are heavily invested in the 

future of insurance globally, and the NAIC is committed to coordinating with our international 

regulator colleagues to ensure open, competitive, stable markets around the world. In this regard, 

the most important thing we can do is to promote a level playing field across the globe through 

strong regulatory systems while recognizing that there will continue to be cultural, legal, and 

operational differences in regulatory regimes around the world. Our national state-based system 

in the U.S. has a strong track record of evolving to meet the challenges posed by dynamic 

markets, and we continue to believe that well-regulated markets both here and abroad make for 

well-protected policyholders. 

With that said, I want to address the concept of a global capital standard for insurance, which has 

previously been raised at the IAIS and in the context of the Common Framework project, or 

"ComFrame." Much in the same way a bank-centric, one-size fits all approach to capital 

standards is not appropriate domestically, it is also not appropriate at the globallcvel for 

numerous reasons. 

Firstly, state regulators are concerned that an overconcentration on capital calculations can breed 

a dangerous overconfidence in the ability to measure requirements perfectly. Capital 

requirements are but one of many tools in the U.S. system, and go hand in hand with solvency, 

monitoring, enforcement, and the world-leading data collection described earlier. 

Furthermore, a single global group capital standard also runs the risk of itself creating systemic 

risk: if it is wrong or creates the wrong incentives, there is no fallback, whereas diversity of 

regulation and requirements minimize the scope of such an eventuality. Total uniformity is 

neither necessary nor prudent, especially given that most insurance products are still local, and 

6 
303 


79691.218

that there is far less ability on the part of international insurers to participate in local markets 

without meeting local regulatory requirements. 

Thirdly, the entire point of solvency capital is the protection of policyholders when things go 

wrong and local capital requirements at the insurer level arc needed - it is for this reason that the 

NAIC believes arguments about regulatory arbitrage or a level playing field miss the point. A 

capital standard is not for when things are going well- it's a backstop for when everything goes 

wrong. Unless the so called global capital standard for insurers is to be looked at on a legal 

entity basis, fungibility of capital in a crisis is likely to be a serious impediment to achieving any 

sensible global capital standard requirements. Any assessment of group capital cannot be a 

unilateral exercise; it requires the understanding of local jurisdictional capital requiremcnts, the 

assessment of intra-group transactions, the accounting framework, the nature and fungibility of 

capital, and the use of stress testing. Indeed, the existence of global capital standards in the 

banking sector did not prevent the last crisis, and overlaying such an approach on the insurance 

sector could exacerbate the next crisis. 

Conclusion 

In light of the 2008 financial crisis and subsequent developments, the insurer business model 

continues to evolve. We at the NAIC, along with our fellow financial regulators at the federal 

and global levels, must also evolve and improve the way we supervise our markets. We must 

continue our ongoing efforts to develop better structures and tools to help us anticipate risk. 

We will continue to work with and advise our federal and international colleagues as they gain a 

better understanding of existing financial standards required of insurers here in the United States 

and seek to assist them in developing a regulatory approach that appropriately captures the 

complete risk profile of an insurance enterprise, while keeping in place the walls of legal entity 

insurance regulation that protect policyholders. We look forward to sharing our expertise and 

experiences regulating insurers here in the United States, which we hope will assist our 

colleagues as they continue to implement capital and other regulatory changes here at home and 

abroad. 

Thank you again for the opportunity to be here on behalf ofthe NATC, and I look forward to 

your questions today. 

7 
304 


79691.219

November 29, 2012 

Testimony of 

Daniel T. Poston 

On behalf of the 

American Bankers Association 

before the 

Subcommittee on Financial Institutions & Consumer Credit 

and 

Subcommittee on Insurance, Housing and Community Opportunity 

of the 

Committee on Financial Services 

United States House of Representatives 

~I American 

Bankers 

Association 
305 


79691.220

November 29.2012 

Testimony of Daniel T. Poston 

On behalfofthe 

American Bankers Association 

before the 

Subcommittee on Financial Institutions & Consumer Credit 

and 

Subcommittee on Insurance, Housing and Community Opportunity 

of the 

Committee on Financial Services 

United States House of Representatives 

November 29. 2012 

Chairman Capito, Ranking Member Maloney, Chairman Biggert, Ranking Member Gutierrez, 

and members of the subcommittees, my name is Daniel T. Poston and I am the Chief Financial 

Officer of Fifth Third Bancorp, a regional bank based in Cincinnati, Ohio with retail branches in 12 

states including West Virginia and Illinois. I appreciate the opportunity to be here to represent the 

American Bankers Association (ABA) and will testify on the impact that the proposed Basel 1Il 

rules would have on the entire banking industry and on regional banks like Fifth Third. 

ABA represents banks of all sizes and charters and is the voice for the nation's $14 trillion 

banking industry and its two million employees. Fifth Third is a typical regional bank: we are a 

traditional banking organization that is domestically focused, serving our local communities by 

providing traditional banking services-primarily deposits, loans, and trust and asset management 

services. We do not have large trading or capital markets businesses. Most regional banks like ours 

are banks between $50 billion and $250 billion in assets, that are not subject to the Advanced 

Approaches framework that applies to internationally active banks or "core" banks above $250 

billion.' 

As an industry, we strongly support standards for appropriate levels of high quality bank 

capital. We also support a more risk-sensitive system of generally applicable rules, one that works 

well and applies broadly. that identifies risks where and as they are, and that treats similar risks with 

1 I would note that there are three institutions that are traditional regional banks of similar characterislcs to OUT bank and 

other regional banks but have approximately $300 billion of assets, making them subject to the Advanced Approaches. 

(\.\:) i American Bankers Association 2 
306 


79691.221

November 29, 2012 

similar capital treatment. A strong capital position enhances the ability of the banking sector to 

serve customers and promote economic growth. 

Banks have shown our commitment to increasing and strengthening the capital base in recent 

years. Even under current capital standards. capital levels are at historically high levels. In fact, 

the industry's ratio of tangible common equity to tangible assets (the TCE ratio) ended the quarter at 

9 percent, which is the strongest capital level since the Great Depression. 

Thus, the issue here is not about higher levels of capital. as it is widely recognized that more 

capital would have made the financial problems for banks less severe in the last crisis. Rather, it is 

the complex operation of the Basel I!l proposals, the volatility of capital measures, and the 

arbitrary and excessive risk weights that will hurt banks, our customers, and the U.S. economy 

overall. 

The proposals related to mortgages, for example, would lead to a significant contraction in the 

mortgage market, completely upset home equity lending, and further tighten and raise the cost of 

mortgage and home equity credit for borrowers. Some proposals specifically target many safe and 

sound mortgage products and services for harsh capital treatment, driving up costs and compelling 

banks to reduee·- or even stop - their involvement in mortgage lending. In addition, the proposals 

require a significant amount of very granular data on a mortgage-by-mortgage basis. Most banks do 

not have the required data in their systems to apply this complex mortgage treatment as the 

proposed risk attribution framework is novel. Small businesses would also suffer, as the proposed 

rules penalize second mortgages, including home equity loans and lines, which are often used to 

start-up and support credit needs of these companies. 

Changes in the treatment of capital would also have severe consequences. For example, new 

requirements for regulatory capital will lead to significant unnecessary capital volatility, which 

banks will have extreme difficulty managing. And the proposal to phase out trust preferred 

securities is not consistent with current law and would burden community banks that would not 

easily find ways to replace this capital. 

A transition period for implementation-which regulators have proposed-is not the answer to 

this problem. Implementing fundamentally flawed rules would be a mistake. Moreover, the impact 

of finalized rules would take effect almost immediately. Investors expect that banks need to meet 

phased-in capital standards early to eliminate or reduce uncertainty regarding potential future 

capital issuance. And because mortgages and home equities are typically 15-30 year assets and 

& 1 American Bankers Association 
307 


79691.222

Novembel 29, 2012 

contracts, banks cannot allow themselves to put on assets that would only escape punitive treatment 

for the first couple of years of their duration. 

There is a very real cost in holding higher and higher levels of capital. Most disruptive would 

be higher capital driven by onerous and complex risk-weighting rules that have not been 

demonstrated to be appropriate or accurate. Many banks will tlnd that the only feasible alternatives 

are to shrink operations and reduce our service to our existing and potential customers. The result 

would be fewer mortgages, fewer commercial loans and less flexibility in reasonably pricing our 

deposit and loan products to our customers. 

Rules with the power to create significant economic dislocations must be carefully considered 

and based on strong analytical research. This was not the case in this rulemaking. Therefore, we 

believe the proposed Standardized Approach should be withdrawn and an empirical study 

undertaken. This will better inform the development of an appropriate set of rules. All banks, 

large and small, would benetlt from an effective but less complex replacement for Basel!. In the 

desire to make changes, it should not be forgotten that the more complex the rules and the larger the 

change, the more likely they are to create unforeseen and detrimental consequences to our economy. 

We recognize and appreciate that banking regulators have indicated that they will carefully 

consider the many observations and comments made by the industry. It is our hope that as the 

banking agencies move forward, they will engage in close consultation with Congress and our 

industry. We look forward to working with Congress, regulators and others to address these issues, 

for the good of all. 

In the remainder of my testimony, I will concentrate on the following four key points: 

'y The proposed capital requirements would unnecessarily burden economic activity; 

'y The proposed risk weights would redirect credit in an abrupt and harmful manner; 

'y Empirical study is needed to develop capital rules that work for the U.S. banks, large 

and small; and 

'y Capital rules for all banks should be simpler and more directionally and proportionally 

aligned with risks. 

~ I American Bankers Association 4 
308 


79691.223

November 29, 2012 

I. The Proposed Capital Rules Would Unnecessarily Burden Economic 

Activity 

The industry generally supports the proposed increase in required minimum capital, although 

we have signiticant concerns with certain aspects of (he definition of capital and the operational 

aspects of the proposed Basel III capital rule. These proposed requirements would replace the 

generally applicable capital minimum requirements for all U.S. banks, based on Basel I, which have 

been in place for several decades. 

Increased capital levels are a prudent response to our experience of the past several years, and 

banking regulators. political leaders, and the public support such increases in generally applicable 

capital requirements. Increased capital requirements arc not free-capital is expensive and that 

added cost means higher cost of credit for customers. Nevertheless, we generally believe that the 

proposed minimum levels, if appropriately tailored to risk, represent a prudent balance between 

safety and soundness and impact to the economy through higher costs and pricing. 

Proposed Treatment a/Unrealized Gains Would Constrain Banks' Ability to Manage Interest 

Rate Risk and Liquidity 

While the Basel III Capital proposal is generally consistent with the international Basel III 

framework, we believc U.S. regulators should modify selected aspects of Bascl accords for U.S. 

banks. where appropriate, as they have done with previous Basel frameworks. One orthose areas is 

that unrealized gains and losses on available-for-sale securities have not been included in the U.S. 

generally applicable capital measurements. We believe-and virtually all U.S. banks large and 

small agree-that excluding unrealized gains and losses i" critical to enabling banks to 

appropriately manage their overall interest rate and liquidity risk. 

Many banks, including Fifth Third. currcntly have significant net unrealized gains which would 

actually increase their capital levels under the proposed rules. We believe that in a lypical strcssed 

cnvironment such as that experienced recently, the inclusion of unrealized gains or losses in capital 

calculations would be more likely to increase capital than decrease it. However, we expect lhat 

interest rates are likely to increase in the future. When that happens, unrealized gains would likely 

become unrealized losses and, under the proposal, would decrease capitallcvels solely due to the 

impact of the increase in inlerest rates on securities portfolios. Our recommendation on this mattcr 

~ I American Bankers Association 
309 


79691.224

November 29, 2012 

is not so much about reductions in capital but instead about banks being able to appropriately 

manage the overall risk of our portfolios, which include many assets other than investment 

securities as well as all of our liabilities. 

The industry believes that the current exclusion of such gains and losses, which was prudently 

put in place for these very reasons, should remain in place. Further, banks use these investment 

security portfolios to prudently manage both interest rate and liquidity risk, and removal of the lilter 

could seriously impact the ability of banks to prudently manage such risks. We also do not believe 

it would be sensible to institute this change in U.S. rules in advance of new liquidity rules being 

considered by regulators, which would compound the challenge of managing those rules, and we 

would ask that it be left out, at least for the time being. 

The proposed phase out of Trust Preferred Securities (TruPS) as Tier 1 capital instruments is 

inconsistent with the grandfathering Congress provided for these instruments (for institutions 

between $500 million and $15 billion in consolidated assets). These instruments were eliminated as 

Tier 1 capital for banks larger than $15 billion. The ABA supports maintaining the grand fathered 

treatment under current law. To invalidate usage now would be a very significant burden to the 

capital plans of many community banks and would force them into very expensive alternatives to 

replace what is now working quite well. Community banks face greatly reduced alternatives in 

raising capital. Many smaller banks have fewer alternatives to raise capital. With limited liquidity 

for shares and with limited options for obtaining replacement capital, smaller banks would be 

especially hard pressed to come up with suitable alternatives at a reasonable cost. These banks 

would potentially find it necessary to shrink to meet the capital requirements, thus reducing lending 

to businesses and consumers, including residential mortgages and small business loans. 

There are other aspects of the BaselllI Capital proposal which merit careful consideration and 

are included in the more than 2,000 comment letters that have been sent to the regulators. We 

believe these issues have solutions that could be resolved in relatively short order and would be 

appropriate for all banks, large and small, as is the ease under current rules. 

Most banks have strong capital positions, well above minimum requirements, for a variety of 

reasons. However, smaller banks, including especially banks organized in mutual form, have less 

immediate market access to capital and generally rely on retained earnings to add to their capital. 

Therefore, the ABA has supported a delay in the application of any Basel III Capital proposal for 

smaller banks until July 2015, approximately two years after its general application. It is in the 

~! Ame;ican Bankers Association 6 
310 


79691.225

November 29, 2012 

public interest for community banks to be successful, just as it is in the public interest for all banks 

to have strong capital appropriate to their risks. 

II. The Standardize Approach Would Redirect Credit in an Abrupt and 

Harmful Manner 

The higher capital requirements in the Basel III Capital proposal would be expected to raise the 

price of credit but should not cause a significant redirection of credit flows in the broader economy. 

The Standardized Approach NPR, in contrast, would redirect credit in what we believe would be 

fairly abrupt and yet un-quantified ways. We believe it would have a far reaching impact on all 

banks, small and large, and on their customers. 

The ABA strongly recommends that the Standardized Approach be withdrawn and that 

careful empirical studies be conducted to evaluate its allribution of ril'k and its impact to banks, 

borrower.f, and the economy. At Fifth Third, we support this approach, as do other regional banks 

like ours. This standardized risk weight framework of capital attribution was never considered or 

proposed in previous forms of standardized approaches. Banks were informed of these proposed 

risk attributions in June, and it has proven extremely difficult for them to even estimate the complex 

interactions the proposed rules would have on their risk weighted assets. Some have provided these 

estimates to the market, though without much detail, and as a result there is still no basis to actually 

estimate the impact of the Standardized Approach to the industry overall or to most of its 

participants. 

The industry provided thousands of comments to the agencies regarding this proposal. While 

all the issues of importance are too numerous to discuss, it is worth noting that, in addition to the 

problems detailed throughout this statement, ABA and its member banks are particularly concerned 

that the proposed Standardized Approach: 

y Mismatches risk among asset classes; 

y Risk weighs non-performing loans lower than some performing loans, including certain 

home equity loans and lines; 

y Causes risk weights under the rule to exceed the value of the asset. 

~ I American Bankers Association 
311 


79691.226

November 29, 2012 

The Proposed Framework Will Have Significant Negative Impacts on Mortgage Availability 

The proposed framework for risk-weighting mortgages is based upon qualitative attributes of 

loan products that create the potential for risk, without considering other key underwriting factors, 

the appropriateness of the loan for that borrower, or the credit-worthiness of the borrower. These 

factors, along with loan-to-value ratios (LTVs), were the actual dominant causes of differential loss 

experience during the crisis, as they have always been. As such, banks' management of risk is 

oriented toward those very factors. They manage risk and pricing, using L TVs, debt-to-income 

ratios, credit scores, and other measures known to provide strong prediction of credit risk. The 

product types that arc appropriate for borrowers differ, based on borrower preferences and these 

attributes. Assigning risk to product type before considering underwriting ignores the key role of 

underwriting in determining risk and product appropriateness. Previous standardized risk-weight 

proposals were much less complex and much more aligned with identified sources of risk, and we 

encourage the revisiting of those proposals. 

Key concerns outlined in industry and individual bank comment letters include the assumption 

that many traditional hybrid ARM mortgages and many mortgages with balloons or interest deferral 

periods have double the risk of other loans 2 We fully agree that some mortgages are riskier than 

others-·for example, mortgages with higher LTVs, higher debt-to-ineome, and lower FICO scores 

are generally riskier than the reverse-but we do not believe that loans with the above attributes are 

automatically risky and all of them arc certainly not twice as risky as other mortgages. 

While we believe the proposed framework for eategorizing mortgages is problematic, the effect 

of the proposal on home equity loans would be profound. This is because of the impact of home 

equities on the risk weightings for tirst mortgages, held by a lender that also made or makes a home 

equity loan to the same borrower. Home equity lines of credit have been found to have performed 

relatively well during the crisis, likely because they tended to be provided to relatively higher 

:'. Banks are very concerned about the treatment of balloon mortgages, particularly given their importance as an effective 

interest rate risk management tool. These loans also pro"ilidc a means ro balance property prices and affo:rdability, which is 

especially diffi(:ult in higher cost states like ~e\v York and Califomia. In fact, tn some areas, such as rural communities, 

balloon loans arc the only product that may be offered. Importantly, many banks can demonstrate that, when prope:rly 

underwritten, balloon (and tntercst-only) loans have a strong historical performance. lbe e"\cidence that balloons can be 

made safely makes for a very strong example against an assumed automatic high risk weighting for them. We do not believe 

that treating these loans punitively is justified unless the banking agencies are able to p:rove tbat such mortgages are risky 

despite proper under\vriting. Adjustahle rate mortgages, likewise, enable banks to hold them while protecti.'1-g against 

interest .rate risk, whlle also heing a product that is appropriate for and desired by certain consumers. 

Cli..\J lllmerican Bankers Association 
312 


79691.227

November 29,2012 

quality borrowers.' However, they often have one or more features that would cause them to be 

assigned to "Category 2" attracting double risk-weightings. (These common characteristics for 

home equity lines include floating indexed rates, interest-only periods, and / or balloon maturities.) 

The proposal requires home equity loans and [irst mortgages made by the same lender to be 

combined for purposes of evaluating the loan-to-value of both the first and second lien (despite the 

first lien having a lower LTV and having priority right to the collateral), and using the category of 

the second lien to determine that of the first (despite the senior lien not having any such 

characteristics and being fully senior to the junior lien). 

First lien mmigage loans are usually much larger than second lien loans and, therefore, this 

methodology can and will cause small home equity loans to double (or more) the risk weighting ofa 

first mortgage on the same property (because of the risk-weighted asset inflation it causes to the 

first mortgage). The effective risk weighting for such a home equity loan could easily be in the 

many hundreds of percent4 [n contrast, a junior lien provided by another lender would be risk 

weighted at its direct risk weight of 100-200 percent. We believe this disparity may make it 

impossible for banks to provide competitive home equity products at a reasonable price to their own 

customers, despite there being no difference in risk for the home equity loan based upon who 

provides itS Home equity loans and lines of credit are commonly provided to borrowers for many 

purposes, including small business investment. These purposes are important to the economy, and 

utilize part of the borrower's net worth in the form of equity they have built in their homes to 

conduct these activities. [n short, we believe this combining of first and second liens should be 

eliminated from a re-proposal, except in the cases of piggybacks, and first and second mortgages 

risk-weighted independently.6 

There are other aspeets orthe Standardized Approach for which we believe the industry has 

made constructive comments, including aspects of the treatment of early default guarantees for sold 

mortgages, "high volatility commercial real estate" (HVCRE) and securitization treatment. These 

"Donghoon Lee eL aI., Federal Reserve Dank of New York, _--lugust 2012. 

4 Because tills 1S so counter to economic reality and experience, it is also a prime example of how the Standardized 

.-\pproach would produce vcry different result<; than under the Advanccd ."\pproaches, which is based upon economic reality 

and experience. 

5 r\ lender subject to the Standardized Approach in competition with a lender not subject to it would have difficulty 

competing for certain mortgages or home equities at all. 

t; We suspect that a concern about piggyback lending ~ Issuing and funding a flrSt and second lien simultaneously to a 

customer to reduce do\1,lu-payment requirements - is the source of this aspect of the proposaL \v'e and the American 

Bankers Association (and its joint comment letter partners) have proposed insread that simultaneously funded firs! and 

second liens be the only loans that are combined for dercrmtoing the applicahle LIY for the first mortgage. 1bese 

borrowers should not be penalized to address a form of risk that can instead be addressed directly. 

& I American Bankers Association 
313 


79691.228

November 29, 2012 

have been detailed in comment letters by the ABA, a regional bank working group that includes 

Fifth Third, as well as other letters including those from individual banks. We would be happy to 

provide the subcommittees with these documents and details on these other important issues. 

III. Empirical Study is Needed to Develop Capital Rules That Work for All U.S. 

Banks 

The ABA strongly recommends that the Standardized Approach be withdrawn, and that studies 

be conducted to evaluate its attribution of risk and its potential impact on the mortgage market, the 

economy, banks and their customers. We believe an empirical study of the Standardized Approach 

would inform the better development of an appropriate set of new rules. 

We believe it is critical that any proposed changes to how banks calculate their risk weighted 

assets be directly aligned with actual risk and risk experience. A capital proposal that does not 

build on risk experience will redirect credit away from loans and borrowers even where the risk is 

appropriate for them and the lender. We believe it is not possible to create a set of rigid rules that 

fully capture the key elements of underwriting. The more complex the rules, the more likely they 

are to create unforeseen issues.' As a result. we believe an appropriate standard set ofrisk weights 

must necessarily be simpler than what has been proposed. 

As of yet, it is not possible to evaluate the competitive or customer impact of the riskweighting approaches on groups of banks or on their businesses like mortgages. Banks have only 

recently estimated (or are estimating) the impact, but that data has not been collected, aggregated, 

and then its results applied for consideration of how the "Collins Amendment" floor 8 would work or 

how capital buffers would and should be calculated. These issues should be evaluated through 

study. Just as the largest banks are concerned about competitive balance internationally, 

domestically focused U.S. banks are concerned about domestic competitive balance. The mortgage 

business is so vitally important to all banks, large and small, that ifthe mortgage activities of any of 

them are constrained through prescriptive risk-weights for certain types of risk, those constraints 

7 For example, we understand there are non-U.S. banks (not subject to the Standardized ~-\pproach) who are investigating 

opportunities to acguire (at significant di~counts) from U.S. banks mortgage or home equity loans which would receive 

punitive treatment under the rules. They would risk weight !hcse mortgages at, say, 35 percent, or perhaps even fe-securitize 

them to be carried <It an even lower risk weight. Such a development would represent the transfer oEvalue, and 

capital, from U.S. banks to non-U.S. barlks, without a commensurate reduction in nsk that wouJd jusdfy it. 

k Dodd Frank Act, Section 171 (1»(2). 

~ i American Bankers Association 10 
314 


79691.229

November 29, 2012 

should be common. A balloon mortgage or traditional ARM loan should not be more costly to 

make for a smaller bank than a larger bank. This is not only important for competitive reasons, but 

because the customers of any bank with different restrictions would also be affected differentially 

through no fault of their own. 

We believe it would be useful for banking regulators to also evaluate the work and findings 

related to the FDIC's rulemaking on high risk consumer loans, which capture important clements of 

underwriting that are not incorporated in the approach taken with this proposal 9 

IV. Capital Rules for All Banks Should Be Simpler, and Directionally and 

Proportionally Aligned with Risks 

The Basel III Capital NPR and Standardized Approach NPR are proposed to apply to all U.S. 

banks whether or not they are internationally active. This approach - that there should be a set of 

common capital rules that apply to all U.S. banks operating domestically - is consistent with the 

current approach which has applied to such banks for decades. All banks use the same definitions 

for each type of capital, are generally governed by the same U.S. capital requirements, and, for a 

given type of risk, each bank is required to hold the same amount of capital for that risk. These 

factors make it critical that such a system be appropriately designed and one that all banks can 

implement. 

Any change should represent an improvement on Basel!. A more risk-sensitive riskweighting framework would be valuable in the U.S., but if mis-calibrated it could be very 

damaging. Such a proposal should be consistent with risk, be exceptionally careful not to overascribe risk, and not be overly complex or di ffieult to implement. If risk-weightings are not truly 

correlated with actual risks, risks would shift inappropriately among banks or to and from the 

banking industry to non banks that may be less regulated and more difficult to regulate. 

Banks of all sizes, from the largest banks to community banks. have expressed remarkably 

consistent concerns with the substance of the proposals. The proposal for new risk weightings is 

overly complex and does not build on an analytical foundation from demonstrated experience, and 

we believe it would lead to market distortions that ate neither necessary nor desirable. The added 

complexity of the proposed Standardized Approach has the appearance of accuracy and 

<) This was a point made by a group of regional banks in commenting on the proposals. Assessments, Large Bank Pricing, 

77 FR 18109 (Macch 27. 2(12). 

'(\\) ! American Bankers Association 11 
315 


79691.230

November 29, 2012 

sophistication, but we bclieve the reality is far different, It would be more appropriate to emphasize 

the role of appropriatc supervisory oversight and judgment, rather than crcating highly complex 

risk-weighting frameworks that are untested and unlikely to be correct either at thc beginning or 

over time as markets change. 

The implementation of a proposal of such complexity would affect all banks, and the customers 

of all banks, significantly. The administrative and logistical burden of data collection, management, 

reporting, and compliance alone would be very high for any bank. This burden is primarily related 

to the sheer complexity ofthc operations of the proposal, rather than its inclusion of greater risk 

sensitivity. However, as burdensome as the rules would be to implement, that burden would pale in 

comparison to the impact on business activities and customer disruption for any bank to which tbey 

applied, as they tried to manage connicts where there was high attributed risk and much lower 

actual risk. 

As proposed. the rules arc overly complex and need to be simplified and aligned with risk so 

that they can work for all banks. As written, the proposed rules arc not appropriate for banks of any 

size. In fact, application of any new rules based solely on the size of the bank inevitably would lead 

to distortions that cannot be justified by the risks taken by the institution. For example, some 

observers have suggested that the proposals only apply to banks greater than $50 billion. which 

would include banks like Fifth Third. We believe there is absolutely no reason that the proposed 

rules would be appropriate only for banks of our size (or larger), in the absence of any special 

propensity shown for taking risks or holding risk concentrations. 'O Again, banks should be required 

to hold similar capital for similar risks. whether they are large or small institutions. We believe a 

replacement for Basel I that works for smaller banks would work,iust as well for larger banks, 

including regional banks. 

The appropriate way to address this is for the rules to be withdrawn, studied and, if necessary, 

re-proposed, in a simpler form more directionally and proportionally aligned with risk. We believe 

until such rules are identified and applied that would work for all banks, small and large, the current 

Basel I rules should remain in place for all banks. 

10 Banks of our size, as well as fhe largest hanks, already are subject to extensive and detailed sCnItlny of our risk, at granular 

detail, through stress~testing and other processes. In our bank's opinion, by rule, these data reporting, capital planning and 

stress testing processes are far more strenuous than will ever be reguired for smaller institutions. Furthermore, institutions 

that have $50 billion in assets are already subject to very significant "cliff effects" despite the small size of our institutions 

relatiye to the banking sector or economy. 

<l..\J I American Bankers Association 12 
316 


79691.231

November 2-9, 2012 

Summary 

In conclusion, the ABA believes the proposed Standardized Approach should be withdrawn 

until further study. The issue is not whether U.S. banks have the capital for these rules-the vast 

majority of banks already do. It is the complex way the rules would work that would be so 

damaging to all banks, the mortgage market, and most importantly our customers. Thereforc, 

careful study to cnsure consistent and workable rules for all is absolutely critical given that this 

proposal is not required under any Basel agreement or any federal legislation. 

The industry supports a more risk-sensitive system of generally applicable rules, one that works 

well and applies broadly, that identifies risks where and as they are, and that treats similar risks with 

similar capital treatment. There are nearly 7,000 banks in thc United States, the vast majority of 

which are community banks; thcrcforc any general risk-weights must work for these banks, or else 

they don't work. We believe that such an approach would be entirely appropriate for regional 

banks, like Fifth Third, and the risks they take as well. 

Banks large and small have voiced very strong and rcmarkably consistent concerns about its 

operation orthe Standardized Approach, its complexity and burdens. We urge that these concerns 

be carefully considered and we very much appreciate that the banking agencies have indicated they 

will do so. 

Lawmakcrs, banking regulators, and bank employees are all under incrediblc pressure to 

implement many changes in the way banks are rcgulated in the U.S. Replacing the generally 

applicable rules for risk-weights is a complex process, and requires that rcgulators and the industry 

communicate and work together to calibrate risk-sensitivc rules appropriately, and have the time to 

study and align them. This approach would better to ensure that resulting impacts to credit flows 

and economic activities are desirable and appropriate in hath dircction and scope. 

The ABA appreciates thc opportunity to present these views to the Subcommittees for your 

consideration. We look forward to working with you. regulators and others to address these issues, 

for the good of all. 

'(S.\) I American Bankers Association 13 
317 


79691.232

Testimony of Paul Smith, CPCU, CLU 

Senior Vice President and Chief Financial Officer 

State Farm Mutual Automobile Insurance Company 

before the 

Subcommittee on Insurance, Housing and Community Opportunity 

Subcommittee on Financial Institutions and Consumer Credit 

of the 

Financial Services Committee 

United States House of Representatives 

Joint hearing on 

Examining the Impact ofthe Proposed Rules to Implement Basel III Capital Standards 

Thursday, November 29,2012 

o 
318 


79691.233

Introduction/Summary 

Chairwomen Biggert and Capito, Ranking members Gutierrez and Maloney, and members of the 

subcommittees, thank you for providing State Farm Mutual Automobile Insurance Company 

("State Farm Mutual") the opportunity to testify this morning on the Federal Reserve Board's 

(the "Board") proposals (the "Proposals") to regulate savings and loan holding companies 

(SLHCs) engaged in the business of insurance in the same manner as bank holding companies 

(BHCs) under the Basel Framework. 

At the outset, I would like to emphasize that State Farm fully supports the fundamental goals of 

capital adequacy that underlie the proposals. However, utilizing the Basel banking-oriented 

framework for SLHCs engaged predominantly in the business of insurance (bereinafter, 

"insurance-based SLHCs"), does not satisfy these goals. 

In approaching this issue, we recognize the extraordinary responsibilities, complex issues, and 

unprecedented number of rulemakings the Board is responsible for addressing under the DoddFrank Wall Street Reform and Consumer Protection Act ("Dodd-Frank Act"). We also 

understand that, within the universe of entities the Board supervises, SLHCs such as State Fann 

Mutual comprise just a small part. Nonetheless, it does not appear that the Board gave any 

meaningful consideration to insurance-based SLHCs or to the most appropriate and effective 

alternatives to implement congressional directives. To the extent the unique needs of insurance 

companies were addressed, it was in the context of how the Board should treat an insurance 

subsidiary within a much larger banking organization. 

By failing to adequately consider issues unique to insurance-based SLHCs, the proposed bankoriented Basel framework would impose an ill-fitting and structurally flawed regulatory structure 

upon insurers, which have starkly different business models, risk exposures, and capital needs 

than banks and traditional BHCs. In addition, the regulatory mismatch creates tremendous and 

costly difficulties in the recordkeeping, accounting and reporting requirements for a number of 

insurance-based SLHCs, while offering little, if any, commensurate benefit to regulators in 

understanding the capital needs and financial state of the companies impacted. 

Indeed, far from promoting safety and soundness for insurance-based SLHCs, these bankoriented rules and requirements are counterproductive and may promote capital structures and 

practices that undermine prudential management of an insurance company. 

We submit that this is not what Congress intended or mandated in the Dodd-Frank Act. Instead 

Congress preserved state-based functional regulation of insurance and clearly indicated that 

nothing in the Act was intended to replace existing and well-functioning capital and accounting 

regimes for insurers. Unfortunately, this reality is not reflected in the proposed rules. 

Consequently, unless the Board is willing to modify the Proposals to accept existing state-based 

capital requirements for insurers in the current rule, we believe the only responsible recourse is 

for the Board to issue a new proposal for insurance-based SLHCs so these issues can be 

addressed. We further believe that if the Board ignores existing state regulation and pushes 

ahead with entirely new standards for insurers, a strong case can be made that the Proposals run 

afoul of the McCarran-Ferguson Act, which places authority on insurance matters with the states. 

1 
319 


79691.234

Background on State Farm and its Thrift 

State Farm Mutual is a state-regulated mutual insurance company established in 1922 and is the 

parent ofthe State Farm group of companies. Headquartered in Bloomington, Illinois, State 

Farm Mutual and its subsidiaries provide personal lines of insurance. We are the largest insurer 

of automobiles and homes in the United States, and although we have a substantial life insurance 

business, more than 85% of our revenucs are provided through property and casualty insurance 

activities. 

Our thrift was established in 1999 to meet our customers' needs for an efficient and convenient 

"one-stop shopping" source of products and services for the broad range of their financial 

services needs. Through ownership of the thrift, State Farm Mutual is a "grandfathered" unitary 

SLHC, as defined in Section IO(c)(9)(C) of the Home Owners' Loan Act ("HOLA"). 

Notwithstanding the benefits we and our customers derive from the thrift, it remains a small part 

of our business. More than 91% ofthe consolidated assets of the State Farm group are related to 

our insurance operations, which also generate 98% of the group's total revenues. There should 

be no confusion that State Farm Mutual is predominantly engaged in the business of insurance. 

State Farm Mutual, is both an SLHC and an Operating Insurance Company that is 

Functionally Regulated on a Consolidated Basis 

In addition to being overwhelmingly engaged in the business of insurance, it must be emphasized 

that State Farm Mutual, the holding company for the State Farm group of companies and the 

regulated SLHC, is also a regulated insurance company in its own right. It is not a shell holding 

company. It is directly regulated by the Illinois Department of Insurance (the "Illinois 

Department"). As such, all parts of the State Farm group are comprehensively regulated. For 

example, all of State Farm Mutual's subsidiaries, as assets of State Farm Mutual, are subject to 

holding company system examination by the Illinois Department. There is simply no material 

aspect of our business that is not currently subject to comprehensive prudential regulation. 

Insurance regulation entails strong rules and regulations governing solvency, operations, and 

investments. Solvency regulations are designed to ensure that all insurance companies, including 

State Farm Mutual, have the financial ability and liquidity to pay claims. Regulation and laws 

include strict risk-based capital (RBC) requirements and statutory investment limitations and 

solvency requirements. Insurers also prepare financial statements on the basis of Statutory 

Accounting Principles (SAP) that are generally more conservative than Generally Accepted 

Accounting Principles (GAAP) in the valuation of assets and liabilities. Further, while State 

Farm Mutual has little in the way of off-balance sheet exposures, statutory accounting rules 

require insurers like State Farm Mutual to disclose any off-balance sheet exposures that represent 

a material contingency. Again, these rules are specifically designed to address the particular 

risks facing insurers, which are starkly different from those facing banking institutions. 

This comprehensive supervisory framework for insurers is similar in approach to the supervisory 

system developed by bank regulators for BHCs and SLHCs that are not insurance companies; 

however, the insurance system has been designed to specifically address the business of 

insurance and the risks insurance companies face and has been highly successful. 

2 
320 


79691.235

Insurance Risk-Based Capital Requirements are Superior to the Basel Framework for 

Insurance-Based SLHCs 

A critical component of solvency regulation is the maintenance of adequate capital and reserves. 

The insurance RBC calculation is intended to assess the capital adequacy of insurers and to 

identify and assess various risks, including asset, business, and insurance risks. As with bank 

capital and leverage ratios, breaches of prescribed RBC levels trigger regulatory intervention. 

Separate RBC formulae exist for each type of insurer (i.e., life, property and casualty, and health). 

Unlike some other areas of insurance law, RBC standards exhibit a high degree of uniformity 

across state insurance regulatory systems. RBC model laws have been adopted in their standard 

form in virtually every state. 

Insurance RBC captures the risks associated with insurance operations, assets, and investments 

in a manner that is tailored to the business models and asset utilization stratcgies of insurers. For 

example, the RBC system recognizes that high-quality, long-term, investment-grade corporate 

bonds are a necessary component of an insurer's investment portfolio because the insurer must 

match longer-term, relatively stable insurance policy liabilities with long-term assets. 

Consequently, although the valuc of long-term bonds fluctuates as interest rates rise and fall, 

such volatility has limited impact on the financial condition of an insurer that holds the bonds to 

maturity because redemption of the bonds at par and other eash flows are timed to coincide with 

the insurer's payment obligations under the insurance policies. Importantly, the Proposals' bankoriented focus on asset risk and inadequate recognition of insurance and other non-asset risk is 

troubling. The Proposals do not appropriately recognize that insurance risk is necessarily 

different than banking risk and that these differences impact the capital required to prudently 

manage each type of business. 

In fact, because the calculation of capital nceds for insurers and banks is so different, there are 

scenarios where an insurance-based SLI IC could be subject to potential seizure levels under 

RBC guidelines, but would look well-capitalized under the Basel "consolidated" framework. 

Thus, if the goal ofthe Proposals is to ensure the capital adequacy and financial safety of 

regulated holding companies, the Basel framework contains gaping holes that fail the test for 

insurance-based SLHCs. 

Mandating GAAP Accounting is Costly and Counterproductive to Prudential Regulation 

For State Farm Mutual, the most significant, costly and obvious example of a regulatory 

mismatch in the proposed rules is the apparent requirement that all insurance-based SLHCs 

utilize GAAP in preparing financial statements and in the reporting of data to the Board. As a 

mutual insurance company, State Farm Mutual is not required to and does not prepare GAAP 

financial statements. Instead, it prepares its financial statements using SAP, the state-mandated 

accounting system utilized by all insurance companies in the United States. Mandating GAAP 

would take several years to implement and be extremely costly-both in terms of financial 

resources and the burden of taking management time away from business operations. Moreover, 

our use of GAAP accounting would not provide thc Board meaningful new information about the 

financial condition and capital strength of State Farm Mutual. 

To the extent GAAP reporting provides any limited new information to the Board, the benefits of 

this information would be vastly outweighed by the costs of instituting GAAP and producing 

3 
321 


79691.236

duplicative financial statements. A recent study performed on behalf of State Farm Mutual and 

its subsidiaries indicated it would require a multi-year effort - exceeding four years LO 

implement a consolidated OAAP and regulatory reporting process. The estimated costs could 

approach $150 million initially with millions of dollars to maintain it annually. Moreover, the 

effort just to implement an automated regulatory reporting process even without converting to 

OAAP was estimated to take at least 12 months. Such time, effOli and cost cannot be 

overlooked - or justified - especially when a time-tested and proven regulatory solvency 

framework is already in place for functionally regulated insurers like State Farm Mutual and no 

cogent analysis has been presented as to why such a framework falls short of congressional goals 

and directives. The bottom line is that SAP and the insurance RBC regime provide a much 

clearer and more insightful picture of the capital adequacy and financial condition of an 

enterprise where the overwhelming portion of its assets is held by an insurer(s). 

As the National Association of Mutual Insurance Companies has explained: "The use of SAP is 

codified in all states because its more conservative approach in assessing an insurance 

company's solvency and ability to pay claims, and meet its obligations is the very foundation of 

financial entity regulation." SAP has a long history of highly effective use in the insurance 

sector and is well recognized within the accounting profession as an Other Comprehensive Basis 

of Accounting and, like OAAP, allows for audited financial statements. 

Finally, the Board should not ignore that the sufficiency of SAP was clearly recognized by 

Congress as an acceptable accounting measure for insurance-based SLHCs in its consideration of 

the Dodd-Frank Act, as well as the Board's similar acceptance of reporting from foreign entities 

utilizing different accounting systems. 

The Board Should Accept its Own Staffs Determination that Bank Rules arc 

Inappropriate for Insurance 

In 2002, in connection with the creation of financial holding companies under the OrammLeach-Bliley Act, members of the Board staff coauthored a report with the National Association 

of Insurance Commissioners (the "NAIC") in which they found that significant difficulties exist 

in reconciling the capital approaches used by bank regulators and those used by insurance 

regulators, particularly given that "the two frameworks differ fundamentally in the risks they are 

designed to assess, as well as in their treatments of certain risks that might appear to be common 

to both sectors." The report stated: 

Banking and insurance industry supervisors use very different approaches for 

identifying and addressing exposure to risks and losses, and to setting regulatory 

capital charges. The divergent approaches arise from fundamental differences 

between the two industries, including the types of primary risk they manage, the 

tools they use to measure and manage those risks, and the general time horizons 

associated with exposures from their primary activities. 

The report concluded, "the effective regulatory capital requirements for assets, liabilities and 

various business risks for insurers are not the same as those for banks .... [T]he effective capital 

charges cannot be harmonized simply by changing the nominal capital charges on individual 

assets." Thus, the staff of the Board recognized at least as early as 2002 that bank-oriented 

capital rules are not appropriate for insurance companies. Not only has nothing changed since 

4 
322 


79691.237

2002 that would alter this conclusion, but the Board specifically stated in its early Dodd-Frank 

Act capital rule releases concerning SLHCs that it would "to the extent reasonable and feasible 

tak[e] into consideration the unique characteristics ofSLHCs and the requirements of HOLA." 

AIG Does Not Justify Establishing Inappropriate and Counterproductive Standards for 

Insurance-Based SLHCs 

On numerous occasions the Board's senior leadership and staff have indicated to the insurance 

industry and Congress that the Basel framework is required for insurance companies in order to 

avoid another AIG and the need for a taxpayer bailout. As a substantive regulatory matter, 

however, this is truly a non-sequitur. Top-tier insurance-based holding companies like State 

Farm Mutual are subject to state holding company statutes that impose strict oversight of affiliate 

transactions. which substantially restrict a company's ability to engage in regulatory arbitrage. 

In contrast, AlG's holding company was not a functionally regulated insurance company and the 

lack of effective supervisory oversight of holding company activities and risk management 

practices across that enterprise was central to the company's overall liquidity crisis in 2008. 

Moreover, nothing that occurred at AlG, including the difficulties experienced in its securities 

lending program, warrants or justifies imposing a regulatory regime that does not match the 

business model and economic reality of the SLHC being regulated and that could actually 

weaken the SLHC. 

The Collins Amendment Does Not Mandate Using the Basel Framework for Insurance 

Companies 

Under Section 171 of the Dodd-Frank Act, commonly known as the Collins Amendment, the 

Board is required to establish minimum leverage capital requirements and minimum risk-based 

capital requirements, each to be met on a consolidated basis by depository institutions and their 

holding companies, including SLHCs. As stated in the statute, these requirements "shall not be 

less than the generally applicable leverage [and risk-based] capital requirements" that were in 

effect for insured depository institutions as of the date of enactment of the Dodd-Frank Act (i.e., 

July 21, 2010). 

Although Section 171 requires the Board to set minimum capital requirements for depository 

institution holding companies, it does not preclude the Board from taking into account the 

existing and comprehensive RBC structure of insurance-based SLHCs in establishing these 

minimum capital requirements. Nor does anything in the Dodd-Frank Act as a whole suggest 

any such limitation. The statute does not, for example, require the Board to impose capital 

requirements based on GAAP rather than SAP (see further discussion below). Nor does Section 

171 or any other part of the Dodd-Frank Act otherwise preclude the Board from designing 

capital standards that otherwise reflect appropriately fundamental differences between insurance 

SLHCs and other types of institutions so long as those requirements meet the statutory floor. 

To the contrary, Congress recognized and preserved in the Dodd-Frank Act, in numerous ways, 

the "functional" regulation of "grandfathered" SLHCs that was an important aspect orthe 

Gramm-Leach-Bliley Act. In so doing, Congress made clear that the implementation of Section 

171 should be accomplished in a manner that accords appropriate treatment to the distinct nature 

of particular types of SLIlCs, the distinct types of products and services they offer, and the 

comprehensive regulatory environment in which they operate. Indeed, in a letter sent this past 

5 
323 


79691.238

Monday to federal banking regulators, Senator Collins of Maine expressed her view that "it was 

not Congress's intent that federal regulators supplant prudential state-based insurance regulation 

with a bank-centric capital regime." She added that recognizing the distinctions between 

banking and insurance was consistent with her amendment. 

Any Basel type regulation is not only inconsistent with evaluating insurance risks, but may, and 

likely will, produce dramatically wrong results. Inflexible adherence to a Basel I benchmark that 

is in direct conflict with economic reality should not be considered consistent with congressional 

intent in setting a floor for capital and leverage requirements. Therefore, in cases where the 

SLHC is engaged predominantly in the business of insurance and the holding company is a 

functionally regulated, operating insurer, we submit that the incorporating insurance RBC 

methodology is in fact the most reasonable interpretation of this floor and should be used for 

such purpose. Again, the issue is not about whether strong capital standards should be 

required-everyone shares that objective. The issue is about using the most appropriate and 

effective standards. 

The Collins Amendment and the McCarran-Ferguson Act 

Congress's intent regarding the application of the Collins Amendment to insurance company 

SLHCs whose subsidiaries are also engaged primarily in the business of insurance also must be 

construed against the background ofthe McCarran-Ferguson Act of 1945, in which Congress 

explicitly codified the primacy of the states in regulating the business of insurance. Specifically, 

the McCarran-Ferguson Act provides that no act of Congress, unless it "specifically relates to the 

business of insurance," shall be construed in a manner that would effectively "invalidate, impair, 

or supersede any law enacted by any State for the purpose of regulating the business of 

insurance. ~~ 

Under the Supreme Court's decisions interpreting the McCarran-Ferguson Act, it does not 

appear that the Collins Amendment specifically relates to the business of insurance. The 

business of insurance is not expressly mentioned in the provision and nothing in its legislative 

history suggests that Congress specifically contemplated insurance companies in the Amendment. 

Furthermore, state insurance laws, including state insurance RBC requirements, clearly were 

enacted for the purpose of regulating the business of insurance. Consequently, any federal rules 

that fail to take into account state insurance RBC requirements threaten to impair the solvency 

laws enacted by the States for the purposes of regulating the business of insurance. They do this 

by adversely impacting the effective functioning of the business according to the wellestablished principles and practices that insurance companies would otherwise undertake in 

accordance with State insurance law requirements. Without a clearly expressed Congressional 

directive, the proposed rules run the risk of legal challenges under the McCarran-Ferguson Act. 

The Proposals' Implications for Insurance-Based SLHCs, their Customers, and the 

Markets they Serve 

If the Board persists in insisting upon bank-oriented rules that are inappropriate for insurancebased SLHCs, it is hard to avoid the conclusion some have offered that the proposed rules are the 

latest step toward the back door elimination of the thrift charter and grandfathered unitary 

SLHCs. For many such SLHCs, the Proposals would make operating a diversified SLHC, 

particularly one in which the savings bank subsidiary is a small part of the organization, 

6 
324 


79691.239

prohibitively expensive and subjected to managing to two different capital regulatory regimes, 

including one that is fundamentally inappropriate. Indeed, even the prospect of the adoption of 

the proposcd rules has contributed to the decision of several insurance-based SLHCs to divest or 

convert their savings banks to non-depository trusts in order to avoid the expense and regulatory 

burdens potentially associated with SLHC status. 

Congress, however, specifically preservcd the thrift charter, SLHCs and in particular 

grandfathered SUICs - and functional regulation in the Dodd-Frank Act. The proposed rules 

effectively defy that Congressional determination, purportedly to achieve Congress's goals for 

capital adequacy, but apparently without consideration for how those goals can be met through 

measures wholly consistent with functional regulation. This regulation, as we have emphasized, 

relies on a comprehensive, long-standing RBC system that has served the insurance industry and 

consumers extremely well. The current proposed rules do not improve supervision over the 

financial strength of the insurance industry or the thrift industry; they detract from it. 

A New Proposed Rule is Needed for Insurance-Based SLHCs 

The simplest approach to addressing these issues and remaining faithful to Congress's objective 

to maintaining state functional regulation of insurance companies would be to incorporate statebased, capital, accounting, and reporting rules in the Proposals. However, given the lack of 

meaningful consideration for insurance-based SLHCs in the Proposals, we believe the Board 

should go back to the drawing board with respect to insurance-based SLHCs such as State Farm 

Mutual and develop a new proposed rule for public comment. 

In developing a new proposed rule, we urge the Board to consult with the Secretary ofthc 

Treasury in obtaining the advice and assistance ofthe Federal Insurance Office (the "FlO"). We 

also request the Board to work with the insurance experts on the Financial Stability Oversight 

Council (the "FSOC), the NArC, and industry members such as State Farm Mutual. We are 

confident that, in working in a collaborative manner with these insurance experts, the Board can 

develop a set of regulations that recognize and build upon the existing RBC structure in which 

insurance-based SLHCs operate. This will result in the development of a set of guidelines that 

will provide the Board with a more complete and insightful window into the capital adequacy 

and financial condition of the insurance-dominated SLHCs. 

Couclusion 

The Board's emphasis on applying bank-centric regulations to insurance companies creates a 

regulatory anomaly whereby rules intended to make holding companies financially stronger may 

compel behavior that weakens the capital strength of insurance-based SLHCs. In essence, the 

rules designed to fix problems in one industry (i.e., banking) wreak harm if applied to another 

industry. Such misplaced application is not what Congress had in mind in the Dodd-Frank Act. 

Furthermore, the Proposals appear inconsistent with the McCarran-Ferguson Act's approach to 

regulating the business of insurance. 

There are a number of alternatives the Board could apply to correct this problem, including 

modifying the Proposals to accept state-based capital requirements for insurers. Consequently, 

we strongly urge the Board to withdraw the proposed rules as applied to insurance-based SLI-ICs 

and to work together with the insurance experts within the FlO, FSOC, and other entities in the 

7 
325 


79691.240

federal government, as well as the state insurance regulators and the insurance industry to 

develop a new set of proposed rules designed specifically to achieve Congress's intent for a 

strong and competitive financial system that effectively delivers high-quality services to 

consumers within the context of functional regulation of financial institutions. 

Again, we are not seeking weak capital rules or special exemptions-just rules that make sense. 

Thank you. 

8 
326 


79691.241

Hearing before the Committee on House Financial Services 

Subcommittees on Financial Institutions and Consumer 

Credit, and Insurance, Housing and Community Opportunity 

Examining the Impact of the Proposed Rules to Implement 

Basel III Capital Standards 

November 29, 2012 

Statement of Gina Wilson 

Executive Vice President & Chief Financial Officer 

TIAA-CREF 
327 


79691.242

I. Introduction 

Chairwoman Biggert, Chairwoman Capito, Ranking Members Gutierrez and 

Maloney, Members ofthe Subcommittees, thank you for providing TIAA-CREF with the 

opportunity to testify on this very important issue before the Subcommittee on Insurance, 

Housing and Community Opporhmity, and the Subcommittee on Financial Institutions 

and Consumer Credit. 

Our testimony today will focus on the regulatory capital proposals (the 

"Proposals") issued on June 7, 2012, by the Federal Reserve Board ("FRB") in 

conjunction with the Office of the Comptroller of the Currency ("OCC',? and the Federal 

Deposit Insurance Corporation ("FDIC") (collectively the "Agencies").- These proposed 

rules arc designed to implement the capital reforms outlined in Basel III and the required 

changes to capital standards mandated by the Dodd-Frank Wall Street Reform and 

Consumer Protection Act (the "DFA"). 

II. Background 

TIAA-CREF is a leading provider of retirement services in the academic, 

research, medical and cultural fields managing retirement asscts on behalf of 3.7 million 

clients at more than 15,000 institutions nationwide. The mission ofTIAA-CREF is "to 

aid and strengthen" the institutions we serve by providing financial products that best 

meet the needs of these organizations and help their employees attain financial wellbeing. Our retirement plans offer a range of options to help individuals and institutions 

meet their retirement plan administration and savings goals as well as income and wealth 

protection needs. 

TIAA-CREF is comprised of several distinct corporate entities. Teachers 

Insurance and Annuity Association of America CTIAA"), founded in 1918, is a life 

insurance company domiciled in the State of New York operating on a non-profit basis 

with net admitted general account assets of$216.8 billion.I TIAA is a wholly-owned 

subsidiary of the TlAA Board of Overseers, a special purpose New York not-for-profit 

corporation. The College Retirement Equities Fund ("CREF") issues variable annuities 

and is an investment company registered with the Securities and Exchange Commission 

("SEC") under the Investment Company Act of 1940. TIAA-CREF also sponsors a 

family of equity and fixed-income mutual fimds. 

While we arc primarily engaged in the business of insurance, TIAA a.nd the Board 

of Overseers hold a smallthrifl institution within their structure and as a result are 

registered as a Savings and Loan Holding Company ("SLHC"). This thrift provides 

TIAA-CREF with the ability to offer our clients deposit and lending products integrated 

with our retirement, investment management and life insurance products and enhances 

our ability to help them attain lifelong financial well-being. 

1 77 F.R. 52,792 (Aug. 30,2012); 77 F.R. 52,888 (Aug. 30, 2012); 77 F.R. 52,978 (Aug. 30, 2012). 

k As of September 30, 2012. 

TIAA.-CREF Testimony: Basel III Implementation Hearing 2 
328 


79691.243

Our status as a SLHC places us under the purview of the FRB and consequently 

snbjects us to the proposed re~'Ulatory capital regime the Agencies have set forth. TIAACREF supports the ongoing financial regulatory refonn efforts and believes establishing 

a strong set of capital rules is essential to supporting a banking organization's investment 

and risk management goals. It is equally important, however, to ensure the standards 

ultimately implemented by the Agencies fully account for the diverse business models 

under which different financial services organizations operate. In our analysis of the 

Proposals through the prism of a firnl predominantly engaged in insurance, we have 

found thc Agencies have taken a decidedly bank-centric approach. Consequently, this 

approach does not account for the vast differences between insurers who hold thrifts but 

maintain the overwhelming majority of their business in insurance products ("Insurancecentric SLHCs"), and those firn1s that are primarily banking entities. 

We would like to reiterate our support for and understanding of the need for 

appropriate capital regulations for banking organizations and cmphasize that we are not 

seeking to exempt insurers from the Proposals. Nevertheless, applying· standards 

designed for bank.s to an insurer would be inappropriate and could have a number of 

negative effects for insurers, customers and the economy as a whole. TIAA-CREF as an 

organization is particularly concerned about the effects of the proposals on our ability to 

continue providing our clients witb a full menu of high quality, reasonably priccd 

financial services products. 

We have identified a number of our concerns with the Proposals and discuss them 

in detail in our commcnt letter, which is attached for your reference (see Appendix A). 

Our testimony, however, will focus on two specific items that we consider the core of our 

comments and the key to resolving most of the potential repercussions that would go 

along with imposing a bank-focused capital regime on insurance companies. 

First, we will discuss congressional intent and Section 171 of the DFA, commonly 

known as the Collins Amcndmcnt. The FRB has taken the position that the Collins 

Amendment, which requires regulators to establish risk-based capital standards for 

banking organizations, prohibits the FRB from treating insurance assets differently from 

banking assets. We believe, however, tbat the Collins Amendment does provide banking 

regulators with the necessary flexibility to account for and integrate the existing 

insurance regulatory capital regime when developing their new model. 

Second, we will outline two alternative approaches to addressing insurance 

activities that could be integrated into the proposed framework. Each approach utilizes 

the existing insurance regulatory capital standards for insurance activities. Adopting 

either of these alternatives would ensure Insurance-centric SLHCs continue to adhere to a 

robust set of capital standards tailored to the risks of their business model while also 

remaining in line with the FRB's micro and macro prudential supervisory goals of 

I We believe, in this respect, that it is imponant the Agencies conduct a thorough cost-benefit analysis to 

determine thc effects of the Proposal on insurers and other organizations thaI would be subject to the 

enhanced capital standards. 

TlAA-CREF Testimony: Basel HI Implementation Hearing 3 
329 


79691.244

improving safety and soundness of financial institutions and reducing systemic risk for 

the overall economy. 

III. Congressional Intent and the Collins Amendment 

We believe Congress clearly demonstrated throughout the DF A legislative 

process, and in the text of various provisions within DFA, its intent to allow Insurancecentric SLHCs to co'ntinue to own thrifts and offer their customers banking products and 

services. During the DFA legislative process, Congress affirmed the importance of the 

SLHC structure by maintaining the thrift charter, ensuring SLHCs would not need to 

become Bank Holding Companies ("BHCs"), and maintaining the Gramm-Leach-Bliley 

("GLB") grandfather provisions for nonbank activities of certain SLHCs and the 

qualified thrift lender ("QTL") test for SLHCs. Congress went so far as to instruct "the 

Federal Reserve [to J take into account thc regulatory accounting practices and procedures 

applicable to, and capital structure of, holding companies that are insurance companies 

(including mutuals and fratemals), or have subsidiaries that are insurance companies" in 

detemlining SLHC capital standards.:! Indeed, as demonstrated by the Volcker Rule 

insurance exemption, Congress expected insurance companies to continue to own thrifts:~ 

By taking these steps, Congress also confimled that the public is entitled to more, not 

less, competition in the banking industry. Unfortunately, the current Proposals would 

make continued ownership of thrifts by insurance organizations economically prohibitive 

and could effectively accomplish through regulation what Congress not only did not 

intend to do by statute," but what it specifically directed the FRB to avoid doing. 

The Collins Amendment requires banking regulators to establish minimum riskbased and leverage capital reqnirements on a consolidated basis for insured depository 

institutions, depository institution holding companies and nonbank financial companies 

supervised by the FRB (collectively, "Covered Companies"). However, nowhere in the 

language of the Collins Amendment is found a directive to ignore the differences 

between insurance companies and banks. Rather, the langnage only requires that the 

risk-based and leverage capital requirements applicable to covered companies shall not 

be: 

Senate Report 111-176 at footnote 161 (April 30, 201 0) - discussion of Section 616 amending HOLA to 

clarity the FRB's authority to issue capital regulations for SLHCs where the Committee specifically notes: 

It is the intent of the Committee that in issuing regulations relating to capital requirements of bank 

holding companies and savings and loan holding companies under this section, the Federal 

Reserve should take into account the regulatory accounting practices and procedures applicable to, 

and capital structure of, holding companies that are insurance companies (including mutuals 

and fraternals), or have subsidiaries that arc insurance companies. " r emphasis added], 

2 Section 6l9(d)(l)(F) of the DFA. 

" "Dodd-Frank amps insurers for banking exit," SNL Financial (July 11, 2012). 

TIAA-CREF Testimony: Basel III Implementation Hearing 4 
330 


79691.245

i. Less than the generally applicable lisk-based capital and leverage capital 

requirements, which shall serve as a floor for any capital requirements that the 

Agencies may require ("Bank Standard"); or 

ii. Quantitatively lower than the generally applicable risk-based capital and 

leverage capital requirements that were in effect for insured depository 

institutions as of the date of enactment of the OF A (,,2010 Regulations")? 

We do not belicve the Collins Amendment intended that the banking regulators 

iguore the differences between banks and insurance companies in formulating the Bank 

Standard nor for the standards applicable to other Covered Companies. Rather, we 

believe the Bank Standard outlined in Scction 171(a)(2) of the Collins Amendment, 

which sets a floor for SLHC risk-based capital standards, allows the FRB to specifically 

address insurance activities as the Proposals do for policy loans, separatc accounts, or, as 

recommended, more holistically through an insurance deduction or alternative risk asset 

calculation. The requirement of Section 171(b )(2) setting the "generally applicable riskbased capital requirements" floor does not require ail asset-by-asset testing of riskweights, but instead speaks to a "numerator" of capital, a "denominator" of risk-weighted 

assets and a ratio of the two. The Collins Amcndment does not require asset-by-asset or 

exposure-by-exposure minimum requirements, but instead calls for holistic floors. The 

second requircment that the standards not be quantitatively lower than the 2010 

Regulations can be satisfied by either following the terms ofthe 2010 Regulations or 

through a holistic quantitative analysis of equivalence, which we believe would meet the 

"not less than" language of the statute. 

The FRfl apparently does not share this view of the Collins Amendment. Instead, 

they believe the language gives them a mandate to implement a consistent set of asset 

specific risk-weights for all covered companies.!> We have expressed to the FRB, both in 

person and in our comment letter, our view that the language of the Collins Amendment 

provides adequate flexibility to interpret the statute in a way that would allow them to 

account for the differences between banking and insurance. We believe thc Agencies 

should modify the Proposals to recognize that the business of insurance has different 

economic characteristics and serves different economic purposes than thc business of 

banking and, accordingly, Insurance-centric SLHCs should be measured through capital 

standards designed to crcate appropriate incentives and standards for the bnsiness of 

insurance. 

IV. Equivalency and Calibration Alternatives 

We have developed two alternative solutions that would allow the FRB to 

implement a consolidated risk-based capital regime that utilizes the existing insurance 

I Scction 171(b)(1) of the DFA. 

£ U.S. Senate Committee on Banking, Housing and Urban Affairs, "Oversight of Base1III: Impact of 

Proposed Capital Rules," Statement of Michael S. Gibson, Director, Division of Banking Supervision and 

Regulation, Board of Governors ofthe Federal Reserve System, November 14, 2012. 

TIAA-CREF Testimony: Baselllllmp!cmcntation Hearing 5 
331 


79691.246

capital standards and still meets the requirements that these standards not be "less than" 

or "quantitatively lower than" the bank risk-based and leverage capital requirements 

referenced in the Collins Amendment. We strongly support the use of either of these 

equivalency and calibration approaches for addressing how to incorporate insurance 

activities into the risk-based capital rules for Insurance-centric SLHCs. We believe the 

existing National Association of Insurance Commissioners ("NAIC") insurance company 

risk-based capital framcwork utilizcd by insurance supervisors ("NArC RBC") accounts 

for the types of risks inherent in insurance, whereas the proposed bank-centric capital 

standards do not. NAlC RBC is a comprehensive capital regime for insnrance activities 

that should be viewed as equivalent to the Basel regime of bank risk-based capital in 

comprehensively addressing on- and off-balance sheet risk. Through calibration of 

required capital, NAIC RBC can be incorporated into a consolidated risk-based capital 

requirement for Insnrance-centric SLHCs. We believe the Agencies should strongly 

consider the two altcrnativcs to calibrating and incorporating NArC RBC into thc 

Proposals to better reflect the treatment of insurance activities. 

A. Deduction and Calibration Alternative 

The first altemative is to follow the approach agreed to in Basel II and Basel III 

and deduct both the capital and assets of insurance subsidiaries. The FRB could then 

hold these insurance subsidiaries to a prudent level of capital in excess of insnrance 

regulatory minimums with such a standard measured in terms ofNAlC RBC. This 

approach would be consistent with the "not quantitatively less than" requirement of the 

Collins Amendment, since under the 2010 Regulations, each Agency reserved the right at 

its discretion to deduct the ca~ital and assets of any subsidiary from the calculation of 

bank level risk-based capitaL- Likewise, the "not less than" test of the Collins 

Amendment would be satisfied by applying this deduction equally to both bank- and 

holding company-owned insurance company subsidiaries. The resulting standard would 

remain "on a consolidated basis" because the capital deduction would be part of the 

numerator calculation and the asset deduction would be part of the denominator 

calculation for determining a SLHC's capital ratios. Such an approach is identical to the 

treatment for other assets deducted from consolidated capital under the Proposals and still 

satisfies the "consolidated basis" standard of the Collins Amendment.l!l On a preliminary 

basis, we believe setting an NArC RBC ratio of 300% as equivalent to the wellcapitalized ratios required for banks is appropriate. 

2. Seg 12 C.F.R. Part 208 Appendix A. Section II.B.ii. (FRE Regulation H); 12 c'F.R. Part 3, Appendix A, 

Section 2(c)(7)(i) ("Deductions from total capital. The following assets are deducted from total capital: (i) 

Investments, both equity and debt, in unconsolidated banking and finance subsidiaries that are decmed to 

be capital of the subsidiary; and It]he OCC may require deduction of investments in other subsidiaries and 

associated companies, on a case-by-case basis"); 12 c'P.R Part 325, Appendix A, Section II.B.3. (FDIC 

regulations) ("FDIC may also consider deducting investments in other subsidiaries, either on a case-by-case 

basis Of, as with securities subsidiaries, based on the general characteristics or functional nature of the 

subsidiaries."). 

LQ See § __ .22 Regulatory capital adjustments and deductions generally deducting items from Tier 1 

common equity and subsection (I) treatment of assets that are deducted "A [BANK] need not include in 

risk-weighted assets any asset that is deducted from regulatory capital under this section." 77 F.R. at 

52,863 (Aug. 30,2012). 

TIAA-CREF Testimony: Basel III Implementation Hearing 6 
332 


79691.247

B. Conversion and Calibration Alternative 

The second alternative was proposed by the ACLI in its comment letter to the 

Agencies dated October 12,2012.11 Under this approach, regulators would use NArC 

RBC to calculate risk-assets to be included in the SLHC's lisk-based capital calculations. 

This approach incorporates NATC RBC into the Basel-based rules in a manner that avoids 

the misalignment of the incentives for managing insurance activities through a 

quantitative calibration of insurance capital requirements with and into the Basel 

requirements. Thus, it maintains the numerators of Tier 1 common equity, Tier I capital 

and total capital, and through a calibrated conversion process calculates risk-weighted 

assets for the denominator and the capital ratio calculations. 

Under each of these approaches, only activities conducted under an insurance 

company would be subject to NArC RBC. Any non-insurance subsidiary of a SLHC that 

is not also an insurance company would be subject to Basel capital standards. Likewise, 

the activities of the thrift subsidiary would remain subject to Basel eapital standards. In 

combination, all activities would be snbjcct to consolidated capital requirements. A noninsurance subsidiary ofa non-insurance company SLHC would be snbject to the Basel 

risk-weighting and consolidated capital requirements under these approaches. 

Additionally, the consolidated leverage ratio requirement of holding 4% Tier 1 capital to 

average total assets wonld continne to set a universal capital floor for all SLHC activities, 

including those conducted through insurance companies. 

C. Regulatory Arbitrage Concerns 

Because we recognize the FRB 's historic concerns regarding regulatory arbitrage, 

we think it is important to note neither of the approaches would allow businesses 

predominantly engaged in banking to park assets with insurance affiliates in order to 

lower their consolidated capital requirements. Either altemative conld be tailored to 

apply to organizations primarily engaged in the business of insurance and then only for 

activities ofregulated insurance companies. In addition, these approaches could include 

a provision allowing the Agencies the discretion to apply the general bank risk-weights to 

insurance company assets on a case-by-case basis in order to eounter identified cases of 

regulatory arbitrage. 

Further, we do not believe any organization not already an insurer would have an 

incentive to become primarily engaged in the insurance business in order to take 

advantage of the differing capital treatment ofindividual assets under NArC RBC and the 

Basel capital standards. Indeed, regulatory arbitrage between these two standards calIDot 

be eliminated for the financial system as a whole unless all regulated and unregulated 

financial institutions are subjectcd to a single integrated capital standard. In this regard, 

we arc concerned insurance companies not subject to FRB oversight will set the market 

price for insurance products and the additional capital and other costs imposed by FRB 

11 See APpendix AA to the ACLJ's letter. 

TIAA-CREF Testimony: Basel JJJ Implementation Hearing 7 
333 


79691.248

oversight will make insurance products offered by SLHC-affiJiated insurance companies 

non-competitive. 

V. Conclusion 

The proposed capital standards set forth by the Agencies as drafted would have a 

dctrimental effect on insurers' ability to offer affordable financial products, which would 

in turn trickle down to individuals who utilize insurance products to help them build a 

more secure financial future. The proposals also could have macroeconomic implications 

that, for example, would create disincentives for insurers to invest in asset classes that 

promote long-term economic growth such as long-term corporate bonds, project finance 

and infrastructure investments, commercial real estate loans and alternative asset classes 

such as timber. 

Strong capital standards are vital to strengthening the overall structure of the u.S. 

financial system. The existing capital regime under which insurers operate has served the 

industry well and proved extremely effective when put to tbe test during the recent 

financial crisis. We are confident the alternative proposals we have outlined would allow 

the Agencies to establish a strong capital regime that also accounts for the business of 

insurance. We hope that as they continue to analyze the comments they have received, 

regulators will find our altcrnative approaches offer a sensible way to integrate into their 

proposed capital structure an alternative designed for insurers. 

Thank you again for the opportunity to testify. Given the potential affect the 

Proposals could have on our business and our clients, we have been very active in our 

efforts to educate policy makers about our concerns and will continue to leverage all 

opportunities made available to us. We appreciate that the Subcommittees have taken an 

interest in this issue and have afforded us another venue in which to discuss our concerns. 

TIAA-CREF Testimony: Basel III Implementation Hearing 8 
334 


79691.249

Financial Services 

October 22,2012 

The Honorable Thomas J. Curry 

Comptroller 

Department of the Treasury 

Office of the Comptroller of the Currency 

250 E Street, S.W. 

Washington, DC 20219 

The Honorable Martin 1. Gruenberg 

Acting Chairman 

Federal Deposit Insurance Corporation 

550 17th Street, NW. 

Washington, DC 20551 

The Honorable Ben S. Bemankc 

Chairman 

Board of Governors ofthe Federal Reserve System 

20th Street & Constitution Ave., NW. 

Washington, DC 20551 

Re: Regulatory Capital Rules 

Dear Sirs: 

Brandon Secker 

EVP & ChiefLegal Officer 

730 Third Avenue! 5th Floor 

New York, NY 10017 

T 212 916-4750 

F 212 916-6231 

brandonbecker@tiaa-cref.org 

TIAA-CREF appreciates the opportunity to comment on the three notices of proposed 

rulemaking ("Proposals") issued on June 7, 2012, by the Board of Governors of the Federal 

Reserve System ("FRB"), the Office of the Comptroller of the Currency ("OCC"), and the Federal 

Deposit Insurance Corporation ("FDIC") (collectively, the "Agencies,,)l We believe the 

Proposals have created a devil' s dilemma for insurance-based holding companies such as 

ourselves. Because the Proposals do not effectively recognize the long-dated nature of both sides 

of an insurance company's balance sheet, the requirements of the Proposals will force insurance 

companies to carry excess capital as well as restructure their balance sheets and fundamental 

investment activities. Alternatively, they will force insurance companies (as many already have) 

to exit the banking business. Eacb of these results is detrimental to individuals, the indus1J.y and 

the economy at large. If, on one hand, all insurance company chooses to restructure its balance 

1 77 F.R. 52,792 (Aug. 30, 2012); 77 F.R. 52,888 (Aug. 30, 2012); 77 F.R. 52,978 (Aug. 30,2012). 
335 


79691.250

sheet and fundamental investment activities to meet the Proposals' standards, it will both become 

less competitive with non-bank affiliated insurance companies and may be forced to invest in a 

manner inconsistent with its long-term obligations. If, on the other hand, an insurance company 

exits banking, it will further contribute to the increasing concentration of banking activities in a 

few systemically significant firms and simultaneously deprive consumers of the choice of 

obtaining banking services from a trusted financial services organization. This dilemma is 

unnecessary. A reasonable capital rcgime, conpled with FRB oversight at the holding company 

level, can address both the prudential and systemic risk concems the Agencies intended to satisfy 

through the Proposals without creating this dilemma. We set forth below how, by incorporating 

existing insurance regnlatory requiremcnts, the Agencies can ensure adequate capital at the 

holding company level without disrupting the business of insurance and the availability of longterm credit, while preserving consumer choice. 

TIAA-CREF supports a robust and comprehensive regulatory regime for the fmancial 

services sector. Accordingly, we SUppOlt the efforts ofregulators to boost the strength of financial 

in~titutions through improving oversight and increasing safety and soundness of such 

organizations, especially considering the events that unfolded during the 2008 global financial 

crisis. The crisis tested the strength and resiliency of our financial system and the economy as a 

whole and it is our hope that the lessons learned will help ensure that when the United States 

experiences another period of extreme economic stress, the changes made to the regnlatory 

structure will ensure the financial system will be better able to withstand such adverse conditions. 

While we understand the need for reforming the current fmancial system and the important 

role the Agencies' proposed rules around capital standards play in these efforts, we have identified 

several areas within the Proposals with which we have concems. Our ovcrarching concern relates 

to the approach the Agencies have taken to applying enhanced capital standards to Savings and 

Loan Holding Companies ("SLHCs") predominantly engaged in the business of insurance 

("Insurance-centric SLHCs") and the approach to the business of insurance generally. 

The Proposals as drafted would impose a bank-centric consolidated capital regime on 

Insurance-centric SLHCs. A strong capital regime for banking organizations is vital, but it is 

equally important to ensure that the Agencies consider an organization's primary line of business 

when implementing these standards. Thc business of banking and the business of insurance have a 

common goal of helping individuals attain important financials milestones. Nevertheless, they 

each operate under distinct and separate business models that allow them to address different 

aspects of an individnal's financial needs (~, long-term vs. short-tenn financial goals). Applying 

capital standards that have been developed for banks to the entire enterprise of an organization 

primarily engaged in insurance could, in short, result in an insurer having to change the model 

under which it operates, ultimately having a significant affect on those who depend on insurance 

products for their financial security and the economy as a whole. 

We support the steps bcing taken to ensure that banking institutions are well-capitalized 

and better able to weather future economic crises. Establishing a strong capital regime that is 

consistent witl1 safety and soundness and appropriately considers risk is necessary for the 

continned success of our financial system and the overall health of our economy_ We appreciate 

Page 2 of32 
336 


79691.251

that in drafting the Proposals the Agencies took steps to consider carefully the potential affects 

these enhanced standards could have on all banking organizations and accordingly sought to 

"minimize the potential burden of these changes where consistent with applicable law and the 

agencies' goals of establishing a robust and comprehensive capital framework."" Nevertheless, as 

an insurer that would come under the new capital structure because of our SLHC status, we believe 

that there are several issues the Agencies should consider before moving forward with a final rule. 

In the scctions that follow, we will outline our concerns and highlight the important considerations 

that must be made to ensure that Insurance-centric SLHCs can continue to conduct business in a 

prudent manner, while still adhering to a robust set of standards that will ensure such organizations 

are financially healthy and well-capitalized. 

I. Background 

T1AA-CREF is a leading provider of retirement scrvices in the academic, research, medical 

and cultural fields managing retirement assets on behalf of 3.7 million clients at more than 15,000 

institutions nationwide. The mission ofTIAA-CREF is "to aid and strengthen" the institutions we 

serve by providing financial products that best meet the needs of these organizations and help their 

employees attain financial well-being. Our retirement plans offer a range of options to help 

individuals and institutions meet their retirement plan administration and savings goals as well as 

income and wealth protection needs. 

TIAA-CREF is comprised of several distinct corporate entities. Teachers Insurance and 

Annuity Association of America ('TIAA") was founded in 1918 and is a life insurance company 

domiciled in the State of New York operating on a non-profit basis with net admitted general 

account assets of S213.9 billion.l TIAA is a wholly-owned subsidiary of the TLAA Board of 

Overseers, a special purpose New York not-for-profit corporation. The College Retirement Equity 

Fund ("CREF") issues variable annuities and is an investment company registered with the 

Sccurities and Exchange Commission ("SEC") under the Investment Company Act of 1940. 

TLAA-CREF also sponsors a family of equity and fixed-income mutual funds. 

Based on their indirect ownership ofTLAA-CREF Trust Company, FSB ("TLAA-FSB"), 

TIAA and the TIAA Board of Overseers are registered as SLHCs under the Home Owners' Loan 

Act ("HOLA"). TIAA-FSB provides TIAA-CREF with the ability to offer our clients deposit and 

lending products integrated with our retirement, investment management and life insurance 

products in a manner that enhances our ability to help them attain the aforementioned goal of 

lifelong financial security. TIAA's ownership ofTIAA-FSB has made all of our activities 

potentially subject to the bank-centric consolidated capital standards outlined in the Proposals. For 

the reasons discussed below, we are concerned that, unless modified, the Proposals will restrict our 

ability to make long-term investments on behalf of our clients, will unduly reduce our 

competitiveness and will reduce the availability oflong-tenn credit for many sectors of the U.S. 

I 77 F.R. at 52,795-6 (Aug. 30, 2012). 

} As of June 30, 7012. 

Page 3 of32 
337 


79691.252

economy. Moreover, such an outcome can be avoided by incorporating appropriate standards for 

insurance activities into the Proposals. Throughout our letter, we will highlight our chief concerns 

with the Proposals and explain why it is not appropriate for the FRE to impose bank-centric capital 

standards on insurers. 

II. The business of insurance differs fundamentally from banking and this has significant 

public policy implications 

A. Fundamental differences 

As we have stated in our prior letters to the FRE and the Financial Stability Oversight 

Council ("FSOC"), the business of insurance differs fundamentally from other areas of the 

financial services sector.1 Insurance products allow consumers to transfer risk through products 

such as life insurance (the risk of dying too soon) and armuities (the risk of outliving retirement 

savings), as opposed to taldng on greater risk, as is often the case with other financial products 

such as stocks (market risk) and bonds (interest ratc risk). Retirement and life insurance products 

generally require that policyholders pay premiums in exchange for a legal promise that is often 

finally settled years in the future. In addition, insurance liabilities tend to operate independent of 

the bnsiness cycle in that they are predetermined (~ armuities, term life) or randomly dispersed 

(~, natural disasters) and thus the payout schedule is not a function of economic conditions. 

Unlike banks, insurers' stable liabilities provide them far greater freedom to choose when to sell 

assets, and they are unlikely to be forced to liquidate assets to satisfy short-term obligations in 

times of economic difficulty or market disruption, as is common among traditional banking 

entities.;; 

TIAA-CREF believes that the Proposals' failure to take into account the fundamental 

differences between insurance and banking will harm the macro-economy as well as the insurance 

industry, thereby hindering the FRE and FSOC in their efforts to promote financial stability and 

economic growth. Because the Basel capital framework focuses substantially on assets (rather 

than a more holistic approach that recognizes the value of stable liabilities or financing concerns), 

the Proposals do not consider the importance of matching duration of assets and liabilities on an 

i See TIAA-CREF Letters available at: http://www.federalreserve.gov/SECRS/2011/November/20111116/ICp· 

201114/ICP-201114.110111.88449.343583382755.1.pdf; 

http://www.federalreserve.gov/SECRS/2012/May/20120S17 /R-1438/R· 

1438.043012.107245.506832527948.1.pdf; http:! jwww.federalreserve.gov/SECRS/2011/ApriI/20110413/ICP· 

201102/ICP-201102.041111. 69324.570978081157 .1.pdf; and 

http://www.federalreserve.gov/SECRS/2011/June/20110609/0P-1416/0P1416.052311.73348.509124981535.1. pdf. 

,? 1 his strength is particularly evident in periods of market disruption or with regard to less liquid assets where 

insurance companies do not contribute to the downward pressure on asset prices created by the short-term liquidity 

needs of other types of investors. 
338 


79691.253

insurer's balance sheet. To ignore the fundamental importance of this concept is to ignore the 

most important clement of insurer risk management. 

The fundamental differences between insurance and banking have been addressed on 

mUltiple occasions by the International Association of Insurance Supervisors ("IAIS"). In its May 

3 J , 2012 consultation document which proposed a methodology to assess the systemic risk of 

insurance companies, the lArS stated, "insurers vary widely from banks in their structures and 

activities and consequently in the nature and degree of risks they pose to the global financial 

system."!! The lAlS identified several differences between insurance and banking including: (a) 

insurers nse a predominantly liability-driven investment approach; (b) insurance rests on the 

pooling of risks and probability theory; and (c) the nature of insurance claims result in cash 

outflows that are likely to occur over an extended period2 Importantly, the lArS stated insurance 

undelwriting risks generally afe "not correlated with the economic business cycle. The nature of 

insnrance liabilities, and the fact that payments to policyholders generally require the occurrence 

of an insured event, makes it ]ess likely for insurers engaged in traditional activities to snffer 

sudden cash runs that wonld drain liqnidity."~ 

For insurance companies, a key concem is solvency and the ability to pay policyholders 

over long periods. Premiums are collected in advance and invested ahcad of anticipated claims, 

insurers have relative predictability of those claims, and products have safety mechanisms such as 

surrender charges to protect against early liquidity demands.2 Unlike banks, which typically are 

funded by immediately payable deposits, insurers have longer-term liabilities and therefore find 

that longer-term assets, even those with higher short-term volatility, can often pose less risk and be 

a key component to the long-term viability and financial strength of an insurer. Corporate debt 

securities represcnt the largest component of life insurer assets, with life insurers holding 

approximately $1.7 trillion in fixed income securities at the cnd of2010 . .ill For insurance 

companies, in light of their defined liability structure, these substantial holdings of fixed income 

securities are risk-mitigating, rather than risk-enhancing. 

Insurance companies maintain significant reserves against policyholder obligations that are 

taken into account in determining equity capital. insurance companies generally do not have large 

• IAIS, §Iobally Systemic Important Insurers: Proposed Assessment Methodology, 11 (May 31, 2012) 

( www.Ialswe b.o rg/view / el em ent_ h re f.cfm?s rc~ 1/15 3 84. pdf) ("IA IS Re port"). 

z Id.8-9. 

~ Id.8-9. 

,2 In the case of TIAA, a majority of our annuity contracts only allow transfers out of the fixed annuity backed by 

TIAA's general account to other investment options over a period of several years. 

lQ ACLllnvestment Bulletin, "Invested assets portfolio profile year end 2011." (Aug. 2012) (data from NAIC annual 

statutory filings). 

Page 5 of 32 
339 


79691.254

lending portfolios and thus do not maintain significant loan loss rescrvesH Unless such 

differences are considered in calculating regulatory capital, the use of bank-centric standards will 

discourage conservativc insurance company reserving in favor of maintaining bank-centric 

regulatory capital based on a regulatory model that does not consider the Insurance-centric SLHCs 

insurance activities and risks, an outcome that would have both negative safety and soundness and 

macro-prudential conscquences. The existing National Association ofInsurance Commissioners 

("NAIC") insurance company risk-based capital framework utilized by insurance supervisors 

("NAlC RBC") accounts for these types of risks, whereas bank-centric capital standards do not. 

Bank-centric metrics will not provide regulators with the information they need regarding 

the capital and long-term solvency of Insurance-centric SLHCs. Indeed, we believe the 

application of bank-centric capital standards to the business of insurance is not relevant to either 

the FRB's macro-prudential responsibilities or its micro-prudential supervisory responsibilities for 

Insurance-centric SLHCs and will likely lead to unintended and inappropriate results. NAIC RBC 

and life insurance enterprise risk management focus on the solvency of the insurer and the 

matching of assets to liabilities over the long-term. Insurance regulators require insurers to 

conduct regular stress tests using conservative assumptions to test insurance company reserves in 

the context of insurers' long-term liabilities. Bank-centric metrics focus on short-term events and 

will not accurately reflect an insurer's solvency. More specifically, bank capital standards focus 

primarily on equity capital, not adequacy of reserves, and lending activities and related regulatory 

capital considerations. 

NArc RBC, along with other regulatory tools, has proven effective in limiting insolvencies 

and preserving financial strength, as was highlighted during the recent financial crisis. According 

to the FSOC's 2011 report,just 28 of approximately 8,000 insurers became insolvent in 2008 and 

2009.11 

B. @J)lications of differences 

Business and risk model diversification is an important element in reducing systemic risk 

and actions that increase the correlation of different companies' business and risk models will tend 

to increase systemic riskLl. By creating incentives that encourage synchronization of the banking 

11 See footnote 35 below. 

g FSOC, 2011 Annual RepQI1, 61. The FSOC 2011 Annual Report (at 58) also states that: "as the crisis has unfolded, 

370 bank and thrift failures occurred through June 30, 2011, or 4.5 percent of institutions operating at the beginning 

of 2008." During that same time 0.35% of insurers became insolvent. 

11 ThiS was seen in the period leading up to the financial criSIS as common business models relying on fisk 

management models with common assumptions regarding the mortgage and securitization markets led to overly 

aggressive pricing and lending standards and as a consequence significantly higher losses and market disruption 

during the financial crisis. See International Monetary Fund, Chapter 3, The Reform Agenda: an interim report o~ 

QIQgress toward a safer financial system. 5 (Oct. 2012) ("In a cornman pattern before and, in some cases, during the 

global crisis, banks used structured investments and proprietary trading to generate additional return (fialpha") at 

Page 6 of32 
340 


79691.255

and the insurance investment and risk management models, the Proposals will act to increase their 

correlation and will reduce systemic resiliency. At the same time, the incentives created by the 

Proposals act as a disincentive in the credit transmission mechanism, and for insurers specifically 

they crcate a disincentive to invest in a variety of asset classes that promote long-term economic 

growth such as long-term corporate bonds, project finance and infrastructure invcstments, 

commercial real estate loans and alternative asset classes such as timber. The presence of 

insurance companies traditionally has been greatest in the bond and mortgage markets. As 

demonstrated by the table and charts in Exhibit A, insurers are significant investors in thesc asset 

classes and types of investments and manage a sizable portion of all financial assets heJd by 

intermediaries in the United States. Further, economic research shows that these financial 

investments are correlated with increased economic activity and that shifts away from these 

investments will result in a rednction in credit allocation, long-term investment and economic 

growthH 

Similarly, withdrawal oflnsurance-centric SLHCs from the business of banking would 

increase systemic risk and have negative conseqnences to the economy. Over the past several 

decades, consolidation in the banking sector has been rapid with the market share of the top ten 

banking organizations (as measured by total deposits) increasing from 29.8% in2000 to 43.4% in 

2008E The financial crisis only has served to accelerate this trend with the top tcn banking 

organizations now having over a 50% market share oftotal deposits and the top five organizations 

having a more than 41 % share of total deposits.1.2 l11e insurance sector represents one of the few 

industries that can provide new competition in banking services and financial intelmediation, both 

directly and through thrift subsidiaries, and decrease systemic reliance on the five largest banking 

organizations. Such competition is one element of the Dodd-Frank Wall Street RefoIDl and 

Consumer Protection Act ("DFA")'s approach for mitigating the "too big to fail" problem 

highlighted by the financial crisisH 

the cost of a rise in UtaH-risk" - the risk of rare but catastrophic events. A realization of such risk is likely to bring 

about long-lasting bank distress." [citations omitted, emphasis added]). 

11. King, Robert G. and Ross LevineJ tlFinance Entrepreneurship and Growth, Theory and Evidence,'J Journal of 

Monetary Economics, (Sept. 1993). 

11 Adams, Robert, "Consolidation and Merger Activity in the United States Banking Industry from 2000 through 

2010," Finance and Economics Discussion Series, Division gf Research & Statistics and Monetary Affairs. Federal 

Reserve Board. 22, Table 3 (Aug. 2012). 

1§ American Banker, "Banks and Thrifts with the Most Deposits on March 31, 2012," American Banker website; and 

FDIC Quarterly Banking Profile Volume 5, No.2, 5 (2012) . 

.!l See Section 622 of DFA and the analysis in the FSOC "Study & Recommendations Regarding Concentration Limits 

on Large Financial Companies/, (Jan. 2011) 

(www. treasu ry ,gov Ii n itiatives/D ocume nts/Study%2 00n%2 OCo nee ntrati a n %2 0 Li m it5%200 n %2 0 La rge%2 OF] rms%200 

1-17-11.pdf). 
341 


79691.256

History has shown that the insurance industry does not experience the same level of 

insolvencies as the banking industry. In comparing the financial condition of the U.S. banking 

system and the U.S. insurance industry, the fundamcntal differences in their strucmre, regulation 

and investment practices help to explain why they perform differently during cyclical downtums. 

As we have discussed, banks primarily manage shOli-term liabilities, whereas insurancc companies 

primarily manage longer-term liabilities such as life policies and group annuities. This liability 

structure allows insurers to invest at fixed rates and not assume significant interest rate mismatch 

risk. This is very different from banks whose fundamental intermediation function is to collect 

short-term deposits from investors and lend these funds for a longer-term to borrowers. 

Likewise, the very structure of the U.S. banking system and its focus on lending makes it 

very difficult for any but the few largest banks to diversify their investments by sector and 

geography and thereby lessen their vulnerability to regional economic cycles. Insurance 

companies affiliated with Insurance-centric SLHCs, by contrast, are national in scope and hold far 

more geographically diversified assets in all asset classes, from commercial and residential 

mortgage loans to corporate bonds. BankE not only are less geographically diversified than 

insurers, but they also concentrate their investments in fewer and historically higher-risk 

investment classes. For instance, whereas banks concentrate their lending in highly cyclical credit 

cards, auto and short-term real estate lending, insurers invest primarily in longer-term commercial 

mortgages granted on income-producing properties that are well leased and generally have high 

loan-to-value ratios. With this income and value cushion, the property value must deteriorate 

sib'Ilificantly before the insurer would suffer a loss. This difference in lending quality between 

insurers and banks is borne out by the relatively low delinquency rate on insurance company 

commercial mortgages, as compared to the much higher rate of delinquency experienced by banks. 

In another example, whereas banks aggressively pursued lending in highly leveraged transactions, 

insurers followed more conservative investment practices. 

One important lesson insurers have learned from the widespread failures in the banking 

industry is the false security and even weakness caused by reliance on FDIC insurance of deposit 

funds, which muted the discipline and selection mechanisms of the market and burdened the public 

and the conservative, stronger banks with the task of bailing out the most aggressive failed banks. 

The consensus among insurers is that it is not healthy to rely on guaranty funds. In fact, it has 

been argued that it is the issue of "moral hazard" related to rising amounts of FDIC insurance per 

account and deregulaiing the industry that heavily contributed to the increase in risk-taking before 

the financial crisis. Thesc are lessons that the insurance industry and its regulators have 

internalized and are reflected in their traditional practices and new rulcs madc since the financial .. 18 CTlS1S.-

ll. Insurers have long been QI.Qb!Qited from advertising the existence of guaranty funds in contrast to banks being 

required to disclose their FDIC insurance on every advertisement. See N.Y. Ins Law § 7718 rNo person, including an 

insurer, agent or affiliate of an insurer and no broker shall make, publish, disseminate, circulate or place before the 

public, or cause directly or indirectly, to be made, pUblished, disseminated, circulated or placed before the public, in 

any newspaper, magazine or other publication, or in the form of a notice, circular, pamphlet, letter or poster, or over 

any radio station or television station, or in any other way, any advertisement, announcement or statement which 

uses the existence of the corporation for the purpose of sales, solicitation or inducement to purchase any form of 

insurance") in contrast to 12 C.F.R. § 328.3(c) (each insured depository institution "shall include the official 

Page 8 of32 
342 


79691.257

III. Proposed timing for SLHCs to comply with new standards is insufficient 

We share the concerns expressed by the Financial Services Roundtable, the American 

Council of Life Insurers ("ACLl") and other industry associations that the Proposals would require 

all SLHCs, regardless of size, to meet new minimum capital requirements beginning January 1, 

2013.12. Putting aside for the moment the numerous reasons why applying such metrics to 

Insurance-centric SLHCs will undennine the very results the FRD is trying to achieve, the FRB 

itself has acknowledged that certain Insurance-centric SLHCs will require a transition period to 

build a second accounting system to produce requisite financial reporting and to produce 

infonnation required to calculate the proposed ratios. The FRB's decision to reverse course now is 

an error and sbould be reconsidered. 

TIAA-CREF appreciates the flexibility the FRB and our designated Reserve Bank, tbe 

Federal Reserve Bank of Boston, have shown as they have assumed supervision for our SLHCs 

pursuant to Section 312 ofDFA. When the FRB began the process of implementing its new 

supervisory authority over SLHCs, it noted in its APlil2011 Notice of Intent that it was 

considering applying to SLHCs capital and leverage requirements applicable to bank holding 

companies ("BHCs") "to the extent reasonable andfeasible taking into consideration the unique 

characteristics of SLHCs and the requirements of HOLA.,,~Q In Supervisory Release 11-11, the 

FRB expressed the view that it would take time for the FRD to understand better SLHCs' business 

models and operations and that it would take SLHC management time "to make operational 

changes in response to tbe Federal Reserve's supervisory expectations.,,21 At the same time, the 

FRB recognized that "SLHCs have traditionally been pelTl1itted to engage in a broad range of 

I10nbanking activities that were not contemplated when the general leverage and risk-based capital 

requirements for BHCs were developed.";u Similarly, in exempting certain Insurance-centric 

SLHCs from many of the BHC reporting requirements, tbe FRS stated tbat SLHCs, particularly 

SLHCs that are insurance companies "could not develop reporting systems to comply with the 

Federal Reserve's existing reporting requirements within a reasonable period of time or withont 

inculTing inordinate expense."Il. Wbile the FRI3 also advised that it would require consolidated 

advertising statement prescribed in § 328.3(b) in all advertisements"). likewise, insurance regulators' post-crisis 

restrictions on insurers' security lending activities continue their focus on restricting the risks that insurers are 

permitted to take. See N.Y. Ins. Dept. Circular Letter No. 16 (2010). 

12 The reporting for compliance with these new capital standards would begin with the March 31, 2013 FR Y-9C 

filing. 

1.Q Notice of Intent to Apply Certain Supervisory Guidance to Savings and Loan Holding Companies, 76 F.R, 22,662, 

22,665 (Apr. 22, 2011). (emphasis added). 

II FRO Supervisory Release 11-11 (Jui. 21, 2011)(www.federalreserve.gov/bankinforegjsrletters/srll11.pdf). 

11 76 F.R. at 22,665 (Apr. 22, 2011). 

11 76 F.R. 53.133 (Aug. 25 2011). 

Page 9 of32 
343 


79691.258

reporting in the future, TIAA-CREF reasonably believed that the FRB would afford SLHCs a 

reasonable period to build the systems necessary to comply with the BHC reporting requirements. 

In the absence of guidance from the FRB to the contrary, TIAA-CREF has engaged in planning 

based on our understanding that the FRB's comments recognizing the difficulties Insurance-centric 

SLHCs would have in building the appropriate systems meant that the FRB would conform its 

implementation date to the specific effective date for SLHC capital standards set forth in the 

Collins Amendment to DFA of July 21, 2015. 

Simply put, the FRB is now asking Insurance-centric SLHCs that have not been previously 

subject to consolidated capital requirements to do the impossible. Even if an Insurance-centric 

SLHC had begun to re-engineer its operations, its compliance systems, its accounting management 

information systems ("MIS") and its basic capital structure in December 20 II ,2,1 it is unlikely that 

such work could be completed on time to meet the deadline set forth in the Proposals. 

Nevertheless, the FRB is now proposing that an insurance group that has heretofore not been 

subject to U.S. Generally Accepted Accounting Principles ("GAAP") financial reporting or 

consolidated capital requirements and for which the affiliated savings association constitutes a 

relatively small percentage of total group assets will somehow be ablc within a matter of months to 

comport with bank-centric capital requirements. In addition to never before being subject to 

consolidated capital requirements, as is the case with all SLHCs, Insurancc-centric SLHCs do not 

engage in a substantial amount of traditional banking activities and therefore have not designed 

their MIS and other compliance systems to collect and aggregate the types of information 

necessary to calculate and report regulatory capital ratios on a consolidated basis. Indeed, the 

financial reporting for BHCs never considered appropriate reporting for the business of insurance 

and thcrefore the assumptions underlying its design are inappropriate for supervising an Insurancecentric SLHC.Ii 

The Proposals do acknowledge, however, the need for time to transition to new standards, 

stating: 

[t]his NPR includes transition arrangements that aim to provide banking 

organizations sufficient time to adjust to proposed new rules and that are generally 

consistent with the transitional arrangements ofthe Basel capital framework.lQ 

Indeed, the Proposals contain numerous transition periods for banks to comply with changing 

capital and leverage ratios. Implicit in these transition periods is an understanding that the highcr 

.H Agency Information Collection Activities Regarding Savings and loan Holding Companies: Announcement of Board 

Approval Under Delegated Authority and Submission to OMB, 76 F.R. 81,933, at 81,936 (Dec. 29, 2011). 

12 For example, on the FR Y-9C report, most of a life insurer's reserves for policies in force are reported as a 

summary entry on Schedule HC-I (BHCK 8994) that is included in Schedule HC-G as "other" (BHCK 8984) which in turn 

is included in Schedule He as "other liabilities" (BHDM 2750). No granularity regarding insurance reserves is 

reported not even a breakdown between annuity and life insurance reserves, 

1£ 77 F.R. at 52,798 (Aug. 30, 2012). 

Page 10 of32 
344 


79691.259

levels of capital will require changes to existing business practices. The recognition that banks 

need time to adapt to changing requirements makes it all the more unreasonable that the FRB 

would not afford similar consideration to SLHCs, especially those that are insurance companies. 

Congress clearly has articulated its intent to afford SLHCs until 2015 to come into 

compliance with FRB capital standards. Section 171(b)(4)(D) ofDFA (part of the "Collins 

Amendment") provides that SLHCs should not be subject to consolidated minimum capital 

requirements until five years after the enactment ofDFA or July 21, 2015. The language of 

Section 1 71 (b)(4)(D) is essentially identical to the language ofDFA Section 17 I (b)(4)(E) which 

affords U.S. BHCs that are subsidiaries of foreign banking organizations and rely on the Board's 

Supervision and Regulation Letter SR 01-01 ("SR 01-01 Entities") until July 21,2015, to comply 

with the Proposals' capital requirements. The FRB offers no rationale for the disparate treatment 

between SLHCs and SR 01-01 Entities, nor does there appear to be any justification for doing so. 

Section 171(h)(4)(0) highlights Congressional recognition that because SLHCs never before have 

been subject to consolidated capital reqnirements, they require an extended period of time to bring 

themselves into compliance with the generally applicable minlmnm capital requirements 

contemplated by the Collins Amendment. The analysis is precisely the same for section 

l71(b)(4)(E), as SR 01-01 Entities are not snbject to consolidated capital requirements in the 

United States, and therefore require a similar extended transition period. Because SLHCs and SR 

01-01 Entities are similarly situated, it is unsurprising that the language of sections 171(b)(4)(D) 

and 171(h)(4)(E) are almost precisely the same. Given Congress's clear intent to provide for 

similar transition periods for both classes of institutions, it is disconcerting that the FRB arbitrarily 

has chosen to afford one class the benefit ofthe plain language ofthe Collins Amendment, but not 

the other. Moreover, there is no pressing policy reason to accelerate implementation. Indeed, 

accelerated implementation will itself create prudential implementation risks. 

A second, perhaps more important component of the timing issne are the substantive 

accounting decisions that must be made as a result of applying an entirely new reporting and 

associated capital regime Ci.&., GAAP) to insurance companies, made all the more difficnlt by the 

fact that GAAP was never designed to assess the solvency, safety and soundness of insurance 

companies. The FRB has acknowledged that some insurance companies that are SLHCs have 

never utilized GAAP to prepare their financial statements. This includes TIAA, which cnrrently 

utilizes Statutory Accounting Principles ("SAP") to prepare its financial reports. There are 

numerous differences between the two accounting systems, the most notable of which is that SAP 

focuses on insurer solvency whereas GAAP focuses on an organization's earnings. Further, we 

believe such differences are not relevant to the assessment of capital adequacy due to the 

conservative nature of SAp.ll 

There are numerous substantive accounting policy decisions associated with insurers 

implemcnting this new regime that will require analysis and will affect an insurance company's 

12 Indeed, many of the differences between SAP and GAAP involve adding intangible assets to the balance sheet 

under GAAP that are not recognized as admitted assets under SAP, particularly goodwill and deferred tax assets. 

Under the Proposals, both goodwill and the deferred tax assets not recognized under SAP are deducted from 

common equity in determining Tier 1 capital, thus adjusting GAAP capital back to what it was under SAP. 

Page 11 of32 
345 


79691.260

business and investment decisions. Given tbe number of important decisions that will have to be 

made regarding appropriate accounting treatment, it is unreasonable to believe that this transition 

could be accomplished within the proposed timeirame. This is not simply a matter of devoting 

funds and resources to meet the proposed deadline becausc, even with unlimited resources, the 

operational work associated with such a drastic change could not be prudently accomplished in the 

time afforded by the Proposals. 

IV. Alternative approaches to address capital standards for insurance activities 

We believe that the Proposals are significantly flawed when applied to Insurance-centric 

SLHCs. As discussed above, tbe business of insurance is fundamentally different than the 

business of banking. Beginning in 2002, FRB staff recognized tbe difficulties associated with 

attempting to "fit" insurers into the BHC model of capital regulation, noting in a 2002 joint report 

of FRB staff and thc NArC (,,2002 Joint Rcport") that the different capital approaches used by tbe 

regulators of insurance companies and banks reflect -the "inherent differences between the 

insurance and banking industries."Il. The different capital approaches "arise from fundamental 

differences between the two industries, including the types of risk tbey manage, the tools they use 

to measure and manage those risks, and the general time horizons associated witb exposures from 

their primary activities.,,;l2 

The appropriate capital standards to apply to insurance activities need to address the true 

risks of the business of insurance. The cxisting NArC RBC regime successfully has addressed 

these risks on an integrated basis. NArC RBC is functionally equivalent to the Basel bank capital 

regime in addressing credit risk and under DF A remains the recognized standard for regulatory 

actions regarding insurance activities.:ill Accordingly, tbe Proposals' incorporation of an insurance 

regulatory capital deduction without considering the assets that support tbe insurance business is 

especially inappropriate. The Agencies have the necessary flexibility under their statutory 

mandates to implement a more appropriate capital regime for insurance activities that docs not risk 

increasing systemic risk and recognizes the fundamental economic differences between insurance 

and banking. Indeed, such an approach would make the Proposals more consistent with the 

guidance of the recently released "Principles for the supervision of financial conglomerates" which 

state "[ s Jupervisors should apply every effort to avoid creating undue burden through duplication 

and conflicts between the sectoral standards applied at the conglomerate level."n Below we 

outline two alternatives the Agencies should consider to address tbese concerns. 

Z~ Report of the NAIC and the Federal Reserve System Joint Subgroup on Risk-based Capital and Regulatory 

Arbitrage. 1 (May 24, 2002). 

£2 2002 Joint Report. 3. 

:ill See section 313(k) of DFA continuing the primacy of state regulation of insurance companies. 

31 The Joint Forum: Basel Committee on Banking Supervision, International Organization of Securities Commissions, 

and International Association of Insurance Supervisors, Principles for the supervision of financial conglomerates, 5-6 

(Sept. 2012) (www.bis.orgjpubljjoint29.pdf). 

Page 12 of32 
346 


79691.261

1. Fundamental Differences Affect the Goals of Capital Standards 

Based on the fact that the business of insurance is fundamentally different from the 

business of banking, the goals of capital standards for insurance companies appropriately vary 

from those for banks. Insurance products serve very different consumer financial needs than those 

served by banking products. Insurance products addrcss policyholders' long-term savings and 

asset protection goals, which are profoundly different than the short-term cash investment 

objectives of bank depositors. In many cases, the insurance products into which policyholders pay 

premiums carry with them withdrawal restrictions or are non-cashable. Thus, insurance liabilities 

exhibit stability and relative illiquidity that fundamentally differentiate them from bank deposits 

and the insurance regulatory goal of consumer protection leads to a focus on long-telm solvcncy. 

Unlike bank deposits, insurance liabilities do not put the FDIC insurance fund at risk. The 

separate state-based resolution regime for insurance has been maintained under DF A.TI This statebased regime consists of industry funded guaranty funds and, as a result, prevents the federal 

government from needing to provide a backstop for policyholder obligations. Because the 

guaranty funds are funded by the industry itself and the failure of onc insurer is borne by the entire 

industry, guaranty funds create an industry-wide incentive for insurers to monitor thc effectiveness 

of the capital rules to which they are subject. This backstop often goes unnoticed and is little 

known among consumers because insurers are prohibited from publicly discussing or marketing 

these protections. Nonetheless, such protections provide a significant mitigant to the systemic risk 

posed by insurers. 

Like the prompt corrective action regulations that use bank capital ratios to trigger 

supervisory action,dd NAIC RBC, as enacted through state laws consistent with the NArc RiskBased Capital for Insurers Model Act, sets triggers for insurance supervisors to take parallel 

supervisory actions.ll The model law creates four action levels under which certain company and 

regulatory remedial actions are required if capital falls below certain specified NAIC RBC 

percentages, with progressively more severe actions required at the lower capitallevcls, up to and 

including mandatory supervisory seizure of control of an insurer. 

The four levels are Company Action Level, Regulatory Action Level, Authorized Control 

Level and MandatOlY Control Level. The actionleve!s are determined by comparing an insurer's 

total adjusted capital to its authorized control level risk-based capital. 

n See section 203(e) of DFA. 

22 Section 38 of the Federal Deposit Insurance Act (12 U.S.c. 18310); 12 C.F.R Part 325 subpart B (FDIC regulations); 

12 C.FR. Parts 6 and 165 (OCC regulations). 

H See N.Y. Ins Law §1322 implementing the model law in New York. 

Page 13 of32 
347 


79691.262

a. Company Action Level. An insurer with total adjusted capital of 150 to 200% of 

authorized control level NArC RBC triggers the Company Action Level, under which the 

insurer must submit to the insurance commissioner a comprehensive NAIC RBC plan that 

identifies the conditions that contributed to the insurer's financial condition and its 

proposals for corrective action. 

b. Regulatory Action Level. When an insurer's total adjusted capital is 100 to 150% of 

authorized control level NArC RBC, the commissioner will require submission of an NAIC 

RBC plan, and also is required to examine the insurer and issue a corrective order 

specifying required corrective actions. 

c. Authorized Control Level. If an insurer's total adjusted capital falls between 70 to 100% of 

the authorized control level NAIC RBC, the Authorized Control Level is triggered, under 

which the commissioner is authorized to place the insurer in rehahilitation or liquidation. 

d. Mandatory Control Level. Total adjusted capital of less than 70% of authorized control 

level NAIC RBC triggers the Mandatory Control Lcvel and requires the commissioner to 

place the insurer in rehabilitation or liquidation. 

Two of the primary functions of capital standards for financial institutions are: (I) to set 

triggers for supervisory action leading up to and including liquidation/resolution and (2) to protect 

consumers and applicable guaranty funds from loss. For insurance activities in the United States, 

the relevant and well functioning capital standards for insurance company resolution and 

policyholder and guaranty fund protection are those established by NAIC RBC. 

2. NAIC RBC Right for Insurance Companies 

NAIC RBC and related accounting and reserving requirements have been developed over 

time to address the risks inherent in the business of insurance. They are based on insurance 

accounting reserves. This is important since such reserves act as a deduction from Tier I capital 

and are not considered within the context of the Proposals unlike loan loss reserves ofbanks.12 

Under SAP used to calculate NArc RBC, both assets and liabilities are valued conservatively, 

resulting in a conservative measure of capital surplus as the model is designed to mitigate any 

insurance industry systemic risk by promoting individual insurance company solvency standards}§ 

2 Even when engaged in holding similar assets, insurance companies and banks may utilize different accDunting. 

For example, an insurance company under general U.S. GMP guidance of ASC 310 will carry mortgage loans held for 

investment at outstanding principal, adjusted for premium/discount (if applicable) and net of any credit charges or 

loan loss reserves. In contrast, mortgage banking entities under ASC 948, report loans held for sale at lower of cost 

or market net of a valuation allowance which is the deficit of market value to cost. 

2.§ See 2002 Joint Report. 16 {/A main focus of insurance company solvency regulation is the adequacy of technical 

provisions (reserves reported as liabilities in statutory financi"lI statements). For life and property/casualty insurance 

companies in the United States, technical provisions for unpaid policy claims are subject to minimum standards {Le., 

the reserves must be determined to be adequate to discharge inSurance policy obligations. The conservative nature 

Page 14 of32 
348 


79691.263

SAP intentionally avoids application of fair value accounting rules to most life insurance company 

assets, thereby avoiding unwarrantcd volatility in regulatory capital, while at the same time 

recognizing assets whose creditworthiness has been impaired. Such short-term volatility is 

inappropriate for life insurers who have long-term and inherently stable liability structures. Credit 

impairments that are other than temporarily impaired ("OTTI") under SAP are recognized and the 

value of previously impaired assets will remain at the reduced valuation basisE 

NArc RBC provides a comprehensive approach to measure supervisory capital [or 

insurance activities. NAIC RBC for life jnsurance companies is calculated using a formula that 

addresses five key risk components: 

C-O (insurance affiliates and off-balance-sheet items) 

C-l (asset risk) 

C-2 (insurance risk) 

C-3 (interest rate/market risk) 

C-4 (business risk) 

Ofthese five, asset-related risks are encompassed in the C-O, C-l and C-3 categories, 

which measure risks arising from the assets held by the insurance company and its affiliates, 

including interest rate and market risks associated with the assets held by the insurer and its 

affiliates.ll These three components represent in aggregate approximately 75% of the capital 

charges (pre-covariance adjustments) under the NArc formula based on 2003 through 2009 

aggregate ljfe insurance industry data.J2 

Statistics on the low levels of insurance company failures validate the success of the NAIC 

RBC approach through and after the recent financial crisis, which is in marked contrast to a higher 

level of bank failures and the associated high cost to the FDIC insurance fund and the overall 

affects on the economy during the same period.±!! 

of the margin in technical provisions relative to liability amounts based on best estimate assumptions for life insurers 

decreases the need for capital to absorb unanticipated losses."). 

II SSAP 37 and INT 06-07. 

2!! These components of the NAlC RBC framework specifically address asset-specific risks and are analogous to the 

risk-weights assigned under the Basel capital rules for banks. 

~ Exhibit B provides aggregate life insurance industry data for these years and updates the information contained in 

Exhibit A-2 to the 2002 Joint Report. 

!'!Q See footnote 12. It is important to note that significant Federal intervention was required to prevent the failure of 

additional banking organizations including seyeral of the largest BHes during the financial crisis. Only three 

insurance enterprises participated in the Capital Assistance Program under TARP, in contrast to 705 banking 

institutions. (source: TARP website) 

Page 15 of32 
349 


79691.264

The NAlC regularly updates and refines its RBC formula to reflect new products and risks 

faced by insurers. NAlC RBC asset charges were developed from historical actual loss experience 

over mUltiple economic cycles. The NATC (including its various committees) has frequent 

periodic meetings at which insurance regulators discuss, recommend and adopt changes to the 

NArC RBC formula. Leveraging NAIC RBC is a straightforward way for the Agencies to avoid 

insurers having to manage their businesses under two different capital paradigms, each of which 

defines its objectives based on industry specific risks, structures and regulatory requirements. 

3. Compatibility and Alignment 

There exists significant compatibility and alignment between NArC RBC and the Basel 

capital frameworks that should be huilt upon to create appropriate capital standards for insurancecentric enterprises. 

a. Comparable comprehensive regimes. 

Both NArC RBC and the Basel capital standards establish comprehensive capital standards 

for the activities they seek to cover. The Basel standards are nuanced to impose more complex 

standards on banks that engage in more complex activities and this approach is reflected in the 

Proposals' application ofthe advanced approaches requirements to only organizations with over 

$250 billion in assets or over $10 billion in foreign exposure. Likewise, SAP and NAIC RBC 

employ reserving methodologies and capital considerations commensurate with the underlying 

complexity of a company's insurance products and with the goal of policyholder protection. As 

discussed above, it is inappropriate to establish the scope of coverage of a capital regime without 

understanding and taking into account the manner in which liabilities are calculated. SAP requires 

insurance companies to use conservative actuarial calculations to determine the sufficiency of 

reserves based on stochastic modeling techniques. Deposits and many other liabilities of banks are 

accounted for at their contractual value, unlike actuarial reserves, which are conservatively 

modeled for adverse deviation. The Basel bank capital regime focuses heavily on assetJcredit risk, 

whereas NArC RBC considers both asset and liability risks, and their interactions. 

b. Both regimes used as standard for supervisory intervention. 

Just as the Basel bank capital standards are used for the bank prompt corrective action 

triggers, NArC RBC, through state laws consistent with the NArC RBC model law, set triggers 

that grant automatic authority to the state insurance regulator to take specific actions against 

insurers based on their levels of capital impairment 

c. Misplaced arbitrage concerns. 

In the context of an insurance-centric organization, the concern that recognizing differing 

capital requirements for banking and insurance activities would create regulatory arbitrage 

opportunities is misplaced. Working in combination, the Basel bank capital standards and NArC 

RBC create proper incentives for an organization to book assets in the appropriate legal entity 

based on their differing liability structures with long-term asscts held by the insurance company 

Page 16 of32 
350 


79691.265

and short-term assets held by its depository institution affiliate. Without recognizing NATC RBC, 

an Insurance-centric SLHC would be disadvantaged versus its non-SLHC insurance company 

competitors in purchasing appropriate long-term assets to fund its long-term obligations. Indeed, 

the FRB would be creating differing capital management incentives for FRB regulated SLHC 

insurance organizations and non-SLHC insurance companies that will lead to market distortions 

and economically inefficient regulatory-driven transactions. l1u'ough its supervision program, the 

FRB also has transparency into any SLHC that seeks to engage systematically in regulatory 

arbitrage and has various supervisory tools that can be utilized to address this risk should it arise. 

4. Consequences of Misapplied Standards 

a. Capital stilndards intended to create incentives. 

Regulatory capital regimes are intended to create incentives to operate financial institutions 

in a prudent manner, but different incentives are appropriate for insurance companies and banks. 

The NAIC RBC regime encourages the matching of cash flows, and in general seeks to have longterm insurance liabilities balanced by holdings oflong-tcrrn low credit risk assets. The Basel 

capital regime focuses on minimizing the costs of a rapid liquidation of banking organizations 

during a period of economic crisis in order to protect depositors and governmental guaranty funds. 

Thus, the Basel regime as implemented in the United States assumes all liabilities are immediately 

dne and payable, and generally assesses relatively higher capital charges against obligations of 

private sector non-bank obligors regardless of quality or maturity.ll The Basel regime, as 

implemented by the Proposals, encourages the holding of short-term government and agency 

secnrities (0% risk-weight), funding of the interbank credit market (20% risk-weight) and 

discourages the holding of long-term corporate obligations (J 00% risk-weight) and commercial 

mortgages (100 -150% risk-weight). Similarly, the Basel regime recognizes the value of bank 

and governmental guarantees by lowering the risk-weight of guaranteed assets (a 100% riskweighted asset becomes a 20% risk-weighted asset), but fails to provide comparable treatment to 

insurance company guaranteeslinsurance contracts which are treated as having no value (a 100% 

risk-weighted asset remains a 100% risk-weighted asset even though guaranteed by an insurance 

cDmpany). Given its focus on banks' inherently short-term financing activities, it is not surprising 

that the Basel regime encourages unsecured consumer and small business lending, which tend to 

be floating rate and short-term, yet with historically higher related default rates and credit losses 

relative to high quality corporate lending/debt.oL< Indeed, the inclnsion ofloan loss reserves in Tier 

II Basel II and Basel III give national regulators the ability to recognize lower risk-weights for highly rated corporate 

obligators including insurance companies, however, the Agencies have chosen not to recognize this higher level of 

risk granularity. i.~ Basel Committee on Supervision, International Convergence of Capital Measurement and 

Capital Standards. at paragraph 66 (June 2006) ("Basel II Revised Framework") . 

.4l See Charge Off and Dellnquency Rates on Loans and Leases at Commercial Banks, Board of Governors of the 

Federal Reserve System. (www.federalreserve.gav/releases/chargeaff/chgallsa.htm) (last updated Sept. 5,2012). 

Page 17 of32 
351 


79691.266

2 capital to an extent rewards higher risk lending and its related required reserving as long as the 

organization's reserves in aggregate do not exceed 1.25% oftotal risk assets.1l 

b. Wrong for insurance. wrong for the economy. 

Bank standards wonld force insurcrs to change their behavior in ways that hurt their 

profitability, reduce consumer choice and negatively impact the availability of long-term credit.41 

The Basel standards would encourage investment in illiquid subordinated loans over publiclytraded senior debt securities because there is no recognition of relative risk. Yet under GAAP, 

only the senior debt would be recorded at fair valne with unrealized loses affecting capital. 

Similarly, to avoid the unwarranted volatility of mark-to-market adjustments, insurers will be 

encouraged to invest in short-tenn securities~, T-bills); even though longer-term fixed income 

investments typically are a better economic match for longer-term liabilities. As a result, the 

Proposals would tend to increase insurers' exposure to interest rate risk - a mismatch of long-term 

liabilities with short-term a~sets. 

These incentives to avoid long-term and non-governmental exposures will tend to place 

insurance guaranty funds and policyholders at risk, without a conesponding supervisory benefit. 

Policyholders are contracting with an insurer for long-term savings and/or asset protection and are 

specifically seeking to benefit from an insurer's ability to invest with a longer time horizon and 

thereby attain higher relative yield, or in the case of asset protection products, lower cost. By 

discouraging long-term investments, the Proposals ultimately would increase consumcrs' costs and 

reduce their returns. Application of the Basel capital regime to the business of insurance is likely 

to lead to increascd macro-prudcntial risk and potentially significant harm to both consumers and 

the economy. 

Assigning a 100% risk-weight to all corporate bonds may be an appropriate simplification 

for banks that typically hold relatively few corporate bonds. For insurers, however, the 100% riskweight significantly overstates the probability of loss on these assets. Moreover, insurers' 

cOJporate bond holdings (primarily investment grade) are often among their largest holdings 

§. Measuring this limitation against totdl risk-weighted assets rather than total loans creates the opportunity for 

higher risk lending with commensurate higher reserving to inflate Tier 2 capital for banks with a significant 

proportion of risk assets generated from non~lending activities. 

1.1 We are already seeing how the conflicting goals of NAIC ReB and the Basel bank capital rules will change our 

investment process. The Proposals will add not just a new h:~verage constraint and associated 4% minimum capita! 

charge into our asset allocation modeling process, but also a bank-centric second risk-based capital constraint. This 

layering of conflicting constraints will change our investment decisions in a manner that reduces our participants' 

returns, increases risk (particularly increasing the interest rate gap) and reduces long-term investments in the u.s. 

economy. The regulatory capital charge associated with making an investment is a key factor considered by our 

investment managers in determining whether to make an investment and under the Proposals this charge is 

fundamentally changed and consequently their behavior wi!! change. 

Page 18 of32 
352 


79691.267

precisely because of insurers' ability to match the cash flows from these assets to their long-term 

liabilities. 

5. Equivalency and Calibration Solution 

We believe that the Agencies should modifY the Proposals to recognize that the business of 

insurance has different economic characteristics and serves different economic purposes than the 

business of banking and, accordingly, should be measured through capital standards designed to 

create appropriate incentivcs and standards for the business of insurance. We strongly support the 

use of an equivalency and calibration approach for calculating insurance related risk assets of 

Insurance-centric SLHCs. We believe that the NArc RBC should be viewed as equivalent to the 

Basel regime of bank risk-based capital in comprehensively addressing on and off-balance sheet 

risk and that through calibration of required capital can be incorporated into a consolidated riskbased capital requirement for Insurance-centric SLHCs. As discussed below, we believc that the 

Collins Amendment and the Agencies' June 28, 201 I final rules implementing the risk-based 

capital floor (".Tune 20 II Rulemaking")'!2 provide the Agencies with adequate authority to 

incorporate NAIC RBC into the SLHC capital adequacy framework. Further, such an approach 

(i.e., to in effcct recognize an "insurance book" in addition to the trading and banking books) is 

entirely consistent with the Basel II and II! framework.±f>. 

a. Holistic approach. 

We believe the definition of generally applicable risk-based capital requirements ofDF A 

Section 171 (a)(2), which sets a floor for SLHC risk-based capital standards, requires the FRB to 

determine holistically that the capital, risk-weighted assets and required capital ratios are not less 

than under the risk-based capital standards applicable to depository institutions. The requirement 

ofDFA Section 171(b)(2) setting the "generally applicahle risk-based capital requirements" floor 

does not require an asset-by-asset testing of risk-weights, but instead speaks to a "numerator" of 

capital, a "denominator" of risk-weighted assets and a ratio of the two. The Collins Amendment 

does not require asset-by-asset nor exposure-by-exposure minimum requirements, but instead calls 

for holistic floors. 

b. Precedent for holistic Collins determination. 

Under the June 2011 Rulemaking, the Agencies stated that they "anticipate performing a 

quantitative analysis of any new capital framework developed in the future for purposes of 

ensnring that future changes to the agencies' capital requircments result in minimum capital 

requirements that are not "quantitatively lower" than "generally applicable" capital requirements 

for insured depository institutions in effect as oftbc date ofcnactment oftbe Act." Since the 

~ 76 F.R. 37,520 (June 28, 2011). 

<l.§ See paragraphs 30, 33 and 34 olthe 8aselll Revised Framework. Under 8aselll, assets and liabilities of insurance 

subsidiaries are deducted and an adjustment to bank capital may be made to reflect the surplus capital in the 

insurance subsidiary (Q.k, the capital in excess of insurance regulatory requirements that is available to be 

transferred to the parent company) with this residual capita! risk-weighted as an equity investment. 

Page 19 of32 
353 


79691.268

Agencies have proposed several reductions in risk-weights for particular assets or off-balance 

sheet items under the Proposals ~, lowering the risk-weight assigned to certain residential 

mortgages from 50% to 35% and creating incentives for swaps cleared through clearinghouses), 

the Agencies presumably already have performed or intend to pelform such holistic quantitative 

analysis and could use such an approach to analyze incorporating NAIC RBC into the Basel 

framework. 

c. Equivalency of scope and coverage. 

The facts demonstrate that the NAIC RBC is a comprehensive capital regime for insurance 

activities and in its components of regulatory capital, assigning risk-weights to assets and 

activities, addressing credit risk, and requiring maintenance of a ratio of capital to asset charges is 

equivalent in scope and coverage to the Basel requirements. 

d. Two alternative approaches to calibration and incorooration ofNAlC-RBC 

into the Proposals. 

We believe the Agencies should strongly consider two alternatives to the Proposals' 

trcatment of insurance activities. 

1. Deduction and Calibration Alternative. The first is to follow the approach 

agreed to in Baselll and Basel III and deduct both the capital and assets of insurance subsidiaries. 

The FRB could then hold thcse insurance subsidiaries to a prudent level of capital in excess of 

insurance regulatory minimums with such a standard measured in terms of NAIC RBC. This 

approach would be consistent with the "not qualitatively less than" requirement of the Collins 

Amendment since under the Agencies' risk-based capital standards in effect on July 21,2010, each 

Agency reserved the right at its discretion to deduct the capital and assets of any subsidiary from 

the calculation of bank level risk-based capital.:l1 Likewise, the "not less than" test of the Collins 

Amendment would be satisfied by applying this deduction equally to both bank- and holding 

company-owned insurance company subsidiaries. The resulting standard would remain "on a 

consolidated basis" sincc the capital deduction would be part of the numerator calculation and the 

asset deduction would be part of the denominator calculation for determining a SLHC's capital 

ratios. Such an approach is identical to the treatment for other assets that are deducted from 

consolidated capital under the Proposals and still satisfy the "consolidated basis" standard of the 

Q See 12 C.F.R. Part 208 Appendix A, Section II.B.ii. (FRB Regulation H); 12 C.F,R. Part 3, Appendix A, Section 2(c)(7)(i) 

("Deductions from total capital. The following assets are deducted from total capital: (i) Investments, both equity and 

debt, in unconsolidated banking and finance subsidiaries that are deemed to be capital of the subsidiary; and [tJhe 

ace may require deduction of investments in other subsidiaries and associated companies, on a case-by-case basis"); 

12 C.F.R Part 325, Appendix A, Section II.B.3. (FDIC regulations) ("FDIC may also consider deducting investments in 

other subsidiaries, either on a case-by-case basis ort as with securities subsidiaries, based on the general 

characteristics or functional nature of the subsidiaries,II). 

Page 20 of32 
354 


79691.269

Collins Amendment,1!\ On a preliminary basis, we believe setting an NAIC RBC ratio of 300% as 

equivalent to the well-capitalized ratios required for banks is appropriate. 

This approach solves: (1) the Agencies current situation where the Proposals' treatment of 

insurance is inconsistent with Basel III as is noted in a recent report of peer international 

supervisors;12 (2) the problems for insurers of needing to manage their business to conflicting riskbased capital regimes and (3) the potential harm to the economy of reduced long-term private 

sector financing. 

2. Conversion and Calibration Alternative. The second alternative has been 

proposed by the ACLI in its comment letter dated October 12,2012. Under this approach as 

outlined in Appendix AA to the ACLI's letter, NAIC RBC is used to calculate risk-assets to be 

ineluded in the SLHC's risk-based capital calculations. This approach incorporates NAIC RBC 

into the Basel-based rules in a manner that avoids the misalignment of the incentives for managing 

insurance activities through a quantitative calibration of insurance capital requirements with and 

into the Basel requirements. Thus, it maintains the numerators of Tier I common equity, Tier 1 

capital and total capital, and through a calibrated conversion proccss calculates risk-weighted 

assets for the denominator and the capital ratio calculations. 

e. Consolidated coverage. 

Under these approaches only activities conducted under an insurance company would be 

subject to NArC RBC and any non-insurance subsidiary of a SLHC not also an insurance company 

would be subject to Basel capital standards. Likewise, the activities of the thrift subsidiary would 

remain subject to Basel capital standards. In combination, all activities would be subject to 

consolidated capital requirements. This eliminates the regulatOlY gap that led to AIG Financial 

Products not being subject to regulatory capital requirements.>D. A non-insurance subsidiary of a 

iii See § __ .22 Regulatory capital adjustments and deductions generally deducting items from Tier 1 common 

equity and subsection (f) treatment of assets that are deducted - "A [BANK] need not include in risk-weighted assets 

any asset that is deducted from regulatory capital under this section." 77 F.R. at 52,863 (Aug. 30,2012). 

12 See Basel Committee on Banking Supervision, Basel [I! regulatory consistency assessment (Level 2) Preliminary 

report: United States of America. 20 (Oct. 2012) ("Nonetheless, the assessment team has identified a difference in 

the treatment of insurance subsidiaries that may be potentially material and has listed it for further follow-up 

analysis>!), 

iQ Indeed, the Financial Crisis Inquiry Report concluded Nbecause of the deregulation of OTC derjvatives, state 

insurance supervisors were barred from regulating AIG's sale of credit default swaps even though they were similar 

in effect to insurance contracts. If they had been regulated as insurance contract, AIG would have been reqUired to 

maintain adequate capital reserves, would not have been able to enter into contracts requiring the posting of 

collateral, and would have not been able to provide default protection to speculators; thus AIG would have been 

prevented from acting in such a risky manner." The Financial Crisis Inquiry Commission, The Financial Crisis Inquiry 

Report, 352 (Jan. 2011) (http://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCICpdf). 

Page 21 of32 
355 


79691.270

non-insurance company SLHC would be subject to the Basel risk-weighting and consolidated 

capital requirements under these approaches. 

f. Leverage ratio acts as a floor. 

Under these proposed approaches, the consolidated leverage ratio requirement of holding 

4% Tier 1 capital to average total assets would continue to set a universal capital floor for all 

SLIlC activities, including those conducted through insurance companies. 

g. Consistent with DF A Congressional intent. 

We believe Congress clearly demonstratcd its intent to allow Insurance-centric SLHCs 

continue to own thrifts throughout the DFA legislative process and in the text of various provisions 

within DFA. Congress went so far as to instruct "the Federal Reserve [to] take into account the 

regulatory accounting practices and procedures applicable to, and capital structure of, holding 

companies that are insurance companies (including mutuals and fratemals), or havc subsidiaries 

that are insurance companies" in detenninillg SLHC capital standardsE Congress specifically did 

not make SLHCs BHCs. DFA left in place the provisions of the Gramm-Leach-Bliley Act, which 

gralldfathered nonbank activities of certain SLHCs, maintained the Qualified Thrift Lender test 

and maintained the thrift charter. Indecd, as demonstrated by the Volcker Rule insurance 

exemption, Congress expected insurance companies to own thrifts.g In DFA, Congress clearly 

demonstrated its intent that insurance-centric organizations would continue to own thrifts and offer 

their customers banking products and services. Unfortunately, FRB oversight as implemented 

through the current Proposals will make continued ownership of thrifts by insurance organizations 

economically prohibitive and thereby have done through regulation what Congress, not only did 

not intend to do by statute,21 but what it specifically directed the FR13 to avoid doing. 

h. Limited potential for BHCs to engage in regulatoIT_arbitrage. 

We recognize the FRS's historic concerns regarding regulatory arbitrage. The equivalency 

and calibration approaches do not provide free rein to BHCs to park assets with insurance affiliates 

to lower their consolidated capital requirements, because they could be tailored to apply to 

II Senate Report 111-176 at footnote 161 (Apr. 30, 2010) - discussion of Section 616 amending HOLA to clarify the 

FRB's authority to issue capital regulations for SLHCs where the Committee specifical!y notes: 

It is the intent of the Committee that in issuing regulations relating to capital requirements of bank holding 

companies and savings and loan holding companies under this section, the Federal Reserve should take into 

account the regulatory accounting practices and procedures applicable to, and capital structure of. holding 

companies that are insurance companies (including mutuals and fraternals), or have subsidiarIes that are 

insurance companies. " [emphasis added]. 

II Section 619(d)(1)(FJ of the DFA. 

g "Dodd-Frank amps insurers for banking exit," SNL Financial (Jul. 11. 2012). 

Page 22 of32 
356 


79691.271

organizations primarily engaged in the bnsiness of insurance and then only for activities of 

regnlated insurance companies. In addition, these approaches could include a provision providing 

the Agencies with discretion to apply the general bank risk-weights to insurance company assets 

on a case-by-case basis in order to counter identified cases of regulatory arbitrage. We do not 

believe any BHC or FHC wonld have an incentive to become primarily engaged in the insurance 

business in order to take advantage of the differing capital treatment of individual assets under 

NArC RBC and the Basel capital standards. Indecd, regulatory arbitrage between these two 

standards cannot be eliminated for the financial system as a whole unless all regulated and 

umegulated financial institutions are subjected to a single integrated capital standard. In this 

regard, we are concerned that insurance companies not subject to FRB oversight will set the 

market price for insurance products and that thc additional capital and othcr costs imposed by FRB 

oversight will make insurance products offered by SLHC affiliated insurance companies noncompctitivc. 

6. Insurancc Capital Deduction Inappropriat", 

Irrespective of the equivalency and calibration approaches snggested above, the Proposals' 

treatment of insurance underwriting subsidiaries, under which they are first consolidated for 

pnrposes of determining SU-IC risk-weighted assets and then a dednction from Tier I and Tier 2 

capital (the "Insurance Capital Deduction") is made for the insurance subsidiary's minimnm 

reqnired capital amount (the "Consolidate and Deduct Approach"), is inappropriate. 

a. The 2007 Advanced Approaches rulemaking. 

FRB staff has pointed to the 2007 Advanced Approaches rulemaking process as 

demonstrating that the Consolidate and Dcduct Approach already has been fully considered and 

that the FRB is just applying its existing policy to SLHCs.i1 We are troubled by this position 

given the context and different constituents affected by the rulemaking and by the implication that 

the principles of stare deeieus and collateral estoppel apply to this "policy" decision. Both on 

process and policy grounds the record underlying the 2007 rulemaking does not support the 

Insurance Capital Deduction. Our review of the comments the Agencies received on the 

Advanced Approaches Releases revealed only five comment letters addressing the Consolidate and 

Deduct Approach with three opposing consolidation. The only letter supporting consolidation was 

submitted by Citigroup after its spin off of Travelcrs Insurance, and Citigroup only supported a 

possible capital deduction for risks such as mortality or morbidity with proxies derived from the 

NAIC RBC requirements.~ None of the comment letters supported deducting insurance capital 

supporting affiliate (C-O), asset (C-l) or interest rate/market risk (C-3). 

21 The advanced approaches rulemaking process included the 2003 advanced notice of proposed rule making [68 

F.R. 45,900 (Aug. 4, 2003)J, the notice of proposed rulemaking [71 F.R. 55,830 (Sept. 25, 2006)J, and the final rule [72 

F.R. 69,288 (Dec. 7, 2007)] (collectively, the "Advanced Approaches Releases"). 

~ Citigroup Letter (Nov. 3, 2003) (http://www.federalreserve.gov/SECRS/2003/Novernber/20031118/R-1154/R1154_62_1.pdf); HSBC North America Holdings Letter (Mar. 26, 2007) 

(http://www.fdic.gov/regulations/laws/federaI/2006/06c50ac73.pdf); The Risk Management Association Letter (Mar. 

26, 2007) (http://www.fdic.gov/regulations/laws/federaI/2006/06c75ac73.pdI); Bank of America Letter (March 26, 
357 


79691.272

It is not sutprising that no insurance companies participated in this highly techllical and 

extended rulemaking process, because the Advanccd Approaches Relcases, by their tenDs, would 

not apply to an insurance organization unless it both had $250 billion in non-insurance assets and 

was already a BHC. Indeed, the FRB specifically stated that the Advanced Approaches framework 

was inappropriate to apply to insurance activities.on The FRB should re-examine this issue anew in 

light of the significant effect the Consolidate and Dcduct Approach will have on Insurance-centric 

SLHCs. 

In the preamble to the 2007 final rule implcmenting the Advanced Approaches, the FRB 

stated, in response to (he banking industry comments discussed above objecting to the required 

deduction of capital held by insurance underwriting subsidiarics, that it: 

[does 1 not agree that the proposed approach results in a double-count of capital 

requirements. Rather, the capital requirements imposed by a functional regulator or other 

supervisory authority at the subsidiaty level reflect thc capital needs at a pariiculat· 

subsidiary. The consolidated measure of minimum capital requirements should reflect the 

consolidated organization.21 

The FRB 's policy rationale for the Insurance Capital Deduction diffcrs in the various 

rulemaking releases associated with the cxtended Advanced Approaches rulemaking.i!i. Starting 

with the 2002 Joint Report, FRB staff has expressed a view that "it may be appropriate to deduct 

the insuratlCe cOmpat1Y's capital, or at least a portion of capital, not freely available to the holding 

company before calculating the consolidated capital ratio.,,22 Yet even in 2002, over 76% of life 

insurance capital was understood to be held against risks comparable to those covered under the 

Basel framework.l& The concept that capital is somehow maintained at the holding company level 

2007) (http://www.fdic.gov/regulations/laws/federaI/2006/06c47ac73.pdf); Wachovia Corporation Letter (Mar. 26, 

2007) ( http://www . fdic.gov / regu lati ons/laws/fed eral/2006 /06c62 ac 73sup. pdf) . 

.i§. tiThe final rule continues to exclude assets held in an insurance underwriting subsidiary of a BHCfrom the asset 

threshold because the advanced approaches were not designed to address insurance underwriting exposures." 72 

F.R. at 69,298 (Dec. 7, 2007). 

~z 72 F.R. at 69,325 (Dec. 7, 2007). 

~ See 68 F.R. 45,907-8 (Aug. 4, 2003)(no mention of regulatory arbitrage, but "[al deduction would be required for 

capital that is not readily available at the holdjng company level for general use throughout the organization,'!)i 71 

F.R. at 55,857-8 (Sept. 25, 2006)(again no mention of regulatory arbitrage, but belief that "full deconsolidation and 

deduction approach does not fully capture the risk in insurance underwriting subsidiaries at the consolidated BHC 

leveL,,"); 72 F.R. 69,325 (Dec. 7, 2007)(first raising a regulatory arbitrage concern ''It eliminates incentives to book 

individual exposures at a subsidiary that is deducted from the consolidated entity for capital purposes where a 

different, potentially more favorable requirement is applied at the subsidiary.") 

;l. 2002 Joint report. 11. 

!i!l Id. Exhibit A-2. 

Page 240[32 
358 


79691.273

is extremely odd in light of the reality of financial holding company ("FHC"), BHC and SLHC 

structurcs, where the vast preponderance of parent company assets are in the form of investments 

in their subsidiaries. Only in the case of insurance companies is the FRB imposing a penalty for 

minimrm1 capital requirements of a subsidiary. 

Unsurprisingly, the Advanced Approaches Releases assume a typical BHC structure in 

which insurance companies and banks are sister subsidiaries of a common holding company 

parent. While such a structure is predominant for BHCs, the structure of Insurance-centric SLHCs 

is more diverse with most having their thrifts owned under an insurance company that is itself 

registered as a SLHC and many insurance companies that are SLHCs have insurance company 

subsidiaries for business or regulatory reasons. This situation is not contemplated in either the 

Advanced Approaches Releases or the Proposals. 

b. Why the Insurance Capital Deduction is inappropriate and discriminatory. 

The FRB's position that NAIC RBC does not address credit risk is factually incorrect. As 

discussed above, for life insurance companies 75% of their NArc RBC capital requirement reflects 

risks comparable to those for which capital reqnirements are applied nnder the Proposals. Why the 

FRB has chosen to single ont the insurance indnstry for this draconian dednction appears to be 

based on regnlatory history, rather than considered regulatory policy. All holding company 

snbsidiaries that have minimrml regnlatory capital requirements are limited in how much financial 

snpport they may provide to their parent holding companies. All other types of regulated holding 

company snbsidiaries are consolidated nnder the Proposals with no reqnired capital dednction. 

Even thongh broker-dealers, future commission merchants and most importantly bank subsidiaries 

are restricted by their respective capital regimes from being able to provide financial snpport to 

their parent and/or affiliates when they would fall below regulatory minimums, QNL Y in the case 

of insurance companies has the FRB required a deduction from holding company capital. 

If the approach of the Insurance Capital Deduction were to be followed for all BHC 

regulated subsidiaries, including banks, it would be quite difficult for any existing BHC to satisfy 

the Proposals' minimum capital standards. Nevertheless, the FRB proposes to apply such a 

discriminatory deduction to Insurance-centric SLHCs with equally inappropriate results. 

Further, the deduction is inappropriate based on the assumption in the FRB's 2007 

Rulemaking of a typical BHC organizational structure with a public holding company parent. This 

is not the case for many Insurancc-centric SLHCs, where insurance companies themselves or 

special purpose non-public entities are often the top level SLHCs. If this deduction were imposed 

at the level of the TIAA Board of Overseers (the special purpose non-profit entity that owns 

TIAA),Rl then the deduction ofTIAA's required control amormt would reduce consolidated capital 

by nearly 20%. Yet nearly 100% of consolidatcd assets and all associated financial activities, 

including all banking activities, are recorded at the level ofTIAA and its subsidiarics. How would 

----------------

§1 This approach would be contrary to current and historic supervisory practice of focusing supervision on T1AA. 

Page 25 of32 
359 


79691.274

such a deduction protcct TIAA' s thrift subsidiary? What purpose would the deduction serve? 

Alternatively, would the deduction be applied at the TIAA level and only TIAA's insurance 

subsidiary TIAA-CREF Life Insurance Company's capital be deducted ftom TIAA's total capital? 

How do the Proposals contemplate the treatment of capital of insurance companies that own 

insurance companies? 

Notwithstanding the forgoing, if the FRB still deems it necessary for a SLHC to deduct 

capital held by an insurance underwriting subsidiary, such a deduction should be limited to capital 

held against insurance underwriting risk (~, C-2), which like may other risks faced by financial 

institutions is not specifically addressed by the Basel framework.2• 

V. Exclude insurer separate accounts from the leverage ratio and ensure they receive the 

same treatment as similar hank affIliated investment vehicles 

We disagree with the Proposals' inclusion of insurance' company separate account assets in 

the denominator ofthe proposed Tier 1 leverage ratio. This inclusion is contrary to the FSOC's 

determination that separate accounts are "not available to claims by general creditors of a nonbank 

financial company" and, therefore, should be excluded from the calculation of the leverage ratio 

used in the DFA Section 113 determination process.§;). The Agencies' implicit rationale for the 

inclusion of separate account assets appears to be based on GAAP's treatment of separate account 

assets as balance sheet assets of an insurance company. The Agencies, however, have selectively 

chosen to overlook the accounting treatment of other assets when in their view the underlying 

cconomic value/risk varies from the treatment afforded under GAAP. Specifically, in the areas of 

the value of goodwill, mortgage servicing rights and deferred tax assets, the Agencies have 

adjusted GMP measurements for purposes ofthe calculation of various regulatory capital 

considerations as well as the leverage ratio, to reflect the underlying economics of these assets in 

the contcxt of prudential oversight and supervision. Yet, to the best we have been able to 

determine, the rationale for inclusion of separate account assets in the leverage ratio calculation is 

that "GAAP treats them as balance sheet assets."M 

Importantly, this position misconstrues the position of the Financial Accounting Standards 

Board ("F ASB") regarding the treatment of separate account assets for financial reporting 

£6. We would note that, under the genera! Basel framework, BHes do not hold capital against regulatory compliance 

risk, reputational risk, interest rate risk and operational risk (except for Advanced Approaches institutions), yet under 

the Proposals only insurance enterprises would be subject to a capital deduction for a risk not specifically addressed 

by the framework. 

1& Authority to Require Supervision and Regulation of Certain Nonbank Financial Companies, 77 F.R. 21,637, 21,661 

(Apr. 11, 2012). 

H See Ask the Fed: Baselill for banking organizations with assets of at least $50 billion (Jul. 17, 2012) at minute 101 

of the archived audio recording. 

Page 26 of32 
360 


79691.275

purposes.ill Under GAAP treatment of separate accounts, separate account assets rcpresenting 

contract holder funds are reported on an insurance company's financial statements as a summary 

total with an equivalent summary total rcportcd for rclated liabilities, if the following requirements 

are satisfied:2Q 

a. the scparatc account is recognized legally, that is, the separate account is established, 

approved, and regulated under special rules such as state insurance laws, federal 

securities laws, or similar foreign laws; 

b. the separate acconnt assets supporting the contract liabilities are insulated legally from 

the general account liabilities of the insurance cntity, that is, the contract holder is not 

subject to insurcr default risk to the extent of the assets held in the separate account; 

c. the insurer must, as a result of contractual, statutory, or regulatory requircments, invest 

the contract holder's funds within the separate account as directed by the contract 

holder in designated investment alternatives or in accordance with specific investment 

objcctives or policies; and 

d. all investmcnt performance, net of contract fees and assessments, must as a result of 

contractual, statutory, or regulatory requirements be pass cd through to the individual 

contract holder. Contracts may specify conditions under which there may be a 

minimum guarantee, but not a ceiling, as a ceiling would prohibit all investment 

performance from being passed through to the contract holder. 

This presentment reflects a recognition of the legal, but not economic, ownership of 

scparate account assets by an insurance company. Most clearly this is seen in the requirement that 

only fees and assessments related to the separate account and not income and other expenses arc 

reported on the insurance company's statement of operations a treatment mirroring that of 

affiliated mutual funds.Q1 Indeed, to the extent that an insurancc company has an economic 

interest in assets maintained in a separate account or has any liability related to the separate 

account in excess of the fair value of the separate account's assets, GAAP requires such assets and 

liabilities to be reported as general account assets and liabilities.lili The underlying economic 

reality of separate account assets and related liabilities has not been clearly considered in the 

Agencies' proposed approach to rely on total assets including separate account assets for 

calculation of the leverage ratio. Any contingent obligations regarding a separate account would 

be recognized by the insurer in accordance with the applicable general account reportiug 

&!? ASC 944-80 (Financial Services -Insurance, Separate Accounts), 

§f ASC 944-80-25-2. 

§l ASC 944-80-25-3(c). Under ASC 944-80-25-4(c), only revenue and expense of non-qualifying separate accounts are 

reported on the insurance company's statement of operations. 

§§. ASC 944-80-2S-3(b) 2nd ASC 944-80-25-4. 

Page 27 of32 
361 


79691.276

requirements, and the appropriate means to address concerns regarding contingent obligations is 

through the risk-based capital framework, not the leverage ratio. 

The Proposals' treatment of separate accounts is a significant issue for life insurance 

companies and the consumers who rely on them for lifetime income and retirement savings 

products. Variable annuity contracts funded by insurance company separate accounts are a 

significant investment vehicle for individuals to nse for their retirement savings. As of 20 10, $1.3 

trillion was invested in 32.4 million variable annuity policies.@ In the retirement space, variable 

annuity products compete with mntual funds and collective investment funds as funding 

alternatives for defined contribution retirement plans.lQ Nevertheless, al11luities, unlike mutual 

funds or collective investment funds, offer payout options that are designed to provide lifetime • 71 mcome.--

The Agencies' proposed inclusion of separate accounts in the calculation of the leverage 

ratio stands in marked contrast to the agencies' treatment of bank-affiliated mutual funds and 

bank-maintained common and collective' investment funds. We recognize that mutual funds and 

common and collective investment funds are not included as balance sheet assets under GAAP. 

Even so, the economics, risk and regulatory relationship of these vehicles to banks is nearly 

identical to the relationship of separate accounts to an insurance company.ll Indeed, most separate 

accounts suppOliing variable annuities are registered with the SEC as unit investment trusts under 

the Investment Company Act of 1940 and invest in mutual fund shares. For example, a bank may 

act as a trustee of a retirement plan ~, have technical legal ownership ofthe plan's assets as 

trustee) and the plan can invest in mutual funds advised by the bank's affiliates and the bank will 

have no capital charge under the leverage ratio for the plan's mutual fund holdings. In contrast, 

under the Proposals, when an insurance company issues a variable annuity contract to fund the 

same retirement plan and for which insurance company affiliate-advised mutual funds are the 

underlying investments held in a separate account, the insurance company would need to hold at 

least 4% Tier J capital against these mutual fund shares held in the separate account. 

§2 ACLJ Product Line Report: Annuity Insurance (Jan. 2012). 

LQ Just under 70% of separate account assets fund qualified retirement plans, including IRAs. Id. 

Z! The importance of providing consumers with annuities as retirement plan options to address longevity risk has 

recently been highlighted by both the U.S. Department of Labor and the President's Council of Economic Advisers. 

See EXecutive Office of the President, Council of Economic Advisers, Supporting Retirement for American Families, 

(Feb. 2, 2012) (www. whitehouse.gov/sites/default/files/cea _retirementJeport_ 01312012_final.pdf) and 

Department of Labor Press Release, "U.S. Treasury, Labor Departments Act to Enhance Retirement Security for an 

America Built to Last." (Feb. 2, 2012) (www.treasury.gov/press-center/press-releases/Pages/tg1407.aspx). 

71. See New York Law Insurance Law § 4240 r'lf and to the extent so provided in the applicable agreements, the 

assets in a separate account shall not be chargeable with liabilities arising out of any other business of the insurer"). 

Which is in effect parallel to the treatment of fiduciary assets of a bank under 12 U.s.c. § 1464(n)(2) ("A Federal 

savings association exercising any or all of the powers enumerated in this section shaH segregate all assets held in 

any fiduciary capacity from the general assets of the association"}. 

Page 28 of32 
362 


79691.277

Under the Proposals, the Agencies are in effect imposing a capital "tax" on insurance 

company variable products, while exempting comparable bank products from such a requiremcnt. 

We believe this position is not supported by any public policy rationale, favors bank products over 

competing insurance products, and will ncgatively effect consumers' ability to obtain access to 

appropriately priced lifetime income and retirement savings products. We believe the inclusion of 

separate account assets in the leverage ratio has significant anti-competitive implications and a 

detrimental consumer impact. Accordingly, the Proposals should be modified to exelude separate 

account assets from the leverage ratio calculation. 

VI. Affects of recording AOCI for unrealized capital gains and losses 

We have concerns with provisions in the Proposals that would require insurers to record 

unrealized gains and losses on financial instruments within rcgulatory capital ["accumulated other 

comprehensive income ("AOCT')], thus recording unrcalized gains and losses of certain debt 

securities in common equity Tier 1 capital. The Agencies recognize that, "including unrealized 

gains and losses related to certain debt securities whose valuations primarily change as a result of 

fluctuations in a benchmark interest rate could introduce substantial volatility in a banking 

organization's regulatory capital ratios.":u. We believe this statement is especially tme for insurers, 

whose business requires investments in long-dated fixed income securities that are susceptible to 

such volatility. 

The business of insurance largcly involves investing assets on behalf of policyholders in a 

way that will ensure these assets are available for policyholders andlor their families at a future 

date. As a result, insurers invest heavily in long-term fixed income assets that can be greatly 

affected by the interest rate fluctuations referenced by the Agencies. Insurers tend to have a larger 

portion of their investments inlonger-tenn interest rate-sensitive securities when compared to 

banks. For example, insurers held $2.5 trillion of bonds in their general accounts in 2010, and 

62% of these holdings were in bonds with maturities of 10 years or more. 74 

Recording unrealized gains and losses certainly would increase volatility resulting from 

either interest rate fluctuations or other factors that affect the short-term valuations of investmcnts 

ii,&., market illiquidity) and would disproportionately affect insurers' regulatory capital 

calculations compared to traditional banking organizations 

To avoid the negative affects of non-credit fluctuations on their capital ratios, many 

insurers may decrease investments in longer-duration securities, which, considering the significant 

investment activity of insurers in these securities, not only would decrease the availability of long11. 77 F.R. at 52,811 (Aug. 30, 2012). 

11 ACLI, 2011 Life Insurers Fact Book. 8 (2011) (www.acli.com/Tools/lndustry%20Facts/ 

Life%201 ns u rers%2 OFa ct%20 Boo k/Documents/2011 %20Fa ct%2 OBook. pdf). 

Page 29 of32 
363 


79691.278

term credit in the economy, but also would effect insurers' ability to best match asset and liability 

duration. 

We strongly support the exclusion ofumealized gains and losses related to long-term debt 

securities, including long-term debt securities whose valuations primarily change because of 

fluctuations in interest rates, within the calculation of regulatory capital. Such securities include, 

but are not limited to, long-term Treasuries, securities issued or guaranteed by Fannie Mae and 

Freddie Mac, long-term obligations of U.S. states and municipalities, and other forms oflong-term 

debt securities. 

In the absence of such exclusion, insurers would be forced to diminish their investments in 

long-term debt securities and increase the amount of short-term debt securities held in their general 

accounts. Because insurers rely on long-dated assets to match their long-term liabilities, such a 

shift would counteract the safety and soundness principles utilized by insurcrs by making it more 

difficult for them to.engage in effective asset-liability management 

An exclusion of umealized gains and losses from long-term debt securities is appropriate 

for measuring the regulatory capital requirements of insurers because of the nature of their 

business modd compared to traditional banking organizations. Furthermore, it is integral to 

ensuring that Americans who rely on insurance products for their lifelong financial security are not 

suffering disproportionate negative effects from the imposition of such a proposal. 

VII. Capital treatment of owned securitizations 

We have concerns with the proposed securitization framework outlined in the Proposals, 

requiring banking organizations to satisfy specific due diligence requirements for securitization 

exposures. As part of this due diligence, a banking organization must conduct a detailed analysis 

of all owned seeuritization vehicles no less frequently than quarterly and maintain an extremely 

granular level of data for all such investments. As part of this analysis, banking organizations 

"would be reqnired to demonstrate to the satisfaction oftheir primary federal supervisor a 

comprehensive understanding of the features of a securitization exposure that would materially 

affect the performance of the exposure." The banking organization's analysis would be required to 

correspond with the complexity of the exposure and the materiality of the exposure in relation to 

capital. 

Demonsh'ating such a comprehensive understanding would require the banking 

organization to conduct and document an analysis of the risk characteristics of the exposure prior 

to acquisition and periodically thereafter. As part of this analysis, the banking organization would 

need to consider various factors including any structural features of the securitization that could 

materially influence the perfoITnance of the exposure, relevant information regarding the 

performance of the underlying credit exposure, and relevant market data on the securitization, If a 

banking organization were unable to demonstrate a comprehensive understanding of an exposure, 

it would be required to assign a risk weight of 1,250% to the exposure. 

Page 30 of 32 
364 


79691.279

This new requirement likely would call for most banking organizations to enhance their 

recordkeeping and tracking processes for securitization activity. Traditional banking organizations 

that own and originate such securitized vehicles would have in place the systems and compliance 

infrastructure necessary to manage proprietalY loan data, enabling such organizations to better 

prepare for the proposed due diligence requirements. 

By contrast, implementing these enhancements may prove to be an excessive burden for 

insurers who invest in, but do not originate the loans included in these securitized vehicles, and 

therefore do not have the same level of data as the loan originator. This dichotomy in data 

collection capability places insurers at a significant disadvantage relative to traditional banking 

organizations, and will make it substantially more difficult for insurers to comply with the 

proposed due diligence requirements for securitizations. Further, if insurers were to determine that 

the proposed requirements were too burdensome, too costly to implement, or too difficult to 

maintain, insurers would likely diminish their investments in such securitized vehicles. Removing 

insurance enterprises as an investor in these vehicles has the potential to diminish the liquidity 

currently available in the private securitization market. 

It is also worth noting that insurers primarily invest in the high quality, upper tranches of 

the securitization exposures. In fact, two recent NAIC studies looking at recent changes madc to 

the procedure for assigning NArC designations to non-agency residential mOltgage-backed 

securities ("RMBS") and commercial mortgage-backed securities ("CMBS") demonstrated that 

95% of insurer investments in CMBS and 80% of insurer investments in RMBS received either the 

highest or second highest NArC-assigned ratings2~ These studies reflect continued improvements 

in insurers' methodologies for assessing the credit quality of securitization exposures based on 

experience of the recent crisis as well as insurers' overall investment history in securitizations as a 

10ng-telID investment, and demonstrates that insurers both understand the credit risk inherent in 

securitization exposures and are committed to holding adequate capital for these exposures. 

The results of these NAIC studies indicate that the insurance industry already has adequate 

measures in place that have resnlted in improvements in transparency and regulatory oversight of 

the securitized vehicles, as well as accurate valuation processes. We believe that the cun'en! 

process and modeling results show tbe strong principles maintained by the insurance industry with 

regard to ensuring adequate levels of capital and that insurance holdings are appropriately 

sensitized to the credit risks inherent in securitization activities. 

Finally, as the FRB moves forward with the rulemaking with respect to securitization 

exposures of insurers, we strongly recommend reviewing the SSAP 43R standard, which requires 

investors conduct a prudent discounted cash flow ("DCF") analysis of their investment and record 

valuation impairments based on proprietary valuation results compared to the externally derived 

NAIC valuation. 

~ See NAIC, Modeling of u.s. Insurance Industry's Holdings in Commercial Mortgage-Backed Securities, 

(www.naic.org/capital_markets_archive/120626.htm); NAIC, Modeling of U.S. Insurance Industr:y'~Holdings in 

Residential Mortgage-Backed Securities, available at http://www.naic.org/capital_markets_archive/120601.htm. 
365 


79691.280

VIII. Conclusion 

As the Agencies and particularly the FRB implement their responsibilities under DFA, we 

hope that they will keep in mind the ancient maxim - Primum non nocere - "First, do no harm." 

We believe that, if the Agencies fail to address our concerns regarding the impact of the Proposals 

on insurance companies, the likely outcome will be the continued exiting of banking by these 

fIrms, which would result in an increase in the concentration of banking activities in a few 

systemically significant firms as well as a reduction in competition and consumer choice. Capital 

regulation for insurance activities in the United States is important to get right because it affects 

Americans' ability to mitigate longevity, mortality and catastrophe risks as well as the availability 

of long-term fInancing for the economy. Insurance capital regulation is not a problem looking for 

a solution - NAIC RBC works. Just as the Basel framework addresses trading and banking 

activities separately, it also addresses how insurance activities should be treated by respecting the 

insurance sectoral standards at the "conglomerate level" through a parallel capital and asset 

deduction. As drafted, the Proposals are inconsistent with Basel ill and would harm consumers, 

insurers and the economy, while providing no discernable supervisory benefit. We have outlined 

above two alternative approaches that would allow the Agencies to satisfy their mandate under the 

Collins Amendment, while simultaneously avoiding disruption to consumers, insurers and the 

economy. 

Again, we appreciate the opportunity to participate in this critical rulemaking process and 

are more than willing to discuss our views further to assist the Agencies in this important 

endeavor. 

cc: Mr. Michael McRaith 

Director, Federal Insurance OffIce 

U.S. Department of the Treasury 

Very truly yours, 

Brandon Becker 

Executive Vice President and 

Chief Legal Officer 

79691.281

Exhibit A - Corporate and Foreign Bonds 

Billions of dollars; amounts outstanding end of period, not seasonally adjusted Re

Ho

2006 2007 2008 2009 2010 2011 Q2-2012 Q

Household sector $1,653,5 $2,118.4 $2,052,8 $2,213,1 $2,185,8 $2,118,1 $1,948,9 

State and local governments 135,0 149,1 147,9 154,7 157,0 150,6 147,0 

Federal government 0.0 0.0 0.0 0,6 0,9 0,8 0.8 Rest of the world (2) 2,320.5 2,719,1 2,354.0 2,465,3 2,523,3 2,500,5 2,444,7 

U.S.-chartered depository institutions 563.4 714,6 650.5 667,1 548.9 551,8 528,9 

Foreign banking offices in U,S, 292,5 369.5 401,6 244,9 233,9 234,5 216.6 

Banks in U,S,-affiliated areas 0.4 0,5 0,5 2,0 0.6 4.2 4,1 

Credit unions 30,6 34,6 25,7 18,6 3.7 4,1 4,8 

Property-casualty insurance companies 277.0 282,9 267.5 298,3 322,6 361.0 

Life insurance companies 1,819.5 1,862,6 1,817.0 1,927.2 2,030.2 2,123.6 

Private pension funds 317,6 357.4 400.1 442,9 440.1 440,9 

State and local govt. retirement funds 283.4 297,0 312.9 308,6 312.4 320.9 324.5 

Federal government retirement funds 4,8 6,3 5,8 5,8 5,9 7.4 8.0 

Money market mutual funds 368,3 376,8 228.0 169.9 154.2 129.6 116.5 

Mutual funds 767.0 889,9 959.9 1,126.8 1,275.4 1,465.8 1,617.8 

Closed-end funds 75.1 74.0 49.2 55.4 59,5 57,6 60.5 

Exchange-traded funds 7,6 13.8 27.7 55.4 74,1 107.7 135,7 

Government-sponsored enterprises 481.7 464.4 386.6 310,8 293.9 260,5 227,1 

Finance companies 184.8 189.4 192.4 198.6 84,3 85.1 87,2 

REITs 64,6 34.4 11.7 15.5 20,8 22,1 27.6 

Brokers and dealers 355,5 382,8 123,8 154.4 189,5 103,7 135.5 

Holding companies 16,7 35.9 35,8 31,1 38,3 18,3 94.3 

Funding corporations 60.4 170,0 667,3 710,2 760,1 792.4 904,3 

Total assets $10,080,0 $11,543.4 $11,118,5 $11,577.0 $11,715.3 $11,861,1 $11,956.6 

FEDERAL RESERVE statistical release - Flow of Funds Accounts of the United States, 

Flows and Outstandings Second Quarter 2012,100 (Sept. 20, 2012) - L212 Corporate and Foreign Bonds. 
367 


79691.282

Exhibit A - Composition ofD.S. Credit 

Composition of U.S. Credit 

Financing and Holdings 

Total U.S. Business Financing: Percent of GOP 

Liquid Securities versus Loan and Mortgage Financing 

150% ~--~========::::::::::::::::::::::::::::::::::::::====~-

100% 

50% ~------------~~~==~::::::::::::~~~~-----------------

0% 

2005 2006 2007 2008 2009 2010 --Liquid Markets --Loan and Mortgage Financing 

Total U.S. Credit Market Instrument Holdings: Percent of GOP 

Depository Institutions versus Life Insurers and Private Pension Funds 

2011 

100%~ 

80%t~--~_~~~~~ ____ ~------________ ~~~~~~~--

::: II 

20% ~.--~:::::::::::::::::::::::::::::::::::::::::::::::::::: 

0% +--------r.-------,--------r-------,--------r------~r_-----

2005 2006 2007 2008 2009 2010 2011 

--Depository Institutions --Ufe Insurance & Pensions Funds 

Total U.S. Corporate and Foreign Bond Holdings: Percent of GOP 

Depository Institutions versus Life Insurers and Private Pension Funds 

20% -,----------------------------------------------------------

15% 

I __ 

--

~----

10% ---------------------------------------------------

5% t====-::::::::--======~-~""""""'" 0% DepOoOs6

itory Ihstitu

2

t

o

io

O

n

7

s i -Life Insurance & Pensi6ns Funds 2005 2 2008 2009 2010 2011 

Note: Liquid Markets is composed of commercial paper, municipal securities, and corporate bonds. 

Loan and Mortgage Financing is composed of depository institutions loans, other loans and advances, 

net inter bank lending, and mortgages, less reserves and vault cash at the Federal Reserve Banks. 

Source: Federal Reserve Bank System Flow of Funds 

79691.283

Exhibit B - compositon of NAIC RBC by risk element - 2003-2009 

2009 2008 2007 2006 2005 2004 

CoO - Asset Risk - Affilates 16.25% 15.70% 17.26% 16.26% 16.56% 17.67% 

C-1 Cs - Asset Risk - Common Stock 14.11% 13.43% 17.42% 15.96% 14.51% 13.66% 

C-10 - Asset Risk - All Other 32.41 % 33.87% 31.24% 30.43% 30.57% 31.35% 

C-2 - Insurance Risk 18.53% 19.97% 17.76% 18.93% 18.00% 18.02% 

C-3A - Interest Rate Risk 9.73% 9.94% 9.37% 11.23% 13.35% 13.82% 

C-3B - Health Credit Risk 0.00% 0.00% 0.00% 0.00% 0.00% 0.03% 

C-3C - Market Risk 3.02% 1.04% 1.97% 1.85% 1.73% 0.00% 

C-4A - Business Risk 5.39% 5.49% 4.50% 4.87% 4.85% 4.85% 

CAB - Business Risk Admin. Expenses 0.57% 0.55% 0.47% 0.47% 0.43% 0.60% 

Total of CoO, C-1 and C-3 elements 75.51% 73.98% 77.27% 75.73% 76.73% 76.50% 

Source: AGGREGATED LIFE RBC AND ANNUAL STATEMENT DATA 
369 


79691.284

Written Testimony of America's Mutual Banks 

Joint Hearing before the 

House Financial Services Subcommittees on 

Financial Institutions and Consumer Credit 

and 

Insurance, Housing and Community Opportunity 

Examination of the Impact of the Proposed Rules to Implement Basel III Capital Standards 

Thursday, November 29, 2012 

America's Mutual Banks ("AMB") appreciates the opportunity to provide this testimony to the 

I-louse Financial Services Subcommittees on Financial Institutions and Consumer Credit and 

Insurance, 1I0using and Community Opportunity regarding the joint proposed rules issued by the 

Federal Reserve Board (the "FRB"), the Comptroller of the Currency ("OCC") and the Federal 

Deposit Insurance Corporation intended to implement the Basel III regulatory capital reforms 

from the Basel Committee on Banking Supervision (the "Proposals"). AMB is an unincorporated 

association whose membership consists of banking institutions organized under the mutual form 

of ownership. AMB's membership consists entirely of community based institutions dedicated to 

serving their communities and fostering the economic growth of those communities. Community 

based, mutual form institutions are a historically vital part of the fabric of many communities and 

their future viability must be protected and enhanced. Unfortunately, as presently proposed, the 

impact of the Proposals on AMB's members and mutual form institutions generally will be 

harmful and possible systemically threatening. 

In their attempt to address broad market concerns, the Proposals paint with too broad a brush and 

sweep community based mutual form institutions into the same regulatory scheme as 

systemically large stock form institutions. Mutual form institutions do not have permanent 

capital stock like stock form institutions and, therefore, do not have permanent stockholders. We 

are concerned that the agencies do not truly understand the value, nature and unique role of 

mutual institutions. We believe that without an in depth understanding, the agencies may miss 

the impact the Proposals will have on mutual institutions. 

While the Proposals present much to comment on we will focus on two primary issues, 

fluctuations in capital calculations and the need for alternative capital enhancement for mutual 

institutions. 

Capital Calculations. In the Proposals the agencies stated that "Most of the capital of mutual 

banking organizations is generally in the form of retained earnings (includ ing retained earnings 

surplus accounts) and the agencies believe that mutual banking organizations generally should bc 

able to meet the proposed regulatory capital requirements". Unfortunately, this statement is 

premised on a snapshot in time. While generally accurate now, it does not take into account the 

increased uncertainty and volatility in asset management, earnings and capital calculations which 

the Proposals themselves create. 
370 


79691.285

The Proposals create the likelihood of wide fluctuations in earnings and capital calculations by 

institutions. The Proposals provide that unrealized gains and losses on all available-for-sale 

("AFS") securities held by an institution would flow to and be included in the calculation of 

Common Equity Tier I Capital ("CETl"). The agencies proffered that such an approach "would 

better reflect an institution's actual risk". However, the agencies also acknowledged that 

temporary changes in the market value of securities could create substantial volatility in an 

institution's regulatory capital ratios, possibly even triggering prompt corrective action. Given 

the present interest rate environment, it is virtually certain that rates can only rise from where 

they are today, and that means the market value of securities held will be negatively impacted. 

Not only can this arbitrary movement (which in most instances the institution has no ability to 

influence or control) in the market value of securities negatively impact an institution's capital 

ratios, it quite possibly will negatively affect a mutual community bank's ability to lend and 

manage its risk. The de-facto mark to market of AFS securities will manifestly increase 

volatility which will make the capital ratios of mutual community banking institutions fluctuate 

and harder to maintain. Amplifying the fluctuation of the mutual bank's capital calculations is 

the provision in the Proposals increasing the risk weighting of various residential and other loans 

originated and held by institutions. This provision may impact mutual banks more due to the 

fact that they generally hold loans in portfolio in greater percentages than larger banks and 

substantially more than the systemic banks. A mutual bank's asset portfolio generally consists of 

approximately 70% 1-4 family loans compared to approximately 25% for all other financial 

institutions. This portfolio concentration in mortgages is generally mandated by federal 

requirements under the qualified thrift lender test and the Internal Revenue Code. An additional 

clement of the Proposals which will negatively impact capital is the full deduction from CETI of 

equity investments made by mutual state savings banks in traditional investments which are not 

permissible for national banks. These investments have been traditionally included in Tier I 

Capital by such institutions. Further, the Proposals capital conservation buffer will restrict 

discretionary bonuses to executives which is the only means of rewarding successful 

management of a mutual bank due to the mutual bank not having the ability to provide equity 

based compensation. As a result of economic and market forces beyond their control, mutual 

institutions will be forced to adjust their asset portfolio's to account for this increased volatility 

without the ability to tap the capital markets like stock institutions to support what could very 

well be more profitable operations. As a result of the increased uncertainty and volatility in asset 

management, earnings and capital calculations which the Proposals themselves create and 

without the ability to raise capital beyond retained earnings, many mutual banks may have to 

curtail growth plans and reduce services to their communities in order to husband capital to meet 

unexpected future needs which they can neither foresee nor control. 

One sure way to avoid the problems discussed above is to exempt mutual institutions from the 

Proposals entirely. While organized for historically different reasons, mutual form banks and 

credit unions share a common foundation; they are non-stock form. All credit unions are 

organized as co-operatives which is essentially the same as the mutual form of organization. 

However, the Proposals do not apply to credit unions. This irony is an example of the "one size 

fits all" approach to banks. Credit unions are exempt because there are no systemic aspects 

relating to them and it is accepted that they did not contribute to the recent banking crisis. Mutual 

form community banks, the largest of which is one sixth the size of the largest credit union, also 

are not systemic and did not contribute to the recent banking crisis. Yet, they are being included 

2 
371 


79691.286

in the rules developed for systemically important banking institutions. Thus, exempting mutual 

banks would be the most sensible and fairest approach. 

Alternative Capital Enhancement. If excmpting mutual banks is not a viable approach, then 

the agencies should at least consider an alternative capital enhancement method. As stated 

above, retained earnings are the primary method by which mutual institutions raise capital. 

However, the Proposals not only do not provide for alternative methods for mutual banks to raise 

capital, they will effectively eliminate two long standing and legally permissible capital 

formation methods available to mutual banks; pledged savings accounts and mutual capital 

certificates. In light of the foregoing, and notwithstanding that mutual institutions are generally 

somc of the highest capitalized banking institutions, AMB believes that in order to be prepared 

and to be able to comply with the new and evolving capital standards and changing economic 

conditions it is imperative to establish alternative methods by which mutual institutions can raise 

capital which will qualify as CETl capital. Such capital can be used to grow the institution, 

expand operations, act as a buffer against the continuing downturn in the economy, finance 

acquisitions and for other corporate purposes. 

The Basel Committee focused almost exclusively on stock fonn banks in establishing the capital 

requirements under Basel III. Certain criteria and other terms intended to apply to stock form 

institutions are not appropriate in gauging the risk profile of mutual form institutions. 

Ironically, the application of these criteria and terms to mutual banks will increase the risk to the 

deposit insurance fund rather than decrease it. As stated in footnote 12 on page 14 of Basel III, 

the Basel Committee acknowledged that it is appropriate for the specific constitution and legal 

structure of mutual institutions to be taken into account in applying Basel III to them. 

Effectively, it is being left to national regulators to determine exactly how the new requirements 

will be applied to mutual institutions. Clearly, the regulators have the latitude to develop a 

regulatory scheme which does not hinder the viability of mutual institutions, even if it is different 

from that developed to address large systemic banks. 

The European Commission's Capital Requirements Directive IV published in July, 2011 offers a 

degree of flexibility. This has encouraged central bankers and regulators in the EU to work with 

and make an effort to accommodate mutual institutions with capital requirements that will 

comply with Basel III and be compatible CETl capitaL 

As was discussed in an article in the American Banker/Bank Think, dated October 3, 2012, 

perhaps the farthest along are the British Building Societies. The proposal which has emerged is 

for the issuance of "core capital deferred shares" or CCDS. Nationwide Building Society, 

Britain's largest, pioneered the way this past May by obtaining approval in principle from the 

British Financial Services Authority of the CCDS as a CETl instrument. 

What is needed is a proactive collaboration between the FRB, OCC, FDIC and the mutual 

banking industry, through its representatives such as AMB and the national and state 

associations, in designing and customizing a CETl capital instrument for use by mutual 

institutions. Additionally, all involved in this process must realize that any capital instrument 

designed to meet the requirements of CETI must also be marketable and sustainable or the 

capital enhancement will merely be an academic exercise with no real possibility for successfully 

3 
372 


79691.287

augmenting loss-absorption capital and achieving the goal of stronger institutions and a stronger 

industry. With that thought in mind, AMB has proposed an altemative capital instrument to be 

available to mutual institutions. This alternative capital instrument for mutual institutions has 

enough characteristics under GAAP to qualify as CETI non-withdrawable capital, which 

protects the mutual institution and the deposit insurance fund, yet contains no features that are 

inconsistent with the mutual nature of the institution or jeopardize the tax deductibility of the 

income payments. The deductibility of the income payments is particularly important to be able 

to offer an instrument that is economically attractive to both the issuer and the investor. In this 

regard then, AMB proposes the establishment of a non-withdrawable mutual investment 

certificate that would have the following characteristics: 

No voting rights, except that holders of the instruments have the right to elect 

two directors upon the sixth missed interest payment, upon a change of 

control and upon changes in the capital structure of the bank; 

No holder may put the instrument back to the bank; 

Redemption solely at the bank's discretion; 

Income payable may be fixed or variable or tied to an index; 

Income is payable if and when declared by the board of directors, subject to 

the capital requirements of the BaselllI Proposals; 

Income payments are cumulative; 

Perpetual--no maturity date; 

Repayment is subordinate to the claims of creditors and depositors; 

Convertible into shares of common stock upon a mutual to stock conversion 

of the bank based on a fixed exchange ratio basis based on the investor's 

ownership percentage at the time of investment. 

AMB believes that adoption of the non-withdrawable mutual investment certificate will safely 

permit mutual form institutions to enhance capital if it should be necessary while still achieving 

the agencies objectives of increased loss-absorption capital. 

We would note that Congressmen Michael Grimm (R-NY) and Peter King (R-NY) have 

introduced H.R. 4217, the Mutual Community Bank Competitive Equality Act, which provides, 

among other things, for authorization for mutual institutions to issue mutual investment 

certificates which would be eligible for inclusion as Tier I Capital. 

Conclusion. AMB respectfully requests the Subcommittees to urge the agencies to further 

investigate the impact of the Proposals on mutual institutions. AMB has a responsibility to its 

members and to their depositors, members and communities to express its belief that if left 

unchanged, the Proposals could severely negatively impact the mutual banking industry in this 

country. AMB strongly believes that by working closely with the agencies, an acceptable 

resolution can be fashioned. The continuing viability of mutual form institutions should be a 

common goal which together can be achieved. As discussed above, AMB believes that its 

4 
373 


79691.288

proposal to develop a non-withdrawable mutual investment certificate will enhance significantly 

the continued vitality of the mutual banking industry and increase the capital cllshion protecting 

the deposit insurance fund. 

AMB appreciates the opportunity to provide this testimony to the Subcommittees on this very 

important issue. We would welcome the chance to further discuss these comments at your 

convenience. 

5 
374 


79691.289

House Committee on Financial Services 

Joint Hearing Before the Subcommittee on Financial Institutions and Consumer Credit and the 

Subcommittee on Insurance, Housing and Community Opportunity Entitled "Examining the 

Impact of the Proposed Rules to Implement Basel ur Capital Standards" 

November 29,2012 

The Council of Federal Home Loan Banks (Council) appreciates this opportunity to 

submit a written statement for the Subcommittees' consideration in connection with the hearing 

entitled "Examining the Impact of the Proposed Rules to Implement Basel rrr Capital Standards". 

The Council is a trade association whose members are the 12 Federal Home Loan Banks 

(FHLBanks), I and the proposed rules will have a significant impact on FHLBank member 

institutions as well as the mortgage markets as a whole. The Council is therefore very interested 

in the Basel III rulemaking proposals and the congressional oversight of their development. 

The Council agrees that the capital rules need to be revisited, and that a strong capital 

buffer is an important safeguard for both individual institutions and our financial system as a 

whole. Accordingly, the Council supports the underlying goals of the Basel m accord to 

strengthen the capital base of depository institutions and their holding companies; to provide a 

buffer against systemic risk; and to better correlate the required amount of capital and the risks 

presented by particular assets and financial activities. However, for the reasons described below, 

we are unable to support the rules as proposed. We have attached to this statement a copy of the 

comment letter we submitted to the regulatory agencies concerning these proposed rules. 

L Risk Weight for Mortgages Held in Portfolio 

We are concerned that the proposed capital treatment of mortgage loans held in portfolio 

by community-based institutions is excessive. Under the proposal there would be a significant 

increase in the minimum capital requirements for both first and second mortgages, up to twice 

the current requirements, unless the loan-to-value ratio of the mortgage loan is 80 percent or less. 

As a result, unless a home buyer can put down at least 20 percent of the cost of the home, plus 

closing costs, the cost of mortgage credit will increase as the mandated capital increases. This 

will harm both the consumer and the overall economy. 

Today, and for the foreseeable future, mortgage underwriting standards are very 

stringent. Under recent statutory reforms, the federal banking agencies and the Consumer 

Financial Protection Bureau (CFPB) have many new tools that will significantly raise the credit 

I Created by Congress in 1932, the FHLBanks are 12 regional banks, cooperatively owned and used to finance 

housing and economic development. More than 7,700 lenders nationwide arc members of the FHLBank System, 

representing approximately 80 percent of America's insured lending institutions. The FHLBanks and their members 

have been the largest and most reliable source of funding for community lending for nearly eight decades. 
375 


79691.290

standards utilized in the extension of mortgage credit by regulated financial institutions without 

the need for across the board higher capital requirements. Mortgages being made today, and that 

will be made under these new rules, will look much more like the traditional mortgages that were 

originated prior to 2005. These mortgages have proven to be safe with very low default and 

foreclosure rates. Burdening these loans with excessive capital requirements will unnecessarily 

impede the availability of mortgage credit, increase costs to consumers, and hurt our economic 

recovery. Especially hard hit will be first-time home buyers, who often require high loan-tovalue (LTV) lending. 

LTV ratio is an important factor in loan perfonnance. A significant cash investment in a 

home purchase clearly lowers the risk of default and the loss given a default. However, further 

analysis needs to be undertaken regarding the impact of lower down payments when other 

factors indicate that the borrower is creditworthy. When other factors indicate that the borrower 

is a prime credit, the fact that the down payment is less than 20 percent should not automatically 

push the loan into a higher capital category. 

II. Effect of Other Laws and Regulations and Market Conditions 

Another concern in the proposal is that it fails to recognize the impact of all of the 

statutory and regulatory changes that have been adopted or that are expected to be adopted 

shortly. The CFPB is currently promulgating regulations to implement the requirement ofthe 

Dodd-Frank Act that prohibits a creditor from making a mortgage loan without considering the 

ability of the borrower to repay. These regulations will effectively require that lenders use very 

conservative mortgage underwriting standards, or face potential liability for failure to consider 

adequately repayment ability when originating the loan. The Dodd-Frank Act also requires 

regulators to implement new rules relating to the securitization of mortgage loans. These 

regulations will define a "qualified residential mortgage" which will likely beeome the standard 

for all new mortgages that are going to be placed into securitization vehicles. These regulations 

will also require stringent loan underwriting. The CFPB is given broad powers to regulate 

mortgage originators, including restrictions on incentive compensation. All ofthese new 

mandates will significantly raise the credit standards utilized in the extension of mortgage credit 

by regulated financial institutions. In establishing new capital rules, it is critically important to 

consider these new laws and regulations, both in terms ofthe quality of mortgages that will be 

originated going forward, and also in the cumulative impact these new rules will have on 

mortgage availability and cost. We are concemed that the cumulative effect of the proposed 

capital requirements coupled with the other new statutory and regulatory requirements could 

result in an adverse impact on mortgage availability and affordability. 

Ill. Balloon Payments 

Under the proposal, loans that have balloon payment features are subject to more onerous 

capital requirements. Many of our member institutions, including community financial institution 

members, view balloon loans as an effective way to provide low cost mortgages to their 

customers. Many customers desire these loans because they know in advance that they will be 

moving within a prescribed number of years, or for other legitimate reasons. For community2 
376 


79691.291

based lenders, the use ofthese products has not been problematic. We also note that from an 

asset-liability management perspective, community banks are more readily able to retain balloon 

mortgages on their balance sheet, reducing the need for securitization. Retention of the mortgages 

on balance sheet also provides a strong incentive for community banks to effectively and 

prudently underwrite and manage the risks in these loans. 

Congress specifically recognized the importance of these loans in rural and agricultural 

communities and created an exception in the Dodd-Frank Act's qualified mortgage standard for 

balloon loans made by lenders in these communities. We urge that any final capital rule treat well 

underwritten balloon loans like any other first mortgages, especially if such loans are written by 

lenders in rural or agricultural areas. 

IV. Home Equity Lines of Credit and Second Liens 

During tbe past decade, some borrowers avoided making any meaningful down payment 

towards the purchase of the home by using a second loan. These so-called "piggy back" loans 

increased the risk to the lender. IIowever, home equity lines of credit CHELOC) and second liens 

that are not used for the purpose of funding down payments are an important source of financing 

for home improvement projects, medical expenses, educational payments, and paying oil more 

expensive credit card debt. Under the proposal,junior liens are subject to more stringent capital 

requirements, which can double the capital required under current rules. 

V. Commercial Real Estate 

The proposal would increase the risk weight of certain commercial real estate loans from 

100 percent to 150 percent. The increased risk weight would apply to so-called High Volatility 

Commercial Real Estate (HVCRE) exposures: loans for the acquisition, development and 

construction of multi-family residential properties and commercial buildings. The higher risk 

weight would not apply to loans made for the development and construction of 1-4 family 

residential units. 

Commercial real estate lending is very important to our community bank members to 

support their local communities. We understand that this can be a volatile asset, and that during 

the financial crisis these loans deteriorated, but not across the board for every community bank. 

Recent indications are that this market is recovering, underwriting standards have improved, and 

there is a significant need for credit in this sector. The regulators have numerous tools to prevent 

a deterioration in underwriting standards, and the use of these tools would be a more effective 

means of addressing the potential risks in this type of asset than raising the capital charge for 

these loans without regard to the quality of the loan. Further, it makes little sense to have a 

higher capital charge for a secured loan (150 percent) than the capital charge that would result 

from making an unsecured loan to the same builder. 

VI. Mortgage Servicing Rights 

Another area of our concern is the treatment of mortgage servicing rights (MSRs). These 

are valuable assets that produce a stream of income that can contribute to the health of our 

financial institutions. Under current rules the value ofthese assets is marked to market quarterly, 

and the market value is then haircut by 10 percent. 

3 
377 


79691.292

We understand that MSRs are sensitive to changes in interest rates, prepayment rates and 

foreclosure rates. However, they are nevertheless a valuable asset that can be sold in a liquid 

market. Under the proposal these assets would essentially be driven out ofthe banking system, 

to the detriment of both consumers and insured institutions and their holding companies. We 

believe that the proposed treatment needs to be reevaluated to ensure that it will not result in 

harming our institutions rather than protecting them. 

We recommend that the agencies' concerns with regard to MSRs focus on the quality of 

the loans associated with the servicing rights, and not lump all MSRs together. Ifthe underlying 

loans are prudently underwritten the associated MSRs should be allowed to count as an asset for 

up to 100 percent of Tier I capital. Ifthe underlying loan does not meet this standard, a more 

stringent limit on the associated MSRs may be appropriate. 

VI!. Securitization Issues 

The proposal does not change the treatment ofMBS that are issued or backed by a U.S. 

agency (zero-percent risk weight), or MBS that are issued or backed by Fannie Mae or Freddie 

Mac (20 percent risk weight). However, the proposal makes significant changes in the treatment 

of private label MBS, that will make it much more difficult for community banks to purchase 

private label MBS, and increase the capital charge for those that do. This result will 

unnecessarily impede the return of private capital to the mortgage markets. 

VIII. Inclusion of AOCI in Calculation of Tier I Capital 

The "minimum regulatory capital ratios, capital adequacy" proposal would require that 

unrealized gains and losses on securities held as "available for sale" (AFS) be reflected in a 

banking organization'S capital account. The inclusion ofthese unrealized gains and losses 

creates the potential for several unintended consequences. 

Community banks holding interest rate sensitive securities for asset-liability management 

or other sound business reasons, would see changes to their capital ratios based solely on interest 

rate movements rather than changes from credit quality, without commensurate change in capital 

ratios resulting from movements in the market price for other assets classes or long term or 

structured liabilities. 

Community banks would be incented to hold short term or floating rate securities to 

minimize the impact on their capital ratios from changes in interest rates. Although there could 

be beneficial reasons for holding longer term fixed rate assets such as municipal or mortgage 

securities, banks could be hesitant to do so realizing the long term, fixed rate nature of these 

investments would subject them to increased price sensitivity and impact on their Tier I capital. 

Community banks would be incented to hold their securities in "held to maturity" 

category rather than available for sale to avoid the impact on their capital ratios. This would 

adversely affect a bank's ability to manage its balance sheet to respond to growing loan demand 

or changing economic fundamentals. 

The inclusion of unrealized gains and losses in AFS securities would diminish the 

relevance and transparency of the Tier I capital measure due to institutions receiving inflated 

levels of Tier I capital from declining interest rates (and hence) rising market values of fixed 

4 
378 


79691.293

rate, non callable securities. This changc in capital could overstate the amount of Tier I capital 

if the subject bank had no intention of monetizing the gain on the securities; this could be the 

case in a scenario where economic activity is stagnant resulting in falling interest rates. 

IX. Disparate Competitive Impacts 

As discussed above, we believe that the proposal will impose capital charges that are far 

in excess of the actual risks presented, especially for mortgages written since the financial crisis 

of2008. As a result, non-regulated lenders will be able to gain market share at the expense of 

regulated banking institutions. Making this problem more severe, the bifurcated capital approach 

(standardized vs. advanced) creates the potential for significant disparate competitive impacts 

across the two approaches. The significant differences in capital requirements across the 

advanced and standardized approaches will almost certainly negatively impact community 

financial institutions as they compete with larger institutions in low credit risk portfolios like 

traditional mortgages. 

X. Conclusion 

The Council supports the efforts of the federal regulators to enhance regulatory capital 

requirements for insured depository institutions and their holding companies. However, overall 

we arc unable to support these rules as proposed. We believe that any increased risk weight must 

be appropriately aligned with the actual risk presented by the asset. High capital for nontraditional or poorly underwritten loans makes sense, and we support that policy. However, 

applying higher capital charges for traditional and prudently underwritten mortgages would be 

extremely counterproductive to our economy and to the American consumer. 

Thank you for the opportunity to include our views in the hearing record. If you have 

any questions, please contact me at the Council's Washington office. 

Attachment 

5 

John von Seggem 

President and CEO 

Council of Federal Home Loan Banks 
379 


79691.294

FHIBAN<S 

A NAnON OF LOCAL LENDERS 

October 22,2012 

Mr. Robert deY. Frierson 

Secretary, Board of Governors of the Federal Reserve System 

20th St. and Constitution Avenue, N.W. 

Washington, D.C. 20551 

COUNC1LOFFEDERAl 

HOME LOAN BANK5 

2120 L Street, i\--w, Suire 208 

\\ashingtoll. DC 20037 

202.9S'.0002 Tel 

202.835.1144 Fax 

www.llilbanks.com 

RE: Docket NoR-1430; RIN No. 7100 AD 87 and Docket NoR-1442; RIN No. 7100 AD 87 

Mr. Robert E. Feldman 

Executive Secretary 

Attention; Comments/Legal ESS 

Federal Deposit Insurance Corporation 

550 17th Street, N.W. 

Washington, D.C. 20429 

RE: RIN 3064-AD 96 and RIN 3064-AD 95 

Office ofthe Comptroller of the Currency 

250 E Street, S.W" Mail Stop 1-5 

Washington, D.C. 20219 

RE: Docket ID OCC-20l2-0009 and Docket ID OCC-20l2-0008 

Re: Standardized Approach for Risk Weighted Assets; Market Discipline and Disclosure 

Rcquircments 

Re: Regulatory Capital, Implementation of Basel Ill, Minimum Regulatory Capital Ratios, 

Capital Adequacy, Transition Provisions, and Prompt Corrective Action 

Dear Sir or Madam: 

I am submitting this comment letter on behalf of the Council ofFedera! Home Loan 

Banks (Council). The Council appreciates the opportunity to comment on two notices of 

proposed remaking ("NPR" or "Proposals") that are designed to implement the Basel III capita! 

framework and make other changes to U.S. capital rules. The first NPR, denominated 

"Standardized Approach," is the focus of the majority of our comments. We will indicate in the 

body of the letter the comments that are directed at the accompanying notice (Minimum 

Regulatory Capital Ratios, Capital Adequacy). 
380 


79691.295

The Council appreciates the need to revisit the capital rules applicable to U.S. depository 

institutions and holding companies. As the financial crisis made clear, a strong capital buffer is a 

ncccssary safeguard for both individual institutions and our financial system as a whole. The 

Council agrees with the underlying goats of Basel III to strengthen the capital base of depository 

institutions and their holding companies; provide a buffer against systemic risk; and better 

correlate the required amount of capital and the risks presented by particular assets and financial 

activities. The concept of adjusting regulatory capital requirements to risk has been a key goal of 

our regulatory capital system since the implementation of the original Basel Accord in 1989. One 

of the most important reforms made by the Basel III revision is to require the use of more 

sensitive measores of risk when establishing minimum capital levels for the internationally active 

banking organizations that are subject to the so-called "advanced approach." 

We are concerned, however, that the regulatory proposals, and in particular the 

provisions relating to the treatment of mortgage loans held by community-based institutions, fail 

to accurately align required capital and the credit risks presented by mortgage loans made since 

the financial crisis. We have a number of other concerns with the proposals, including the 

proposed treatment of private label mortgage-backed securities, other issues relating to 

securitization, mortgage servicing rights, commercial real estate lending, and the inclusion of 

Accumulated Other Comprehensive Income (AOCl) in the calculation of Tier I capital. All of 

these issues and others will be addressed in more detail below. 

1. Mortgages Held In Portfolio Will Be Subject to Significantly Higher Capital Charges 

Under current risk-based capital rules, a prudently underwritten mortgage loan, with a 

loan-to-value (LTV) of90 percent or less, is assigned a risk weight of 50 percent. The current 

rules also consider private mortgage insurance as a substitute for part of the cash down payment. 

As a result, a borrower can combine a small down payment with private mortgage insurance in 

order to meet the 90 percent LTV standard. Likewise, by statute, both Fannie Mae and Freddie 

Mac consider the existence of private mortgage insurance as an alternative to meeting those 

companies' LTV requirements. 1 

Pursuant to the NPR, mortgages are divided into two categories, and then subdivided 

based on the LTV of the mortgage. Unlike the current rules, private mortgage insurance does not 

cOllnt when determining LTV. Therefore, a home buyer with a 10 percent cash down payment 

who obtains mortgage insurance on the loan will be considered as having a 90 percent LTV for 

regulatory capital purposes, notwithstanding the mortgage insurance protection. 

Category 1 mortgages have lower capital charges than Category 2 loans. In order to be a 

Category 1 loan, the mortgage must be a first mortgage, may not exceed 30 years, and CalIDOt 

have a balloon payment or negative amortization feature. The borrower's income must be 

verified. If it is an adjustable rate mortgage, any increase in the interest rate CalIDot exceed two 

percent per year, or six percent over the life of the loan. Most importantly, the creditor must 

make a reasonable determination that the borrower can repay the loan based on the maximum 

interest rate possible during the first five years of the obligation. These requirements are very 

1 Section 305(a) (2) of the Federal Home Loan Corporation Charter Act and Section 302(b) (2) (C) of the Federal 

National Mortgage Association Charter Act. 

2 
381 


79691.296

similar to the recently proposed definition of a "Qualified Mortgage," (QM) under section 1412 

of the Dodd-Frank Act. 2 All other mortgage loans are Category 2 loans. 

The risk-weight is then determined by looking at the LTV. For Category I loans, the 

following risk-weights apply: 

LTV Risk Weight 

Equal to or less than 60% 35% -- Greater than 60% but equal to or less than 80% 50% 

Greater than 80% but e.<J.ll..a..l to or less than 90% 75% - Greater than 90% 100% ... _--

For Category 2 loans the following risk weights apply: 

II. Category I Mortgages Are Safe and Sound Loans 

Historically, mortgage lending has been a safe and sound activity presenting very low 

credit risk to banking institutions. Until the recent period of high defaults and foreclosures 

following the initiation of the financial crisis, default rates on residential mortgages were 

exceedingly low. According to Federal Reserve Board data, from 1991 through 2005 the charge 

off rate on mortgage loans held by all commercial banks was never higher than.45 percent, and 

typically was much lower.3 Delinquency rates on loans held by commercial banks during this 

period were likewise low, generally between two and three percent.4 However, beginning in the 

early 2000s, lenders (primarily unregulated mortgage companies) began originating vast numbers 

of so-called Alt-A and subprime loans, often with one or more non-traditional terms such as; no 

down payment requirement; principal balances in excess of the market value ofthe home; low- or 

no-documentation requirement; very low initial rate for two or three years followed by a large 

jump in the applicable interest rate; deferred payments or interest-only payments, or negative 

amortization.s Ultimately, these loans began to default in record numbers 6 

There is no question tbat the LTV ratio is an important factor in loan performance. A 

significant cash investment in a home purchase clearly lowers the risk of default and the loss 

given a default. However, the available evidence indicates that the proposed risk weights for 

2 The major differences between the two requirements are that with the Qualified Mortgage points and fees are 

limited to three percent, and the mortgage underwriting must comply with any debt to income or residual income 

¥uidance that may later be issued by the prudential regulators. 76 Fed. Reg. 27390 (May 11, 20 I I). 

http://www.federaJreserve.gov/releases/chargeoff/chgallnsa.htm 

, Id. 

, Board of Governors of the Federal Reserve System, The Federal Reserve and the Financial Crisis at &-12 (2012). 

6 Although (as noted below) recent studies have shown that loans that used these nontraditional tenns and nontraditional underwriting standards have experienced increased default rates, it should also be noted that investors 

have filed complaints asserting that mortgage companies and other lenders originating these non-traditional loans 

did not adhere to stated underwriting standards. 

3 
382 


79691.297

Category 1 mortgages with an LTV in excess of 80 percent are not warranted. Category 1 

mortgages are, by definition, similar to the traditional mortgages that were fully documented and 

underwritten according to historical standards. And because regulated financial institutions will 

have to determine independently that the borrower has a reasonable "ability to repay" the loan, 

according to its terms, when the loan is made, it is likely that Category 1 mortgages will be 

subject to even more stringent underwriting than loans made before the subprime boom. In this 

regard it is important to note that the requirement to make this independent "ability to repay" 

determination is not presumed to have been met if the loan also meets the requirements for a 

qualified mortgage (QM). Thus a lender would have to make an "ability to repay" determination 

for all Category I loans, including qualified mortgages" 

In light of the characteristics of Category I mortgages it can be expected that these loans 

will have, at worst, the same performance characteristics of loans made in the early 2000s. Low 

down payment loans (loans with an LTV in excess of 80 percent) made up a substantial 

percentage of loans made before the subprime boom. For example, in the years 2001 - 2004, 

approximately 40 percent of the single-family loans purchased by the GSEs had L TVs in excess 

of80 percent.s For first-time home buyers the percent of high LTV lending is greater. Low 

down payment mortga§'es constituted the majority of the financing for first-time home buyers in 

every year since 1990. 

Historically, these loans (including loans with L TVs in excess of 80 percent) performed 

welL 10 The delinquency rates for single- family mortgages purchased by the GSEs were less 

than 1 percent for every year between 1988 and 200511 As noted earlier, the delinquency rates 

on residential mortgages held in portfolio by U.S. banks were also exceedingly low in the years 

prior to 2005. Based on the performance of mortgage loans at the time, the Basel Committee 

recommended a risk weight of 35 for residential mortgages under the Basel II standardized 

approach issued in 2004. 12 The Basel Committee has not amended this recommendation as part 

of the Ba~e1 III revisions. In 20 II, the Center for Responsible Lending conducted a review of 

mortgage loan performance and concluded "badly structured loans and lack of underwriting, not 

low down payments, caused the foreclosure crisis.,,13 A logistical regression analysis performed 

in 2011 by Genworth Financial Corporation using CoreLogic data for 2000-2008 found that the 

loan terms with the greatest correlation with performance were related to loan amortization 

(whether a loan is an interest- only loan or a negative amortization loan), and that the amount of 

the down payment (evaluated in I % increments) was only the sixth most significant variable. 

Although we have not conducted our own analysis of this data, these studies conclude that 

7 We question whether this represents good policy. A better approach would be to consider all QM loans as 

Category I and also subject to the presumption that the ability to repay test has been satisfied. 

'Department of Housing and Urban Development, Profiles ofGSE Mortgage Purchases: 2001-04 at Table 10. 

Attached as Exhibit A. 

9 J. Duea, J.Muellbauer and A. Murphy, Federal Reserve Bank of Dallas, Shifling Credit Standards and the Boom 

and Bust in u.s. House Prices: Time Series Evidencefrom the Past Three Decades 31 (2012). 

1 D According to economist Mark Zandi, "While there is no question that larger down payments correlate with better 

loan performance, low down payment mortgages that are well underwritten have historically experienced 

manageable default rates, even under significant economic or market stress." Mark Zandi, Special Report: The 

Skinny 011 Skin in the Game, Moody's Analytics (March 11,2011). 

Il Office of Federal Housing Enterprise Oversight, Annual Reporteo Congress, Table 9 and 19 (June 15,2006). 

12 Basel Committee on Bank Supervision, [ntemational Convergence on Capital Methods and Capital Standards 

(Basel II) (Rev. June 2006). 

Il Center for Responsible Lending, Comment Letter submitted to the federal banking agencies on Interagency 

Proposed Rule on Credit Risk Retention (August 1,2011). 

4 
383 


79691.298

various non-traditional loan tenns and weak underwriting have a stronger correlation with loan 

defaults than the amount of the down payment. 

Category I mortgages are safe and sound loans that should have similar, if not better 

performance characteristics as the mortgages that were made before the subprime boom. These 

loans included millions of high LTV mortgages that performed welL Any change in the current 

capital rules should be based on the perfonnance of well undenvritten traditional mortgages, and 

should exclude mortgages that have non-traditional structures or followed nontraditional 

tmderwriting standards, such as without documentation of the borrower's resources. We believe 

that the performance data for high LTV pre-200210ans demonstrate that the proposed risk 

weights for mortgages with LTV ratios in excess of 80 percent are too high. We urge the 

regulators to revisit the proposal in order to ensure that the regulatory capital charge is aligned 

with the economic risk of Category I loans that have LTV ratios in excess of 80 percent 

m. Effect of Other Laws and Regulations and Market Conditions 

Another shortcoming in the proposed capital regulation is that it fails to recognize fully 

the impact of all of the statutory and regulatory changes that have been adopted or that arc 

expected to be adopted shortly. The Dodd-Frank Act prohibits a creditor from making a 

mortgage loan without considering the ability of the borrower to repay.!4 And the Consumer 

Financial Protection Bureau (CFPB) is currently promulgating regulations to implement this 

requirement These regulations will effectively require that lenders use very conservative 

mortgage underwriting standards,!5 or face potential liability for failure to consider adequately 

repayment ability when originating the loan. The Dodd-Frank Act also requires regulators to 

implement new rules relating to the securitization of mortgage loans.!6 These regulations will 

define a "qualified residential mortgage" which will likely become the standard for all new 

mortgages that are going to be placed into securitization vehicles.!7 These regulations will also 

require stringent loan undenvriting. The CFPB is given broadfowers to regulate mortgage 

originators, including restrictions on incentive compensation.! All of these new mandates will 

significantly raise the credit standards utilized in the extension of mortgage credit by regulated 

financial institutions. In establishing new capital rules, it is critically important to consider these 

new laws and regulations, both in terms of the quality of mortgages that will be originated going 

fOIWard, and also in the cumulative impact these new rules will have on mortgage availability 

and cost. We are concerned that the cumulative effect of the proposed capital requirements 

coupled with the other new statutory and regulatory requirements could result in an adverse 

impact to mortgage availability and affordability. 

Even without these new laws and regulations, the evidence from the market is quite clear. 

Unlike the experience of the last decade, in which qualifYing for a mortgage loan was easy, it is 

currently very difficult to qualifY for a mortgage loan. Banks and other lenders are demanding 

far higher credit quality than they did even before the early 2000s. 19 The problem for our 

14 See Title XIV, Subtitle B ofthe Dodd-Frank Act 

15 76 Fed. Reg. 27390 (May 11,2011). 

16 Section 941 of the Dodd-Frank Act. 

17 76 Fed. Reg. 24090 (April 29, 20 II). 

Ii Semi-annual Report of the CFPB, Significant Rules. Orders and Initiatives, (July 2012). 

" Joint Center for Housing Studies Harvard University, The Slate of the Nation's Housing 2012 at 19. 

5 
384 


79691.299

economy is not unsafe mortgage lending but the reluctance of private capital to enter the market. 

Higher capital requirements will only further reduce the availability of mortgage credit. 

Concerns that mortgage underwriting standards may decline in the future are also 

misplaced. If there were ever an attempt to return to the home loan financing practices of the 

mid-2000s, the regulators have a broad array of new tools at their disposal to stop these 

practices.z° In addition, the Financial Stability Oversight Council (FSOC) has the authority to 

determine that any financial practice presents risks to the U.S. financial system, and can request 

that the appropriate federal agency implement steps to prevent or curtail that activity.21 This 

authority is not limited to large institutions, and thus the FSOC can use its influence to curtail 

risky practices conducted by any financial company without regard to asset size. 

Regulatory tools, including the ability to raise underwriting standards immediately 

through regulatory guidance, should mitigate the concerns that the experience of the past decade 

will be repeated. Utilization of these regulatory tools to address risky lending practices is more 

effective than raising capital standards on all mortgage loans that have an LTV in excess of 80 

percent, which would raise the cost of mortgage loans for all but the wealthiest segments of our 

country, and limit the ability of credit-worthy, first-time home buyers and minorities to obtain 

mortgage loans.z2 

IV. Balloon Payments 

Another issue raised by the proposal is the blanket prohibition on balloon payment loans 

in Category 1. The Council believes there are balloon payment loans that are appropriate to a 

borrower's needs and repayment abilities and should be considered for Category I treatment with 

a risk weighting that addresses associated risk. Many of our member institutions, induding 

community financial institution members, view balloon loans as an effective way to provide low 

cost mortgages to their customers. Many customers desire these loans because they know in 

advance that they will be moving within a prescribed number of years, or for other legitimate 

reasons. For financial institutions that have applied appropriate underwriting standards, 

particularly community- based lenders, the use of these products has not been problematic. We 

also note that from an asset-liability management perspective, community banks are more readily 

able to retain balloon mortgages on their balance sheet, reducing the need for securitization. 

Retention of the mortgages on balance sheet also provides a strong incentive for community 

banks to effectively and prudently underwrite and manage the risks in these loans. 

Congress specifically recognized the importance of these loans in rural and agricultural 

communities and created an exception in the Dodd-Frank Act's qualified mortgage standard for 

2" The federal banking agencies are empowered to issue enforceable real estate lending standards under section 304 

orthe Federal Deposit Insurance Corporation Improvement Act. TIle agencies are also authorized to increase 

required capital levels on an institution specific basis when they find that increased capital is required in light of the 

activities and assets of that institution. 12 U.S.C. § 3907(a) (2). See, e.g .. 12 C.F.R. § 3.9 ("The acc is authorized 

•.. (0 establish such minimum capital requirements for a bank as the acc, in its sale discretion, deems appropriate 

in light of the particular circumstances oftha! bank." 

2J Section 120 of the Dodd-Frank Act. 

22 Increasing the capital charge, and thus the cost, for mortgage loans with an LTV in excess of 80 percent will hurt 

all first-time home buyers that predominately rely on lower down payment mortgages. However, minorities as a 

group will be hardest hit. According to data from the American Housing Survey, 72 percent of African-American 

buyers and 63 percent of Hispanic buyers took out mortgages that were above 90 percent LTV in 2009. 

6 
385 


79691.300

balloon loans made by lenders in these communities?3 We urge that any final capital rule treat 

well underwritten balloon loans as for Category I mortgages, especially if such loans are written 

by lenders in rural or agricultural areas. 

V. Home Equity Lines of Credit and Second Liens 

During the past decade, some borrowers avoided making any meaningful down payment 

towards the purchase of the horne by using a second loan. These so-called "piggy back" loans 

increased the risk to the lender. However, horne equity lines of credit (HELOC) and second liens 

that are not used for the purpose of funding down payments are an important source of financing 

for home improvement projects, medical expenses, educational payments, and paying offmore 

expensive credit card debt. Under the proposal, all junior liens are considered Category 2 loans, 

unless the same party holds both the first and second exposure. 24 

The interest rate on home equity lines is typically indexed, but not capped. In addition, 

home equity lines of credit often allow the homeowner the option to make interest- only payments 

for an established period oftime. Under the proposal the existence of either of these features 

would result in classifying a horne equity line as a Category 2 loan. Thus, even if the HELOC is 

in a first lien position, or is held by the same lender who holds the first loan, the horne equity line 

would be a Category 2 exposure. 

As Category 2 loans, both HELOCs and second mortgages would have twice the capital 

charge as would be imposed on a first lien with a similar LTV. Even worse, if the second lien or 

HELOC does not qualify for Category 1 treatment, for example because it has a balloon feature or 

because its interest rate is not capped, and both loans are held by the same bank, the entire 

exposure (both the first loan and the second or HELOC) is treated as a Category 2 mortgage asset. 

The proposal fails to distinguish between traditional variable rate loans and the much 

more troublesome teaser loans with an artificially low teaser rate for two or three years followed 

by a high jump in the interest rate resulting in "payment shock" to the borrower. Traditional 

variable rate loans, such as an underwritten 5f! or 711 product, have been demonstrated to be both 

safc for the lender and useful to the consumer. Clearly there are many other well underwritten 

variable rate loans that should not be lumped into Category 2 because of the poor performance of 

the non-traditional 2/28 and 2/27 teaser products. Moreover, from an interest rate risk perspective, 

511 or 711 mortgages, as examples, are likely to be more readily and effectively hedged by a 

financial institution than might be the case with a 30-year mortgage. 

In short, the risk weight of home equity lines and other second mortgages that are made 

in conformancc with traditional and prudent underwriting standards (including consideration of 

the combined first and second liens for LTV exposure purposes, and a determination that the 

borrower has the ability to repay both loans) should be adjusted to reflect the actual risk ofthe 

second loan or home equity line of credit. Simply doubling the risk weight from current rules 

does not appear to reflect the actual increase in risk. 

VI. Commercial Real Estate 

" Section 1412 of the Dodd-Frank Act. 

24 Category I treatment is allowed if the same lender holds both the first lien and the second lien or RELOC, with no 

intervening liens. The lender combines the two exposures to determine the LTV of the combined loan. Ifboth 

exposures meet the requirements for Category I, the combined loan will qualifY for Category I treatment. But if 

either loan does not meet the standards for Category I, both loans are treated as Category 2 exposures. 

7 
386 


79691.301

The proposal would increase the risk weight of certain commercial real estate loans from 

100 percent to 150 percent. The increased risk weight would apply to so-called High Volatility 

Commercial Real Estate (HVCRE) exposures: loans for the acquisition, development and 

construction of multi-family residential properties and commercial buildings. The higher risk 

weight would not apply to loans made for the development and construction of 1-4 family 

residential units. 

Commercial real estate !ending is a significant source of income for many of our 

community bank members. We understand that this can be a volatile asset, and that during the 

financial crisis many of these loans went bad. However, recent indications are that this market is 

recovering, underwriting standards have improved, and there is a significant need for credit in 

this sector. The regulators have numerous tools to prevent deterioration in underwriting 

standards, and the use of these tools would be a more effective means of addressing the potcntial 

risks in this type of asset than raising the capital charge for these loans without regard to the 

quality ofthe loan. Further, it makes little sense to have a higher capital charge for a secured 

loan (150 percent) than the capital charge that would result from making an unsecured loan to the 

same builder. 

VII. Mortgage Servicing Rights 

The tenn "mortgage servicing rights" (MSRs) refers to the right to service a mortgage by 

collecting monthly payments, managing the escrow, paying taxes and other fees, and dealing 

with delinquent loans and loans in foreclosure. These rights arise when a mortgage loan is sold 

but the servicing is retained by the loan originator or sold to a third party. For example, a 

community bank may want to sell a loan into a securitization pool, but retain the right to service 

the loan in its local community. Also, a small bank may wish to originate loans but sell the 

servicing to a larger institution that has the appropriate infrastructure to service the loan 

efficiently. 

Under current rules, mortgage servicing rights may be treated as an asset of a bank in 

amounts up to 100 percent ofthe bank's Tier I capital. The value of the bank's MSRs must be 

reduced to 90 percent of fair market, and adjusted quarterly. The "minimum regulatory capital 

ratios, capital adequacy" proposal would reduce the amount ofMSRs that may be included as a 

bank asset to 10 percent of the bank's common equity Tier I capital, and the remainder would 

have to be deducted from capital. Under the "standardized approach" NPR, the MSRs that are 

not deducted would have to be risk weighted at 250 percent. In essence, under the proposed 

treatment many banking organizations would likely leave this market, and the mortgage 

servicing function would move to nonbanking entities. 

While mortgage servicing rights are sensitive to changes in interest rates, prepayment 

rates and foreclosure rates, they are nevertheless a valuable asset that has perfonned well prior to 

the financial crisis. These assets can be sold in a liquid market and can be used to support a 

bank's other activities. 25 Driving this asset out of the banking system will greatly decrease the 

25 See, e.g. Testimony of FDIC Chair Sheila Bair, Hearing on Implementing the Dodd-Frank Act, Before the Senate 

Comm. On Banking, Housing and Urban Affairs, 111'" Congo 2d Sess. 67 (20 1 O)(While the value of mortgage 

servicing rights can be volatile, they clearly have value); Testimony ofFeder.l Reserve Board TaTUllo, Hearing 

Before the Subcommittee on Security and International Trade of the Senate Comm. on Banking, Housing and Urban 

8 
387 


79691.302

number of companies able and willing to perform this activity, and thereby raise the cost of 

servicing for the public, and deprive regulated financial companies of a stream of revenue that 

can be used to support other lending activities. The net effect will be to increase the cost of 

mortgage loans. 

Because MSRs gain value when interest rates increase, this asset acts as a natural hedge 

against interest rate risk. IfMSRs are forced out of the banking system, banks will either have 

more exposure to the risks of increased interest rates, or will have to purchase swaps and other 

hedges at an increased cost to the institution, and ultimately to the public. 

We are well aware that in recent times MSRs suffered significant declines in value due to 

the large number of delinquencies, defaults and foreclosures. All of these events raise the cost of 

servicing. In addition, when a loan is refinanced the servicing fee for that loan is terminated. 

However, the capital rules should be forward looking, and not based on the unique circumstances 

of the past few years. As previously noted, on a going forward basis home mortgages will be 

underwritten, and will likely perform, according to historicall1orms. In the 1990s, the regulatory 

agencies increased the amount ofMSRs that could be counted as an asset from 50 percent to 100 

percent of Tier 1 capital. 26 At that time the agencies expressed the view that the requirement to 

haircut this asset by 10 percent, and determine its fair market value on a quarterly basis, would 

provide sufficient safety to enable banks to hold MSRs in an amount of up to 100 percent of Tier 

I capital. 

We recommend that the agencies' concerns with regard to MSRs focus on the quality of 

the loans associated with the servicing rights, and not lump all MSRs together. If the underlying 

loans are prudently underwritten (i.e., if they meet the QM standards that will soon be released), 

the associated MSRs should be allowed to count as an asset for up to 100 percent of Tier 1 

capital. If the underlying loan does not meet this standard, a more stringent limit on the 

associated MSRs may be appropriate. 

VIII. Securitization Issues 

Under the capital rules in effect today, mortgage-backed securities (MBS) that are issued 

or backed by an agency of the United States, such as GNMA, are given a zero-risk weight. MBS 

issued by a Government-Sponsored Enterprise, such as Fannie Mae or Freddie Mac are assigned 

a 20 percent risk weight. Private label MBS are assigned a risk-weight based on the credit rating 

of the position. For example, securities in the highest or next highest grade (AAA or AA) have a 

risk weight of20 percent. Securities in the third highest grade (A) have a risk weight of 50 

percent. 

The proposal does not change the treatment ofMBS that are issued or backed by a U.S. 

agency (zero-percent risk weight), or MBS that are issued or backed by Fannie Mae or Freddie 

Mac. However, the proposal makes significant changes in the treatment of private label MBS. 

For private label securities the proposal does away with reliance on credit ratings,27 and 

instead will require the investing bank to undertake its own due diligence of the credit risks 

Affairs, 111'" Congo 2d Sess. 16 (luly 20,20 11)(Mortgage servicing rights, again, are not the same as an asset 

already on the balance sheet, but they are an expected stream of earning which have perfomled well in the past) 

"63 Fed. Reg. 42669 (Aug. 10, I 998). 

27 Under section 939A of the Dodd-Frank Act the regulatory agencies are required to end the use of credit ratings for 

regulatory purposes. 

9 
388 


79691.303

involved, and demonstrate to the bank's examiner a comprehensive understanding of the 

structure and risks of the security. The due diligence must include an analysis of the features of 

the securitization that could materially affect performance, including the cash flow waterfall, 

triggers, credit enhancements, and the specific definitions of default used in the securitization. 

A bank would also be required to consider relevant information about the performancc of 

the underlying securities, market data, price volatility, trading volume, liquidity support, 

percentage ofloans that are 30,60 and 90 days past due, loans in foreclosure, overall default 

rates, occupancy data, average LTV of the underlying loans, average credit scores of the 

borrowers, the extent of the geographic diversification of the loans and size, depth and 

concentration of the market for the securitization including bid-ask spreads. The bank's analysis 

must be conducted and documented prior to the purchase of the instrument. If the bank cannot 

demonstrate such a comprehensive understanding, it would be required to risk weight the 

exposure at 1,250 percent. 

Bascd on the bank's analysis, the appropriate risk weight for the security would be 

determined using one of two prescribed models in the regulation. 

With respect to banks selling mortgages into a securitization pool, the "minimum 

regulatory capital ratios, capital adequacy" NPR requires the selling bank to deduct from Tier 1 

regulatory capital any non-cash gain on sale that would be recognized under generally accepted 

accounting principles, and apply a risk weight of 1 ,250 percent to any credit enhancing interest 

only securities generated by the securitization. 

We agree with the proposal that the risk weight for mortgage backed securities issued or 

guaranteed by a U.S. agency and Government-Sponsored Entities should not be changed. 

However, we are concerned that the proposal inhibits private label securitization by making it 

very difficult, ifnot impossible, for community and smaller banks to purchase private label 

MBS. These institutions simply do not have the capacity to undertake the extensive analysis 

demanded by the proposal, and thus are likely to be frozen out of the market for these securities. 

The result will prevent these banks from acquiring higher yielding securities that will be backed 

by the stringently underwritten mortgages that are now being made. 

We understand that under the Dodd-Frank Act the banking agencies can no longer link 

the risk weight for securities with the credit rating of those instruments. However, expecting 

small and community banks to engage in a sophisticated analysis of the products is not realistic 

and will have broader negative consequences for the housing markets. We therefore recommend 

that for small and community banks the requirement to engage in the extensive due diligence be 

waived and that a risk weight of 20 percent be assigned to private label MBS provided that all of 

the loans meet certain underwriting standards. In particular, we suggest that once the QM test is 

finalized, establishing the regulatory standard for a low risk mortgage, secnrities backed solely 

by such mortgages should be assigned a risk weight of 20 percent. 

Further, we believe that the purchasing bank should be able to rely on a representation by 

the securitizer that all the loans qualify, and that the obligation of the purchasing bank be limited 

to a sampling of the loans. A small or community bank should be able to rely on an independent 

third party to conduct this sample. Finally, we recommend that the requirement in the 

"minimum regulatory capital ratios, capital adequacy" NPR that a bank selling loans into a 

secnritization deduct from Tier 1 capital all non-cash gains on sale should be revisited. Rather 

10 
389 


79691.304

than a dollar for dollar deduction, the agencies should consider a supervisory approach in which 

the value of this asset could be adjusted if the examiner has reason to believe it is not valid. 

IX. Repurchase Agreements 

Under current rules, capital is required for anyon-balance sheet exposure that arises ITom 

a repo-style transaction (that is, a repurchase agreement, reverse repurchase agreement, securities 

lending transaction, and securities borrowing transaction). For example, capital is required 

against the cash receivable that a banking organization generates when it borrows a security and 

posts cash collateral to obtain the security. The proposal would impose a capital charge on all 

repo-like transactions, regardless of whether the transaction generates an on-balance sheet 

exposure. 

Under the NPR, a banking organization would be required to apply a 100 percent 

conversion factor to off-balance sheet repurchase agreements, securities lending or borrowing 

transactions, and other similar exposures. The off-balance sheet component of a repurchase 

agreement would equal the sum of the current market values of all positions the banking 

organization has sold subject to repurchase. 

Repurchase agreements are a key part of the financial management of the Federal Home 

Loan Bank (FHLBank) system. The proposed rule will increase the capital charge for banks that 

sell securities to a FHLBank with the obligation to repurchase these securities at a later date. 

When the FHLBank is a counterparty, there is cssentially no risk to the selling bank that the 

FHLBank will not be able to comply with its obligation to return the securities to the 

counterparty. We would urge the rcgulators to provide an exemption from this new capital 

requirement for off-balance sheet positions held as part of a repo transaction. 

FHLBanks, as well as other financial institutions holding interest ratc sensitive assets, 

engage in derivative transactions to protect against changes in prevailing interest rates. The 

proposed rule requires banking organizations to hold capital with respect to such derivative 

agreements, with the amount of the capital charge dependent upon the counterparty, the 

collateral, and the remaining maturity on the contract. The proposal would not require a capital 

charge for dcrivatives cleared through a central clearinghouse. The FHLBanks use a wide 

variety of swap agreements to hedge the various types of funding that our member banks require, 

and therefore the use of a clearinghouse is not practicable for all swaps transactions. Further, 

when the FHLBank is a counterparty, there is essentially no credit risk to the counterparty. We 

believe that capital should not be charged when the counterparty is a FHLBank, even if a 

clearinghouse is not used. 

XL Inclusion of AGCI in Calculation of Tier I Capital 

The "minimum regulatory capital ratios, capital adequacy" NPR would require that 

unrealized gains and losses on securities held as "available for sale" (AFS) would be reflected in 

a banking organization's capital account. The inclusion of these unrealized gains and losses 

creates the potential for several unintended consequences. 

Community banks holding interest rate sensitive securities for asset-liability management 

or other sound business reasons, would see changes to their capital ratios based solely on interest 

11 
390 


79691.305

rate movements rather than changes from credit quality, without commensurate change in capital 

ratios resulting from movements in the market price for other assets classes or long term or 

structured liabilities. 

Community banks would be incented to hold short term or floating rate securities to 

minimize the impact on their capital ratios from changes in interest rates. Although there could 

be beneficial reasons for holding longer term fixed rate assets such as municipal or mortgage 

securities, banks could be hesitant to do so realizing the long term, fixed rate nature of these 

investments would subject them to increased price sensitivity and impact on their Tier I capital. 

Community banks would be incented to hold their securities in "held to maturity" 

category rather than available for sale to avoid the impact on their capital ratios. This would 

adversely affect a bank's ability to manage its balance sheet to respond to growing loan demand 

or changing economic fundamentals. 

The inclusion of unrealized gains and losses in AFS securities would diminish the 

relevance and transparency of the Tier I capital measure due to institutions receiving inflated 

levels of Tier 1 capital from declining interest rates (and hence) rising market values offixed 

rate, non callable securities. This change in capital could overstate the amount of Tier 1 capital 

if the subject bank had no intention of monetizing the gain on the securities; this could be the 

case in a scenario where economic activity is stagnant resulting in falling interest rates. 

XII. Acquired Member Assets 

We recognize that, as a conceptual matter, there may be some merit in the proposed 

rule's approach to RBC requirements for the mortgage programs that have been established by 

many of the FIILBanks whereby they acquire or fund convcntional and government-insured 

residential mortgage loans originated and serviced by member institutions, known as Acquired 

Member Assets ("AM A") Programs. These programs operate under the names Mortgage 

Partnership Finance® ("MPF®") Program28 , first established in 1997, and the Mortgage Purchase 

Program ("MPP"), established in 2000. Dy using a unique risk-sharing structure, these programs 

allow participating members to retain a significant portion of the credit risk of the fixed-rate 

mortgages they originate when selling conventionally underwritten loans to the FHLBanks. 

Allocating the risks inherent in long term, fixed-rate mortgages in this marmer results in a more 

efficient and lower cost mortgage financing benefitting American horne buyers. 

These programs are very popular with smaller community financial institutions because 

they provide an alternative to the traditional secondary market that can be difficult or 

prohibitively costly for many community lenders to access. Approximately 1,500 FHLBank 

member institutions, typically community banks, thrifts and credit unions, have used these 

programs to fund about $235 billion of mortgages that have helped horne buyers in every state, 

including large numbers oflow- and middle- income buyers, purchase a new home or lower the 

cost of their existing home through refinancing. 

The structure of several MPF® products requires a participating member to provide a 

credit enhancement of a defined portion of a pool of residential mortgage loans that have been 

delivered to one of the FHLBanks. Even though the loans are held on the balance sheet of the 

FHLBank, the participating member must hold risk-based capital ("RBC") against its off-balance 

2! "Mortgage Partnership Finance" and "MPF" are registered trademarks of the Federal Home Loan Bank of 

Chicago. 

12 
391 


79691.306

sheet credit enhancement ("CE") obligation. As we understand the proposed rule, the amount of 

RBC required for participating members would be changed to more appropriately reflect the risk 

of potential losses related to the participating members' CE obligation. 

Under the "standardized approach" described in the proposed rule, there are three 

possible definitional paths for a participating members' credit enhancement obligation in the 

AMA Programs; (I) "traditional securitization"; (2) "synthetic securitization"; and (3) "retail 

exposure." Based on our analysis, a member's credit enhancement required under the MPF® 

Program would likely fall into the "synthetic securitization" definition and resulting 

methodology . 

. The proposed rule eliminates the existing regulatory approach for RBC that has been in 

place since the MPF® Program was rolled out to members in 1997, replacing it with a much more 

conceptually appropriate, albeit complicated, formula. Further, the proposed rule would not 

grandfather existing MPF® pools under the current RBC rules. 

Member credit support obligations in MPP programs are structured differently from those 

of MPF® products. Participating members' credit support obligations are limited to funding a 

risk based and FHLBank established Lender Risk Account ("LRA") from the proceeds of the 

sale of the mortgage loans (a purchase price hold-back) or a portion of the amount of interest 

paid by the borrower, and to providing supplemental mortgage insurance for some MPP 

products. Each MPP mortgage pool's LRA is used to reduce or offset credit losses suffered by 

the pool. No member is obligated to cover credit losses over and above the amount of funds in 

the LRA. Amounts remaining in the LRA after losses are returned to the participating member 

according to a predetermined release schedule. The participating member's exposure is therefore 

limited to the risk it will not receive all (or any) of the LRA, because the MPP FHLBank absorbs 

any losses in excess of the LRA. However, as in the case of the MPF® products, we understand 

that the proposed rule would not grandfather existing MPP pools under current RBC rules. 

The Council recommends working toward a solution that implements the formula-based 

approach to determining the RBC requirement related to the member holding the CE obligation 

without requiring the risk weighting tied to Category 1 loans under the proposed rules. The 

formula-bascd approach could fit into the existing RBC framework that recognizes the safe and 

sound loans being sold into AMA Programs. 

Modifying the proposed rule to more appropriately recognize the credit risk members 

accept by retaining a credit enhancement on high quality residential mortgages will encourage 

broader participation and the use of private capital to support the residential mortgage markets. 

However, the proposed rule's highly unfavorable treatment of mortgage servicing rights (as 

indicated in a previous section of this letter under the heading "VII. Mortgage Servicing Rights") 

would be very detrimental to the AMA programs, in which FHLBank member institutions 

generally rctain servicing of the loans and thus maintain their relationship with their customers. 

Moreover, the rules should be simplified to more closely match the existing framework to reduce 

the risk that smaller community financial institutions might exit the mortgage origination market, 

which would further concentrate this market into the hands of a few, very large financial 

institutions and reduce choices for American consumers. 

XIII. llimarate Competitive Impacts 

13 
392 


79691.307

One of the primary purposes of the Basel framework was to better align required capital 

and risk in order to reduce the competitive advantages that capital regulations could provide to 

different banking organizations. The same principle applies within a single country. When one 

segment of the financial services industry is required to hold capital that is in excess of the 

economic risk of its assets, the segments of the industry not burdened by these excessive capital 

requirements will have a market advantage. Thus it is critical that capital charges be closely 

aligned to the risk inherent in the portfolios and activities of the institutions subject to those 

charges. 

As discussed above, we believe that the proposal will impose capital charges that are far 

in excess of the actual risks presented, especially for mortgages written since the financial crisis 

of 2008. As a result, non-regulated lenders will be able to gain market share at the expense of 

regulated banking institutions. Making this problem more severe, the bifurcated capital approach 

(standardized vs. advanced) creates the potential for significant disparate competitive impacts 

across the two approaches. The significant differences in capital requirements across the 

advanced and standardized approaches will almost certainly negatively impact community 

financial institutions as they compete with larger institutions in low credit risk portfolios like 

traditional mortgages. 

XIV. Conclusion 

The Council supports the efforts of the federal regulators to enhance regulatory capital 

requirements for insured depository institutions and their holding companies. However, overall 

we are unable to support these rules as proposed. 

We believe that any increased risk weight must be appropriately aligned with the actual 

risk presented by the asset. High capital for non-traditional or poorly underwritten loans makes 

sense, and we support that policy. However, applying higher capital charges for traditional and 

prudently underwritten mortgages would be extremely counterproductive to our economy and to 

the American consumer. We therefore urge the regulators to evaluate carefully the need to 

increase the risk weight of Category I mortgages, and to take into account both current 

underwriting standards and the overlay of regulatory initiatives designed to assure prudent 

lending in the future. 

The Council also urges the regulators to consider placing well underwritten balloon 

loans, made in rural or agricultural areas, into Category I, as was done in the Dodd-Frank Act for 

QMloans. 

The proposed increase in capital for high-volatility commercial real estate loans 

(HVCRE) is another area that should be reconsidered, in light ofthe changes in both regulatory 

oversight and the more recent performance of these loans. There is a great need for multi-family 

housing development, and increasing the capital requirements for these loans may have 

significant unintended consequences for this sector of the housing market. 

Under the proposal, banking organizations would essentially be forced out ofthe market 

for mortgage servicing rights. We believe that this result is not in the public interest, and a better 

approach would be to link the treatment of mortgage servicing to the quality of the associated 

mortgage loans. For example, MSRs associated with loans meeting a QM standard should be 

afforded better treatment than other MSRs. 

14 
393 


79691.308

We also believe that the proposed treatment of mortgage securitization needs to be 

revised. Under the proposal, non-conforming loans would be particularly hard hit, since private 

label mortgage-backed securities would be significantly disadvantagcd. 

The Council believes that the higher capital required for reverse repurchase agreements 

and swap agreements that are not cleared should be revised to take into account situations where 

a FHLBank is a counterparty. 

While as a conceptual matter there may be some merit in the proposed rule's approach to 

risk based capital requirements for the FHLBanks mortgage programs, known as Acquired 

Member Assets ("AMA") Programs, the proposed rule's highly unfavorable treatment of 

mortgage servicing rights would be very detrimental to the AMA programs. Moreover, the rule 

should be simplified to more closely match the existing framework to reduce the risk that smaller 

community financial institutions might exit the mortgage origination market, which would 

further concentrate this market into the hands of a few, very large financial institutions and 

reduce choices for American consumers. 

The significant differences in capital requirements between the standardized and 

advanced approaches and the likely negative impact of this imbalance on community financial 

institutions also represent a significant concern. We suggest the standardized rule include a 

formal and scheduled recalibration of the standardized approach within the parallel reporting 

period of the advanced approach to achieve a greater degree of alignment and thereby eliminate 

significant competitive imbalances and other impacts detrimental to the safety and soundness of 

community financial institutions. 

Finally, the proposed capital rule includes Accumulated Other Comprehensive Income 

(AOCI) in calculating Tier 1 capital. The inclusion of unrealized gains and losses on securities 

held as "available for sale" in determining Tier 1 capital has the potential to substantially 

increase the volatility of Tier 1 capital and distort the bank's regulatory capital ratios. 

Community banks holding interest rate sensitive securities for sound business purposes could see 

changes to their capital ratios based solely on interest rate changes rather than changes from 

credit quality. 

We thank you again for the opportunity to comment on these proposals. 

15 

Sincerely, 

Carl F. Wick 

Chairman 

Council of Federal Home Loan Banks 
394 


79691.309

i!tfIU\!l,\), 

M B c A 

MID-SIZE BANK COALITION OF AMERICA 

November 20,2012 

Mr. Michael S. Gibson 

Director, Division of Banking Supervision and Regulation 

Board of Governors of the Federal Reserve System 

20th Street and Constitution Avenue, N.W. 

Washington, DC 20551 

Re: Impact of Proposed Capital Rules 

Dear Mr. Gibson: 

On behalf of the Mid-size Bank Coalition of America ("MBCA"), I 

am writing to highlight the MBCA's concerns about the proposed capital rules 

to implement Basel III that would apply to MBCA members if adopted as 

proposed ("proposed rules''). The MBCA submitted a comment letter on the 

proposed capital rules to the federal banking agencies (the "Agencies") on 

October 22,2012. I have enclosed a copy ofthat letter. 

The MBCA is a non-partisan financial and economic policy 

organization comprising the CEOs of mid-size banks doing business in the 

United Slates. Founded in 2010, the MBCA, now with 31 members, was 

formed for the purpose of providing the perspectives of mid-size banks on 

financial regulatory reform to regulators and legislators. As a group, the 

MBCA banks do business through more than 3,800 branches in 41 states, 

Washington D.C. and three U.S. territories. The MBCA's members' 

combined assets exceed $450 billion (ranging in size from $7 billion to $30 

billion) and, togcther, its members employ approximately 77,000 people. 

Member institutions hold nearly $336 billion in deposits and total loans of 

more than $260 billion. 

The MBCA appreciates the willingness of the Fcderal Reserve to 

reconsider provisions in the proposed capital rules that have raised serious 

concerns among our member banks. We are particularly encouraged by your 

statement at the Senate Banking Committee's recent hearing on "Oversight of 

Basel III: Impact of Proposed Capital Rules" that the Federal Reserve is 

"sensitive to concerns expressed by community banking organizations." We 

appreciate your specifically recognizing our concerns about the proposed 
395 


79691.310

treatments of unrealized gains and losses on securities ("AOCI") and the 

proposed risk-weightings of residential mortgage loans. And we applaud your 

pledge to be mindful of our comments when you consider changes to the 

proposed rules. 

The MBCA fully supports the fundamental goal of capital adequacy 

underlying the proposed capital rules, but the cumulative effect of the significant 

changes in capital and risk weights should be weighed carefully and the 

potential ramifications well understood. The MBCA has serious reservations 

regarding the agencies' current proposed treatment and recommends that the 

agencies instead adopt an approach that recognizes the unique characteristics 

and role mid-size banks play in the financial system. 

I. Treatment of Smaller Banks 

At the Senate Banking Committee hearing, as well as in recent public 

statements, the agencies have indicated a willingness to consider simplifying the 

application of the proposed rules as they are applied to community banks 

(generally, those with consolidated assets of$IO billion or less) in recognition of 

the role these banks play in their communities, particularly in the mortgage 

lending area. The MBCA urges the agencies to afford mid-size banks (those 

with total consolidated assets of$10 billion to $50 billion) the same simplified 

capital treatment as community banks. As discussed below, mid-size banks 

more closely resemble community banks than large banks in terms of their role 

in the community and the financial system more broadly. Further, mid-size 

banks will face a similar and disproportionate compliance burden as community 

banks when compared to the large banks. Finally, if the capital rules are 

adopted as proposed, mid-size banks will face strong pressure to consolidate 

andlor merge with larger institutions, increasing systemic risk and decreasing 

consumer choice. 

Like smaller community banks, mid-size banks primarily serve the 

communities in which they are located and are critical providers of credit to 

consumers and small businesses. Mid-size banks, like community banks, 

maintain limited risk profiles and simplified balance sheets, engage in 

conservative lending practices and common-sense underwriting, and have far 

simpler corporate structures compared to large banks with over $50 billion in 

consolidated assets. As a result, mid-size banks have conservative loan-todeposit ratios and good credit availability, but far fewer resources to devote to 

compliance and other administrative costs. Banks under $50 billion in 

consolidated assets were not responsible for the risky banking practices and 

asset structures that contributed to the 2008 financial crisis, and no purpose is 

served by requiring these banks to hold additional capital against risky behaviors 

in which mid-size banks do not engage. Instead, mid-size banks, like 

community banks, should be subject to capital rules commensurate with their 

resources, banking practices, and role in providing credit and other services to 

their customers. 
396 


79691.311

If implemented in their proposed form, the Basel III capital rules will 

place substantial burdens on mid-size and community banks that lack the 

resources to comply with somc of the rules' more complex aspects, such as the 

new categories for risk-weighting mortgages. These new standards would 

require a series of complex evaluations of banks' loan commitments and other 

factors. Although large banks may already undertake such analyses, mid-size 

and community banks will likely have to undergo significant retooling of their 

computer systems in order to comply. They may even need to hire additional 

staff to determine their capital levels on a day-to-day basis, as those levels will 

be determined by new, more complex and volatile regulatory concepts such as 

common equity tier 1 capital and the capital conservation buffer. As Senator 

Patrick Toomey pointed out at the Banking Committee hearing with respect to 

community banks, these would be "very significant compliance costs for 

institutions that nobody has ever suggested are systemically significant." The 

same is true for mid-size banks. 

The Basel III framework was designed to harmonize global banking 

standards applicable to the large, internationally active and systemically 

important financial institutions. Imposing all the complexities ofthat 

framework on banks with assets under $50 billion could have the adverse 

consequence of increasing systemic risk by effectively forcing those smaller to 

consolidate and merge with larger institutions. Further, this would accelerate 

the process of thinning out the community and mid-sized banking sector. For 

consumers, such thinning-out means fewer alternatives, and likely higher rates 

on loans and lower rates on deposits. It also means consumers and borrowers 

will have to deal with a very large bank that may not be familiar with the needs 

of their community - marking an end of the local connection so many mid-size 

and community banks have with the customers they serve. 

II. Precedent for the $50 Billion Threshold 

The approach advocated by the MBCA and community banks is within 

the authority of the banking agencies under Section 171. Moreover, in other 

sections of the Dodd-Frank Act, Congress recognized that financial institutions 

with total consolidated assets of less than $50 billion pose far less risk to the 

financial system as a whole than those with higher asset levels. The MBCA 

asks that the agencies recognize this threshold in developing appropriately 

tailored capital rules as well. 

Section 171 of the Dodd-Frank Act requires the agencies to set minimum 

risk-based capital requirements not less than the generally applicable risk-based 

capital requirements under the prompt corrective action regulations 

implementing Section 38 ofthe Federal Deposit Insurance Act, regardless of 

total consolidated asset size or foreign financial exposure, nor quantitatively 

lower than the generally applicable risk-based capital requirements that were in 

effect for insurcd depository institutions as of the date of enactment of the 

Dodd-Frank Act. 

II 
397 


79691.312

While Section 171 sets a quantitative floor, it also provides the agencies 

substantial flexibility to tailor specific elements ofthc capital requirements to 

diFferent institutions based on asset size. In fact, the agencies already have 

recognized this flexibility in their proposed capital rules - by subjecting only 

banking organizations with $250 billion or more in total consolidated assets or 

consolidated total on-balance sheet foreign exposure at the most recent year-end 

equal to $10 billion or more to separate and additional capital requirements. The 

MBCA urges the agencies to develop a third, simplified set of capital standards 

for smaller banking organizations with less than $50 billion in assets. We 

believe the agencies could do so while maintaining the floor required under 

Section 171, as they havc done with the two approaches in the proposed rules. 

Further, other sections of the Dodd-Frank Act recognize the $50 billion 

threshold as an important indicator of the size and riskiness of banking 

organizations. Section 165 of the Dodd-Frank Act requires the Federal Reserve 

to establish prudential standards, ineluding risk-based capital requirements and 

leverage limits, for bank holding companies with total consolidated assets equal 

to or greater than $50 billion. Such standards must be "more stringent than the 

standards and requirements applicable to ... bank holding companies that do not 

present similar risks to the financial stability of the Unitcd States." This 

statutory language recognizes the greater risks that large banks pose to financial 

stability and requires different capital standards based on whether a banking 

organization crosses the $50 billion asset threshold. Other provisions of Title 1 

of the Dodd-Frank Act also use the $50 billion asset threshold as an important 

metric of the potential threat to financial stability that a financial institution 

might pose. 

Our member banks support the principle that the amount of capital 

required should be reflective of an institution's risk. Applying the proposed 

capital rules to mid-size banks and the largest banks alike could cause 

significant disruption to the banking industry, undennine the competitiveness of 

mid-sized banks, and slow the growth of jobs and the overall economy. 

III. Negative Consequences for the Housing Market and the 

Economy 

Under the capital rules as currently proposed, certain residential 

mortgage products will no longer be profitable unless the interest rate charged to 

the customer increases dramatically to cover the higher capital and compliance 

costs. The expected end result is that many consumers will either have to pay 

more, do without, or go to the unregulated nonbank sector. The MBCA urges 

the agencies to adopt capital requirements that will permit mid-size banks to 

continue to serve these customers. 

The ability to offer prudently underwritten, nontraditional mortgage 

products is one of the ways in which mid-size and smaller banks set themselves 

~dl {:\tl';!!I,\,\\.'''>I!l' \\ \<.,!!!\;:! Ij', 1 i,('. 
398 


79691.313

apart. These products include interest-only loans, low or no-documentation 

loans, and junior liens. Unlike large banks, MBCA members continued to 

underwrite these loans prudently before, during, and after the financial crisis. 

As a result, many MBCA members have interest-only and low or nodocumentation loan portfolios that are performing as well or better than their 

amortizing loan portfolios. Mid-size banks will be placed at a competitive 

disadvantage if these products receive the less favorable Category 2 risk weight 

treatment simply because they do not meet the Category I definition, which 

includes only the most traditional mortgage products. 

Moreover, in many cases, the proposed capital rules will penalize a bank 

that refinances or restructures a customer's loan by requiring the bank to assign 

a higher risk weight to the new loan. This capital treatment would severely 

hamper efforts to aid qualified borrowers who have been hit by the decline in 

home values by discouraging banks from offering the opportunity to refinance 

or restructure loans. The proposed rules also will penalize banks for retaining 

mortgage servicing rights by requiring certain reductions from Tier I common 

equity capital and assessing a capital charge against these assets. Mid-size 

banks are particularly interested in retaining mortgage servicing rights because 

they value long-term relationships with their customers. This capital treatment 

discourages banks from aligning their interests with those of their customers. 

When coupled with the other provisions affecting mortgages including 

Qualified Residential Mortgages, restrictions on capital treatment for mortgage 

servicing assets, an increase in risk weighting for mortgage loans, 

implementation of complex rules resulting in an increase in capital required for 

securitizations - regulated lenders will likely focus only on loans they can sell or 

securitize with or to Fannie Mae or Freddie Mac. This will only accelerate the 

concentration of mortgage credit in these institutions and further hinder the 

resolution of their conservatorship status. 

The proposed capital rules would impose a capital charge on unused 

lines of credit with a term under one year, unless they are unconditionally 

cancellable. This would lead to uncertainty for small businesses. When the 

economy shows signs of trouble, banks may cancel a line of credit even though 

the financial condition of the business borrower remains strong. As a result, 

small business owners will have a more difficult time planning, hiring, and 

running their businesses. 

The MBCA urges the agencies to take these potential consequences into 

account when developing simplified capital rules for mid-size and community 

banks. 

IV. Capital Levels of Banks 

Finally, the MBCA is very concerned that capital levels will become 

more volatile under the proposed rules due to the impact of market-value 

\\ ,',.I:\\I.IU\, IIJ 
399 


79691.314

changes in available-for-sale investment securities. Generally, most analysts 

expect that an increase in lending will accompany an economic recovery, along 

with an increasc in interest ratcs. However, under the proposed capital rules, the 

effect of any increase in interest rates will be a reduction in capital, potentially 

restricting credit and hampering any economic recovery. We believc the 

existing rules for determining impairment are sufficient for determining whether 

an adjustment to income, and thus capital, is necessary and that the proposed 

capital treatment of AOCI introduces volatility into the capital level of banks 

unrelated to credit. 

V. Recommendations 

We believe that it is important that rules implementing Basel III do not 

create an unlevel playing field, aggravate economic volatility, or limit 

consumers' access to banking services. We ask that the agencies consider these 

and other consequences in finalizing any rules applicable to mid-size banks. 

Yours truly, 

cc: Mr. Jack Barnes, People's United Bank 

Mr. Greg Becker, Silicon Valley Bank 

Mr. Daryl Byrd, lBERIABANK 

Mr. Carl Chaney, Hancock Bank 

Mr. William Cooper, TCF Financial Corp. 

Mr. Raymond Davis, Umpqua Bank 

Mr. Vincent J. Delie, Jr., F.N.B. Corporation 

Mr. Dick Evans, Frost National Bank 

Mr. Mitch Feiger, MB Financial, Inc. 

Mr. Philip Flynn, Associated Bank 

Mr. Paul Greig, FirstMerit Corp. 

Mr. John Hairston, Hancock Bank 

Mr. Robert Harrison, First Hawaiian Bank 

Mr. Peter Ho, Bank of Hawaii 

Mr. Gerard Host, Trustmark Corp. 

Mr. John Ikard, FirstBank Holding Company 

Mr. Bob Jones, Old National 

Mr. Bryan Jordan, First Horizon National Corp. 

Mr. David Kemper, Commerce Bancshares, Inc. 

Mr. Mariner Kemper, UMB Financial Corp. 

Mr. Gerald Lipkin, Valley National Bank 
400 


79691.315

Mr. Stanley Lybarger, BOK Financial 

Mr. Dominic Ng, East West Bank 

Mr. Joseph Otting, One West Bank 

Mr. Joe Pope, Scottrade Bank 

Mr. Steven Raney, Raymond James Bank 

Mr. William Reuter, Susquehanna Bank 

Mr. Larry Richman, The PrivateBank 

Mr. James Smith, Webster Bank 

Mr. Scott Smith, Fulton Financial Corp. 

Mr. Carlos Vazquez, Banco Popular North America 

Mr. Philip Wenger, Fulton Financial Corp. 

Mr. Michael Cahill, Esq., City National Bank 

Mr. Brent ljarks, City National Bank 

Mr. Drew Cantor, Peck, Madigan, Jones & Stewart, Inc. 

Mr. Jeffrey Peck, Esq., Peck, Madigan, Jones & Stewart, Inc. 

! 1" ',I U ! 1 

\,1:1 Ii, \ \\ \i 111 \\ '''l III \,_ I (}\, !) ~t 
401 


79691.316

Il\'-!D 1',,(,\ I If! '\PHIl! \\l~IW \ 

11"El/"" \\11"\\1 (:'1) 

H\\Ii<'\P j'\ll' g,\" 

B\\" 

\ \111 \ \ Ill", \! H~\" 

M B c A 

MID-SIZE BANK COALITION OF AMERICA 

October 22, 2012 

Office of the Comptroller of the Currency 

250 E Street, S.W., Mail Stop 2-3 

Washington, DC 20219 

Docket IDs OCC-20 12-000S, --D09 

Jennifer J. Johnson 

Secretary, Board of Governors of the Federal Reserve System 

20th Street and Constitution Avenue, N. W. 

Washington, DC 20551 

Docket Nos. R-1430, R-1442; RIN No. 7100-ADS7 

Robert E. Feldman 

Executive Secretary 

Attention: Comments/Legal ESS 

Federal Deposit Insurance Corporation 

550 ]7th Street, N.W. 

Washington, DC 20429 

FDIC RIN 3064-AD95 

Re: Regulatory Capital Rules: Regulatory Capital, 

Implementation of Basel III, Minimum Regulatory Capital 

Ratios, Capital Adequacy, Transition Provisions, and Prompt 

Corrective Action; Regulatory Capital Rules: Standardized 

Approach for Risk-weighted Assets; Market Discipline and 

Disclosure Requirements 

Ladies and Gentlemen: 

On behalf of the Midsize Bank Coalition of America ("MBCA"), I am 

writing to provide the MBCA's comments on the above-referenced joint notices 

of proposed rulemaking published by the Office of the Comptroller of the 

Currency, the Board of Governors of the Federal Reserve System, and the 

Federal Deposit Insurance Corporation (collectively, "the Agencies") in the 

Federal Register on August 30, 20121 

Regulatory Capital Rules: Regulatory Capital, Implementation qf Basel III, 

Minimum Regulatory Capital Ratios, Capital Adequacy, Transition Provisions, and 

Prompt Corrective Action, 77 FR 52791 (Aug. 30, 2012); Reguiato/y Capital Rules: 

Standardized Approach for Risk-weighted Assets; Market DisCipline and Disclosure 

Requirements, 77 FR 52887 (Aug. 30, 2012). 
402 


79691.317

2 

The MJ3CA is a non-partisan financial and economic policy organization comprising the 

CEOs of mid-size banks doing business in the United States. Founded in 2010, the MBCA, now 

with 31 members, was formed for the purpose of providing the perspectives of mid-size banks on 

financial regulatory reform to regulators and legislators. As a group, the MJ3CA banks do 

business through more than 3,800 branches in 41 states, Washington D.C. and three U.S. 

territories. The MBCA's members' combined assets exceed $450 billion (ranging in size from 

$7 billion to $30 billion) and, together, its members employ approximately 77,000 people. 

Member institutions hold nearly $336 billion in deposits and total loans of more than $260 

billion. 

The MBCA appreciates the Agencies' efforts to implement the risk-based and leverage 

capital requirements agreed to by the Basel Committee on Banking Supervision in "Basel III: A 

Global Regulatory Framework for More Resilient Banks and Banking Systems," as well as the 

capital requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act? We 

understand that the Agencies devoted extensive time and energy to drafting the proposal rules. 

However, consistent with FDIC Director Thomas M. Hoenig's request,3 we respectfully ask you 

to step back, reassess the overall intent and the impact the proposed rules will have on the 

financial system, and delay rolling out any new rules. 

In his recent address to the American Banker Regulatory Symposium, Mr. Hoenig 

summarizes a good capital rule as follows: 

Experience suggests that to be useful, a capital rule must be simple, understandable and 

enforceable. It should reflect the firm's ability to absorb loss in good times and in crisis. 

It should be one that the public and shareholders can understand, that directors can 

monitor, that management cannot easily game, and that bank supervisor can enforce. 

Thc current proposed rules, which seek to control nearly every aspect of a bank's 

operations, rely on highly complex modeling tools and on central planners making 

determinations of risk rather than the markets. As a result, the proposed rules would change risk 

weights from "five to thousands.,,4 Their adoption as proposed would create adversc incentives 

for banks making asset choices, rather than choices that ensure banks' communities and 

borrowers are well served. Bankers react to incentives that are placed before them. We believe 

the proposed rules, if not substantially altered, will potentially skew those incentives and 

misalign risk and returns. The result will be the loss of some products and services. 

At a minimum, the MBCA believes that certain aspects of the proposed rules should be 

revised to take account ofthe implementation burdens on banks, their rules' competitive impact 

on mid-size banks, and the likely consequences of the rules for the availability of credit and 

Pub. L. No. I I 1-203, 124 Stat. 1376-2223 (2010). 

Thomas M. Hoenig, Director, Federal Deposit Insurance Corporation, Address to The American 

Banker Regulatory Symposium: Back to Basics: A Better Alternative to Basel Capital Rules (Sept. 14, 

2012), available at http://fdic.gov/news/news/speeches/chairman/spsepI412_2.html. 

Id. 
403 


79691.318

national financial stability. To streamline our comments, below we address those areas in which 

we believe revision is most critical. 

I. Other Comprehensive Income on Available-for-Sale Securities 

The proposed rules would require banks to include unrealized gains and losses on 

available-for-sale ("AFS") securities currently recorded in accumulated other comprehensive 

income ("AOel") as part of common equity tier 1 capital. We believe this approach is 

misguided for several reasons discussed below. 

A. Inconsistent with Sound Asset/Liability Management Practices 

AFS investments arc critical to a bank's Asset/Liability management practices. In our 

view, the proposed treatment of these investments would create a disincentive for banks to 

engage in sound risk management practiccs. Banks use AFS investments to help stabilize 

interest income over the business cycle while providing a warehouse of liquidity that can be 

accessed during periods of high loan demand and/or declining deposit balances. AFS 

investments servc as a source of liquidity that helps manage the interest rate risk exposure 

created by core banking activities. Most of a bank's longer-term securities are funded with core 

deposits that the bank believes have similar or longer durations. If rates rise, the decrease in the 

value of AFS securities would be offset by an increase in the value of the deposits used to fund 

the securities. Generally, smaller banks try to minimize taking credit risk in the portfolio by 

maintaining significant investments in U.S. government and agency debt obligations, U.S. GSE 

debt obligations, and municipal bonds. This is a sound interest rate risk management practice. 

Banks perform interest rate risk management analyses on a regular basis and make 

hedging decisions based on the performance ofthe entire balance sheet as rates change. The 

proposed rules' treatment of AOel on AFS securities, however, looks at only one piece of one 

side of the balance sheet. As the AOel on a bank's AFS investments would be included in 

regulatory capital under the proposed rules, interest rate changes could have significant 

implications for regulatory capital. The resulting fluctuations could influence a bank's on 

balance sheet hedging strategy economically sound decisions could be compromised if 

management were forced to modify decisions it believed to be in the best interest of the bank in 

order to limit mark-to-market implications from one piece of its balance sheet.5 This could 

create a capital constraint that may limit otherwise sound Asset/Liability management. 

For example, banks might respond by shortening the duration of their securities portfolios in an effort 

to reduce volatility. This would result in significantly reduced eamings and would be contrary to sound 

risk management practices regarding interest rate risk. In a broader sense, if most banks were to follow 

this path, lack of demand for longer term securities might push up longer rates, making mortgages and 

municipals, among other longer borrowings, more expensive. Banks might also choose to shorten the 

duration of liabilities in order to maintain an appropriate mismatch. Where a bank's funding is mostly 

long-term, non-contractual funding, this move would require adding more short-term wholesale fundinga move clearly at odds with the proposed liquidity standards (LCR and NSFR). Finally, a bank may elect 

to move some or most of its securities from AFS to Held-to-Maturity simply to avoid the proposed AFSAOCI requirements. Not only would this result in much less flexibility, but it also may reduce liquidity. 
404 


79691.319

4 

B. Reduced Confidence from More Volatile Capital Measures 

In addition to discouraging sound Asset/Liability management practices, the volatility in 

regulatory capital ratios that would result from thc inclusion of AOCI on AFS securities in 

common equity tier I capital would reduce confidence in thc capital measures themselves. Even 

a bank with very strong capital ratios comprised almost solely of common equity such as one 

ofthe MBCA's member banks, which has a total risk-based capital of 16.6% - could be greatly 

affected if interest rates were to shift quickly. For example, 

A 2% shift up in rates would reduce the bank's regulatory capital by 240 bps as a 

result of unrealized securities losses. 

A 4% shift up in rates would reduce the bank's regulatory capital by 570 bps as a 

result of unrealized securities losses. 

Such a shift in interest rates could even push ratios close to regulatory limits. 

This volatility is exacerbated by the proposed "limited recognition" of deferred tax assets 

to 10% of common equity. Unrealizcd gains and losses, including in AOCI, are tax-adjusted 

such that deferred tax assets are created when unrealized losses exist, reducing the total net 

amount of unrealized losses. Today, these tax assets are not limited when calculating regulatory 

capital. If the tax asset is limited, as proposed, and the limit is exceeded, net unrealized losses 

will create even greater volatility in capital. We believe that the significant volatility created by 

this proposal and cap on deferred tax assets will result in less confidence in capital ratios as a 

barometer of adequacy and as a tool for determining a bank's cushion to contain losses. If the 

proposed rules arc adopted as drafted, investors and others will be reluctant if not unable -to 

rely on an institution's capital ratios unless the institution removes all or most of the AFS from 

its balance sheet. 

C. Reduction in Lending Capacity in an Economic Recovery 

Finally, the proposed rules' treatment of AOCI on AFS securities would decrease the 

ability of banks to extend credit, as regulatory capital may decrease substantially as interest rates 

rise. This structural limit on lending by itself will seriously impede a potential economic 

recovery. Indeed, the effect will be compounded because banks will need to hold additional 

capital above regulatory limits to protect against even the potential for volatility. Lost regulatory 

capital and lower lending capacity could even result in a declining rate environment, if credit 

spreads widen or sccurities lose value simply due to a lack of buyers. This would accelerate an 

economic downturn. 

The MBCA recommends that the Agencies exclude from common cquity tier I capital 

AOCI on certain AFS securities for which the gains and losses are primarily due to interest rate 

rather than credit and market risk changes (including U.S. government and agency debt 

obligations, U.S. GSE debt obligations, and municipal bonds) to preserve sound Asset/Liability 

Management practices and to rcduce volatility in capital ratios. 
405 


79691.320

II. Deferred Tax Assets 

The MBCA believes the proposed rules' requirements regarding deductions of deferred 

tax assets CDT As") from common equity tier I capital fail to reflect praetical realities in several 

key respects.6 

The 10% and 15% limits on DT As and the 250% risk weight imposed by the proposed 

rules arc unduly punitive. U.S. generally accepted accounting principles ("GAAP") require that 

DT As be reduced by a valuation allowance that is sufficient to reduce the DTAs to the amount 

that is morc likely than not to be realized. Therefore, only DTAs that are more likely than not to 

be realizcd stay on the balance sheet of a U.S. banking organization. DTAs subject to the limits 

arise because taxable income computed under the tax laws is higher than income reported under 

GAAP. Such DTAs should not be viewed as indicators offuture earnings problems that would 

result in depletion of capital on the contrary, for MBCA mcmbers, DTAs are highly likely to 

yield tax benefits in the future. 

Moreover, the 10% and 15% limits on DT As would exacerbate the regulatory capital 

impact of the proposed requirement that AOCI on all AFS securities flow through to common 

equity tier I capital. As discussed above, under the proposed rules, unrealized losses on AFS 

securities would reduce common equity tier I capital. Unrealized losses create DTAs. If the 

amount ofDTAs exceeding the 10% and 15% limits were deducted from common equity tier I 

capital, as proposed, AOCI on AFS securities could reduce common equity tier I capital twice: 

first, directly, and second, through the creation of DTAs exceeding the 10% and 15% limits. 

One MBCA member has calculated that a 400 basis-point rise in interest rates would further 

reduce its capital ratios by an entire percentage point because of the proposed limits on DT As 

and, as a result, reduce its lending capacity by $1.1 billion. Furthermore, SUbjecting DT As 

resulting from AOCI on AFS securities to the \0% and 15% limits is not consistent with prudent 

management of assets and liabilities because it fails to recognize that the market value of the 

bank's liabilities funding the AFS securities would rise at the same time as AOCI on such 

securities creates DT As. 

Under the proposed rules, a banking organization would be required to deduct the amount ofDTAs 

that arise from operating losses and tax credit carry forwards, net of any related valuation allowances and 

certain deferred tax liabilities ("DTLs"). In addition, DT As arising from temporary differences that a 

banking organization could not realize through net operating loss carrybacks, net of any related valuation 

allowances and certain DTLs, would be subject to a 10% limit and a 15% limit. Specifically, ifthe 

amount of such DTAs exceeds 10% ofa banking organization's common equity tier I capital, the banking 

organization would have to deduct the excess from its common equity tier 1 capital. Two other types of 

assets mortgage servicing assets (net of associated DTLs) and significant investments in the capital of 

unconsolidated financial institutions in the fonn of common stock - would each be subject to such a 10% 

limit. If the aggregate amount of these three types of assets, after deductions required by the application 

of the 10% limit to each of them, exceeds 15% of a banking organization's common equity tier 1 capital, 

the banking organization would have to further deduct this cxcess from its common equity tier I capital. 

DTAs subject to the 10% and 15% limits, if not deducted from common equity tier I capital as a result of 

the limits, would be assigned a 250% risk weight. 
406 


79691.321

The proposed rules also are problematic in that they would allow netting of DTAs against 

deferred tax liabilities ("DTLs") only for those that "relate to taxes levied by the same taxation 

authority and ... are eligible for offsetting by that authority." Under U.S. GAAP, a company 

generally calculates its DTAs and DTLs relating to state income tax in the aggregate by applying 

a blended state tax rate. Accordingly, banks do not track DTAs and DTLs on a state-by-state 

basis for financial reporting purposes. Tracking DT As and DTLs on a state-by-state basis for 

purposes of the regulatory capital rules would be extremely burdensome. Therefore, the MBCA 

believes that the regulatory capital rules should allow netting in the aggregate for DTLs and 

DTAs relating to state income tax in all U.S. states, consistent with U.S. GAAP. 

The MBCA also believes the Agencies should clarify that banking organizations will not 

be required to compute DT As and DTLs quarterly for regulatory capital purposes. Under U.S. 

GAAP, companies are required to compute DTAs and DTLs annually, not quarterly. The 

MBCA believes that quarterly computation of DT As and DTLs would be unjustifiably 

burdensome for most banks, and that annual computation, as is consistent with U.S. GAAP, is 

appropriate. 

III. Minority Interest 

The proposed rules would limit the amount of minority interest in consolidated 

subsidiaries that could be included in the regulatory capital of the parent company. Specifically, 

if a consolidated subsidiary has regulatory capital in excess of the sum of its minimum capital 

requirement plus the required capital conservation buffer, the minority interest that contributes to 

the excess would not be includable in the parent company's regulatory capital. 

This limitation should not apply to a holding company that conducts substantially all its 

business activities in its depository institution subsidiary and therefore has limited exposure to 

losses outside that subsidiary. Many banks find that subordinated debt, which is usually issued 

to investors unrelated to the parent holding company and thus "total capital minority interest" for 

purposes ofthe proposed rules, provides a cost-effective fonn of capital. Limiting the amount of 

bank-issued subordinated debt that could be included in the parent holding company's tier 2 

capital would nevertheless create a significant disincentive for raising such capital. One MBCA 

member estimates that the proposed limitation would lead to the exclusion of 35% of its 

subordinated debt from the regulatory capital of its parent holding company. Furthennore, 

because the proposed limitation would require deductions from the parent holding company's 

regulatory capital as outside investments in the subsidiary bank increase the regulatory capital of 

the bank, it would appear that the holding company is being penalized for increased capital 

adequacy at the subsidiary bank. 

IV. Mortgage Servicing Assets 

Under the proposed rules, mortgage servicing assets would be subject to the same 10% 

and 15% limits as deferred tax assets. In addition, the amount not deducted from capital under 

the proposed rules would receive a 100% risk weight (and eventually a punitive 250% beginning 

20 I 8). A mortgage servicing asset is the right by a bank to service mortgage loans owned by 

others and in many cases represents servicing the loans originated by the servicing bank and sold 

to other third parties like Freddie Mac and Fannie Mae. The combination of excluding the assets 
407 


79691.322

that exceed the 10% and 15% limits with thc 100% (an eventually 250%) risk weighting could 

severely impact some banks, perhaps even lowering capital levels below well capitalized status. 

As a result, banks would be inelined to sell mortgagc loans on a servicing-released basis. This 

would prevent a bank that originates a mortgage loan from maintaining a long-term relationship 

with thc borrower by continuing to service the loan after selling it. It would also deprive the 

bank of an important source of fee income. 

Furthermore, the proposed limits would disproportionately affect banks with a sizable 

portfolio of mortgage servicing assets that have been retained or acquired in reliancc on current 

regulatory capital rulcs. These new limits might ultimately lead to further consolidation in the 

mortgage servicing industry to very large non-bank servicers that are not subjected to the same 

rules and standards as regulated financial institutions. As a result, bank customers would be 

relegated to dealing relatively impersonally with a large non-bank entity rather than interacting 

with the local community bank that knows them well. In sum, the MBCA believes that mortgage 

servicing assets should not be subject to the 10% and 15% limits, and if any limits arc put in 

place, existing mortgage servicing assets should be grandfathered. 

V. Unused Lines of Credit with a Term Under One Year 

The proposed rules would require a bank to apply a 20% credit conversion factor to 

"commitments with an original maturity of one year or less that are not unconditionally 

cancelable" by the bank. As a result, a bank would need to inelude 20% of the unused portion of 

a line of credit with a term under one year in its risk-weighted assets, if the line of credit is 

extended to a corporate borrower. 

The MBCA does not believe that the proposed 20% credit conversion factor for the 

unused portion of a line of credit extended to small, middle-market, or trade finance companies, 

with a term under one year, is warranted. The majority of such lines of credit have covenants 

based on financial ratios, and any material increase in the credit risk of the borrower would likely 

trigger a violation of a financial covenant, which would prevent the borrower from drawing 

down the unused portion ofthe line of credit: According to an academic paper from the 

University of Chicago Graduate School of Business, in a sample of 11,758 bank lines of credit, 

72% had covenants based on financial ratios. When a borrower violatcs a financial covenant, the 

bank reduces the total line of credit by about 25 % in the year after the violation, and the unused 

portion of the line of credit is reduced by almost 50% from the year before the violation to the 

year after the violation.? In addition, a violation ofthe covenant may trigger an entry to the 

Allowance for Loan and Lease Losses ("ALLL"). 

We note that several analyses of exposure at default of lines of credit extended to 

corporate borrowers, ineluding a 2011 study by Moody's, overstate such exposure because they 

Amir Sufi, Bank Lines afCredit in COIparate Finance: An Empirical Analysis, 22-25 (Jun. 2006), 

htlp:llpapers .ssm.com/so 13/papers.cfm ?abstract_ id=723 3 61. 
408 


79691.323

exclude reductions in the drawn amount that occurred before default. 8 Reducing the line of 

credit and the drawn amount when the borrower's credit risk increases is an important riskmitigation technique, and analyses that fail to recognize this exaggerate the credit risk associated 

with lines of credit. 

Furthermore, most lines of credit extended to small and middle-market companies are 

guaranteed by their owners. There is less incentive for the borrower to draw down a line of 

credit so guaranteed when it is likely to default because such draw-downs would increase the 

personal liability of the business owner. 

The MBCA believes that the proposed 20% credit conversion factor would result in 

further tightening of credit availability to small, middle-market, and trade finance companies. 

Given this capital requirement, even if banks were willing to make loan commitments with an 

original maturity of one year or less to small businesses, they would tend to make such loan 

commitments unconditionally cancellable, which is not common now. As a result, a small 

business would face the new risk of losing access to existing lines of credit when the economy 

shows signs of trouble and credit becomes tight, even where the financial condition of the small 

business itself does not warrant the cancellation of the loan commitments. This uncertainty over 

credit availability would make it harder for small business owners to plan, hire, and run their 

businesses. We urge the Agencies to maintain a 0% credit conversion factor for commitments 

with an original maturity of one year or less and an amount of$5 million or less that are not 

unconditionally cancelable. 

VI. Treatment of Residential Mortgages 

A. Risk-weighting of Residential Mortgages 

The MBCA disagrees with the Category lICategory 2 approach developed by the 

Agencies in the proposed rules. The proposed definition of Category I loans would exclude, 

among others, any loan that (i) results in an increase of the principal balance, (ii) allows the 

borrower to defer repayment of principal of the residential mortgage exposure, (iii) results in a 

balloon payment, or (iv) does not include documented, verified income as a feature of the 

underwriting process. As a result, the proposed rules give the lowest risk weight only to the 

most traditional mortgage products without regard to the true risk associated with the loan. The 

proposed rules would exclude prudently underwritten interest only (10) loans, prudently 

underwritten low or no documentation loans, and most junior liens, regardless of the 

performance of those loans. The MBCA believes the categorical exclusion of certain types of 

loans without regard to the risk associated with the loan is ill-advised, and we discuss the 

problems associated with that approach using these three examples below. 

An 10 mortgage is not an inherently dangerous product; any mortgage underwritten 

properly is a sound asset. Conversely, any loan underwritten poorly regardless of amortizing 

Janet Yinqing Zhao et aI., Usage and Exposures at Default of Corporate Credit Lines: An Empirical 

Study, 8 (Dec. 2011), http://www.moodysanalytics.comllnsightlQuantitative-Research/Default-andRecovery/Research-Papers.aspx. 
409 


79691.324

9 

principal features is a risky asset. Many banks have originated lOs for decades and have had 

very low loss rates even during the recent recession. The 10 mortgage transactions of our 

members historically have experienced very low delinquency rates both in number of accounts 

and in outstanding balances. One member, the experience of which is typical ofMBCA 

members, noted that the vast majority of its mortgage transactions reside within high-quality 

credit buckets (LTV <= 60% and FICO scores above 710). Over the last three years, when real 

estate defaults have peaked nationwide, this member's 10 mortgage loans have performed equal 

to or better than the amortizing portfolio. In other words, this member's 10 residential mortgage 

portfolio is statistically no more risky than the amortizing residential mortgage portfolio. We 

emphasize the following three key points about the 10 loan portfolio: 

Borrowers with low origination LTVs (60% or less) and high FICOs (700+) perform 

excellently regardless of whether it is an 10 or an amortizing loan. 

Our members' stringent underwriting standards, which include qualifying an 10 

mortgage application based on a fully amortizing debt to income ratio, leads to 

superior performance of all 10 mortgages, even those with LTVs in excess of 60%. 

• The Agencies' exclusion oflO mortgages from Category I consideration would 

inadequately represent the true risk involved in a prudently underwritten 10 loan. For 

example, lOs with an origination LTV of 60% have a 12.5 year principal reducing 

"head start" relative to an 80% LTV amortizing 30-year loan. Thus, there is no 

reason to penalize a preferable LTV 10 mortgage relative to a standard amortizing 

loan. Labeling an 80% LTV amortizing loan less risky than a 60% 10 mortgage is 

not justified and gives banks the wrong signal. 

Treating 10 loans as Category 2 by definition does not take into account the fact that 

when prudently underwritten, a bank's 10 loan portfolio can perform just as well or better than 

its amortizing loan portfolio. In the analysis of one of our members, the experience of which is 

typical of the MBCA, as of December 2011, close to two-thirds of the bank's [0 portfolio 

exhibited substantial equity in the borrower's home (where LTV is measured as current loan 

balance to original appraisal value). As indicated in the chart below, approximately 63% of the 

10 portfolio of this bank exhibited LTVs of60% or better over one-third (35%) had LTV's less 

than 50% or better. 

35,00% 

Distribution of Interest Only Mortgages By LTV Bucket 

As of December 31, 2011 

30.00% +-1111-"_--

25,00')1; - --------"---~,~~-".-----~--

20.00'% 

15.00% 

10.00% 

5.00% 

0.00% 
410 


79691.325

Moreover, a comparison of the same bank's 10 loan default rate to its amortizing loan 

default rate indicates a weighted average probability of default difference of only 1 basis point 

on a portfolio-wide basis. 

Average Default Rates by lTV Bucket 

10 

2IJ09.2011 Average <=50% SO.01·55% SS.OI·tiOO! 60.01·65% 65.01-70% 70.01-/5% 75.01·80''' 80.01-85% 85.01·90% A.O.t Grand Total 

10 0.33% 0,30% 0,64% 0.59% 1.27% 0,97% 0.59% 0.00% 0,00% 0,00% 0.57% 

Amortizing 0.33% 0.77% 0.64% 1.27% 0.58% 0,87''' 0,38% 13,89% 0,00% 1.85% 0.58% 

Difference 0,00% ·0.47% 0,00% ·0.69% 0,69% 0.10% 0.20% ·13.89% 0,00% ·1.85% ·0.01% 

2009-2011 Average Default By FICO Bucket 

FICO RANGE Interest Onlv Amortizing Difference 

A) >=830 0.00% 0,00% 0.00% 

B) 8OQ.829 0,03% 0.00% 0.03% 

C) 77Q.799 0,08% 0,02% O.OS% 

D) 74Q. 769 0,04% 0,02% 0.02% 

E) 710-739 0,01% 0.01% 0.01% 

F) 68Q.709 0.03% 0,03% ·0.01% 

G) 650-679 0,05% 0.02% 0.03% 

H) 62Q.649 0,05% 0,05% 0.00% 

I) 590·619 0.19% 0,06% 0.12% 

J) 56Q.589 0.03% 0,06% -0.03% 

K) <560 0.07% 0.28% -0.22% 

L) NO FICO 0.01% 0,03% -0.02% 

Grand Total 0.57% 0.58% -0.01% 

These data indicate that there is very little statistical difference in credit risk between the two 

portfolios, and that the proposed rules' approach in categorically excluding 10 loans from the 

lowest risk-weighting is flawed. That a credit product is non-traditional does not in itself make it 

a higher risk asset; it is the creditworthiness of the consumer that is using the product that must 

be evaluated to determine the risk. A "disciplined consumer" should be allowed flexibility in 

choosing a credit product that fits their financial needs. Penalizing banks for using alternative 

credit products will only cause ovcrall credit to become less available and more expensive. 

The disconnect between the risk of a loan and the loan's treatment under the proposed 

rules also exists for low and no documentation loans. Thcse loans will largely be ineligible for 

Category I treatment as the proposed rules permit a bank to determine a borrower's ability to 

repay only through "documented, verified income." Income is no doubt an important facet of a 

borrower's ability to repay and thus the risk of dcfault. In the experience of our members, 

however, a high down payment (and thus a low LTV) coupled with a high FICO score is an even 

better indicator of that ability. This is because a high down payment and high FICO score are 

two hallmarks of a responsible borrower, and because a borrower who is no longer able to pay 

can more easily sell their house and pay back their loan if the loan has a low LTV. 

By assigning higher risk-weights to low or no documentation loans without verified 

income, the proposed rules will force banks to restrict lending to only the long-term employee 

with a steady paycheck reflected on a W-2, in addition to improperly risk-weighting existing 
411 


79691.326

bank assets. The groups of creditworthy and deserving people negatively affected by the 

Category I requirements are diverse and numerous: small business owners, retired workers, the 

self-employed, workers with seasonal or short term jobs, casual union workers (such as long 

shore workers), independent contractors, and workers who are new in their job or who want to 

move their family to a new city to take a better job. The approach ofthe Agencies in the 

proposed rules is particularly unfortunate given the results of the FDIC's recently released 

National Survey of Unbanked and Underbanked Households, which urged banks to expand 

access to the credit system for those not currently served by the banking system. 

II 

The definitional exclusion of junior-lien mortgages from Category I treatment (except in 

the case in which no other party holds an intervening lien and the junior lien fully complies with 

the Category I requirements) similarly fails to take into account the true risk associated with a 

given loan. In reality, the risks associated with ajunior lien vary greatly based on the amount of 

equity the borrower holds in the home and their ability to pay. We believe the risk 

characteristics of the relationship should be the driving factor in classifying a loan rather than the 

structure of the loan. 

The MBCA urges the Agencies to eliminate the distinction between Category I and 2 

loans and to tailor the risk-weighting of residential mortgage loans based on the underwriting 

standards used to make the loans. The Agencies should treat as prudently underwritten (and thus 

eligible for a low risk weight) loans that a bank extcnds only after determining the borrower's 

ability to repay as judged by (I) the borrower's documented, verified income, or (2) a low LTV 

ratio and high FICO score. 

In the event the Agencies keep the Category IICategory 2 framework, the Agencies 

should broaden the definition of Category 1 loans to encompass prudently underwritten loans, 

rather than only the most traditional loans. 

B. Coordination with the CFPB Qualified Mortgage Provisions 

The Consumer Financial Protection Bureau is evaluating industry comments concerning 

the definition of a Qualified Mortgage C'QM"). The tinal definition is critical for the industry 

because it will represent the standard for residential lending and afford a legal safe harbor for 

lenders. The consensus in the industry is that the QM definition should be as broad as possible 

to avoid restricting the availability of credit. One key factor in the qualification as a QM is the 

detennination by the lender that the borrower has the ability to pay the mortgage. Regardless of 

the ultimate risk weight treatment of residential mortgage loans under the capital rules, and given 

the broad impact of the QM designation and its clear link to risk, we urge the Agencies to 

coordinate the underwriting standards included in the proposed capital rules with the final QM 

definition. 

C. Exemptionfor Loan Modifications 

If a mortgage is restructured or modified, the proposed rules require a bank to classify the 

mortgage in accordance with the terms and characteristics of the exposure after the modification 

or restructuring. Lenders arc allowed to assign a lower risk weight provided they update the 

L TV ratio at the time of the modification, but are also required to assign a high risk weight if 
412 


79691.327

necessary. Ifthe rules are finalized in their cUlTenl form, this provision provides a powerful 

disincentive to banks which might otherwise modify or restructure loans, but will not do so 

where they would be forced to hold the loan at a higher risk-weight. Loans modified or 

restructured solely pursuant to the Home Affordable Mortgage Program ("l-IAMP"), however, 

are not considered modified or restructured for purposes of this section. The exemption 

encourages banks to modify and restructure loans, as banks are not required to revisit the riskweighting treatment of the loan (even though, once modified, the loan has a higher LTV ratio). 

We urge the Agencies to broaden this exemption from re-categorization of loans to include 

private modifications and restructurings not complctcd under HAMP. 

D. Grandfathering Existing Loans 

12 

The MBCA believes the Agencies should grandfather residential mortgages which were 

originated under the existing capital rules. Although banks can adjust their lending practices to 

accommodate the treatment of residential mortgages going forward to avoid some of the more 

punitive risk weights, they cannot do so with respect to loans already made. To penalize banks 

now for long-term decisions made under a previous regulatory regime would work a substantial 

injusticc far into the future. Moreover, many banks might not have the data needed to classify 

existing loans and may find such data difficult, if not impossible, to obtain. Even where they can 

find the data, bank staff would be required to undergo the extremely burdensome process of 

going through decades-old loan files to obtain the information. 

The substantial increase in the capital that would be required for these loans, which may 

constitute a substantial amount of assets on an institution's balance sheet, and the retroactive 

impact of the proposed treatment would be especially harsh. Given that the proposed capital 

rules already substantially increase thc required minimum capital, the need for retroactive 

application ofthe new standards is significantly attenuated. In addition, to the extent that loans 

originated under existing regulations and capital rules truly do rcflect more risk to a bank that 

holds those loans, additional capital should already exist on those portfolios through the ALLL. 

Providing additional capital for those loans on top of what is already in the ALLL would be a 

mistake in our view. We believe any final rule should grandfather all existing mortgage 

exposures by assigning them risk weights as required under the current gencral risk-based capital 

requirements (i.e., 50% risk weight). 

VII. Treatment of High Volatility Commercial Real Estate 

The proposed capital rules would assign a high risk weight of 150% to exposures defined 

as High Volatility Commercial Real Estate CHVCRE"). Any credit facility that finances or has 

financed the acquisition, dcvelopment, or construction of a commercial real estate project will be 

defined as HVCRE unlcss, among other things, 

(ii) The borrower has contributed capital to the project in the fOITl1 of cash or 

unencumbered readily marketable asscts (or has paid development expenses outof-pocket) of at least 15 % of the real estate's appraised "as completed" value. 

We believe thc choice of using "as completed" versus "project cost" or "stabilized 

value" adds unnecessary uncertainty to this definition. While the proposed language may be 
413 


79691.328

technically correct, it fails to address tenant improvements, leasing commissions and interest 

expense after completion. As a result, as drafted, this provision in the proposed rules would 

require a highcr pcrcentage of cash to total cost than 15%, which we do not believe was the 

Agencies' intent. Separately, the Agencies have failed to provide a definition of the term 

"readily marketable assets." Below wc provide four scenarios in which this language will 

create problems. 

13 

First, our members have clients who have owned their land for many years, in one case 

dating back to the 18th century, and carried it at zero cost on a GAAP basis. When the land is 

provided frce and clear of liens as collateral to a loan, along with potential other cash equity 

depending upon the loan structure and appraised valuation, the resulting LTV is well below the 

maximum supervisory loan-to-value ratio. However, in these cases there is likcly not 15% cash 

equity. Instead there is substantial appraised equity which results in a conservative LTV. To 

accommodate such cases, it is our opinion that this provision should permit the appraised equity 

to account for the required equity in a projcct so long as the maximum LTV is below the 

maximum supervisory value. Long-tcnn holders of land should not be singled out and punished 

by the equity requirement. 

Second, in many cities in California, entitlements to build are very difficult to obtain. 

Land may be purchascd at a very low cost if, among other possible circumstances, the 

entitlements at the time of purchase only allow a single-family residence to be built on the land. 

However, if the owner of the land goes through the often lengthy and difficult process of 

changing the entitlements such that the land can be used in a "highest and best" fashion, 

significant equity can be created. If, for example, the aforementioned single-family residential 

lot was later entitled for the construction of a 50-unit apartment building, significant value would 

have been created, thereby allowing for a conservative construction loan to be made well within 

the maximum supervisory LTV ratio and well below a bank's policy LTV. However, as in the 

example above there is likely not 15% cash equity. Instead there is substantial appraised equity 

which results in a conservative LTV. Here again, the same rationale for allowing for appraised 

equity to account for the required equity in a project so long as thc maximum loan-to-value is 

below the maximum supervisory value applies. Those property owners who create value through 

an entitlement change resulting in a usc that is "highest and best" should not be singled out and 

negatively impacted by this requirement. 

Third, the "as completed" value is an opinion of an appraiser. Accordingly that value 

could very likely differ between two different appraisals of the same asset. This has the potential 

to create unfairness to different borrowers building similar projects. We believe the 15% cash 

equity requirement should be calculated against the "project cost" as opposed to the "as 

completed" value. The definition already requires that the loan not exceed the supervisory 

maximum LTV, which prevents a bank from making a loan on a project that is infeasible. Real 

estate investors should not be singled out and potentially negatively impacted by differing 

opinions of value as potentially created by this requirement. 

Fourth, the "as completed" value, again a subjective value arrived at in the appraisal 

process, could be the same value as the "stabilized" value. This would be the case, for example, 

where the proposed to-be-built building were pre-leased, for instance on a long term basis to a 
414 


79691.329

14 

single tenant that carries an Investment Grade rating. The signing of a lease to this type of tenant 

creates significant value and again, as with the prior examples, allowing for a conservative 

construction loan to be made well within the maximum supervisory loan-to-value ratio, but 

without necessarily having 15% cash equity to the "as completed" value. For this reason as well, 

we believe the 15% cash equity requirement should be calculated against the "project cost" as 

opposed to the "as completed" value. Here again, the definition's requirement that the loan not 

exceed the maximum supervisory LTV prevents a bank from making a loan on a project that is 

infeasible. Those property owners who create value through the execution of a lease or leases, 

should not be singled out and negatively impacted by this requirement. 

VIII. Capital Conservation Buffer 

The proposed capital rules would mandate a capital conservation buffer to incentivize 

banks to maintain their common equity tier I capital, Tier 1, and total capital ratios above the 

required minimums. Banking organizations would nced to hold capital conservation buffers in 

order to avoid being subject to limitations on capital distributions and discretionary bonus 

payments to executive officers. 

We believe the capital ratios adjusted for the capital conservation butTer will function as a 

de facto minimum capital requirement since most institutions need and desire the flexibility to 

make capital distributions to shareholders and appropriately reward executive management. As 

the Agencies are well aware, market and supervisory preferences will force banking 

organizations to hold capital in excess ofthis de facto minimum, essentially leading to additional 

"butTers" being maintained in excess of the required "buffers." The result, especially when 

combined with other provisions creating volatility in capital ratios such as the treatment of AOCI 

on AFS securities, will be to put banks in an extremely defensive position regarding the holding 

of capital in excess of regulatory requirements. This may significantly curb the ability of banks 

to extend credit. The Agencies should consider removing the requirement for a capital 

conservation buffer, or, at a minimum, carving out an exemption from it for small and mid-sized 

banks engaged primarily in traditional banking activities. 

IX. Transition Periods 

A. Treatment o.fTrust Preferred Securities 

The Capital Proposal would phase out trust preferred securities ("TruPS") and other nonqualifying capital instruments issued by depository institution holding companies with total 

consolidated assets of$15 billion or more ratably over a 3-year period beginning in 2013, with 

full phase-out occurring on January 1, 2016. In contrast, Basel III suggests phasing out such 

instruments ratably over a I O-year horizon beginning in 2013, with full phase-out occurring on 

January 1,2022. 

The MBCA understands that Section 171 the Dodd-Frank Act requires the phase out of 

such instruments over a 3-year period. However, Section 17l does not require a phase out in the 

aggressive 25% increments contemplated in the proposed capital rules. Moreover, over the 

Agencies' proposed phase-out period, foreign institutions of$15 billion or more subject to the 

Basel III phase-out timeline would be able to include more TruPS in regulatory capital than U.S. 
415 


79691.330

institutions over the 3-year pcriod. In other words, while a foreign institution of$15 billion or 

more would be permitted to include 90% of its TruPS in Tier I in 2013, a similar U.S. BHC or 

SLI·IC would be allowed to include only 75%. In year two, the foreign institution would be 

allowed to include 80%, while the U.S. institution could include only 50%, and so on. 

15 

Although U.S. institutions will ultimately be put at a competitive disadvantagc during the 

later Basel III phase-out period, in order to minimize this disadvantage, and to give U.S. 

institutions additional flexibility to phase out non-qualifying capital instruments in an orderly 

and less punitive fashion, we suggest the Agencies phase-out non-qualifying capital instruments 

issued by such institutions in 10% increments in each of 20 13 (i.e., 90% includable in Tier 1), 

2014 (80% includable in Tier I) and 2015 (70% includable in Tier I), with full phase-out 

occurring in 2016. This phase-out schedule is fully compliant with the Dodd-Frank Act. 

B. Competitive Disadvantage with Treatment o{Goodwill 

Although the proposed rules preserve the existing deduction of goodwill, including 

goodwill embedded in the valuation of significant investments in unconsolidated financial 

institutions, the rules differ from Basel III in that these deductions are immediately applicable 

(i.e., in 2013), whereas Basellll phases in the deduction of goodwill over the period from 2014 

through 2018. The Agencies should adopt the Basel III phase-out framework as it pertains to 

goodwill in order to prevent U.S. institutions from being further disadvantaged relative to their 

global competitors. 

* * * 

The MBCA appreciates the opportunity to express our concerns and suggestions on the 

proposals. We look forward to discussing these matters with you in the future. 

Yours Truly, 

Russell Goldsmith 

Chairman, Midsize Bank Coalition of America 

Chairman and CEO, City National Bank 

ee: Mr. Jack Barnes, People's United Bank 

Mr. Greg Becker, Silicon Valley Bank 

Mr. Daryl Byrd, IBERIA BANK 

Mr. Carl Chaney, Hancock Bank 
416 


79691.331

Mr. William Cooper, TCF Financial Corp. 

Mr. Raymond Davis, Umpqua Bank 

Mr. Vince Delie, F.N.B Corp. 

Mr. Dick Evans, Frost National Bank 

Mr. Mitch Feiger, MB Financial, Inc. 

Mr. Philip Flynn, Associated Bank 

Mr. Paul Greig, FirstMerit Corp. 

Mr. John Hairston, Hancock Bank 

Mr. Robert Harrison, First Hawaiian Bank 

Mr. Peter Ho, Bank of Hawaii 

Mr. Gerard Host, Trustmark Corp. 

Mr. John Ikard, FirstBank Holding Company 

Mr. Bob Jones, Old National 

Mr. Bryan Jordan, First Horizon National Corp. 

Mr. David Kemper, Commerce Bancshares, Inc. 

Mr. Mariner Kemper, UMB Financial Corp. 

Mr. Gerald Lipkin, Valley National Bank 

Mr. Stanley Lybarger, BOK Financial 

Mr. Dominic Ng, East West Bank 

Mr. loseph Otting, One West Bank 

Mr. Joe Pope, Scottrade Bank 

Mr. Steven Raney, Raymond James Bank 

Mr. William Reuter, Susquehanna Bank 

Mr. Larry Richman, The Private Bank 

Mr. James Smith, Webster Bank 

Mr. Scott Smith, Fulton Financial Corp. 

Mr. Carlos J. Vazquez, Banco Popular North America 

Mr. E. Philip Wenger, Fulton Financial Corp. 

Mr. Michael Cahill, Esq., City National Bank 

Mr. Brent Tjarks, City National Bank 

Mr. Drew Cantor, Peck, Madigan, lones & Stewart, Inc. 

Mr. Jeffrey Peck, Esq., Peck, Madigan, lones & Stewart, Inc. 

Mr. Richard Alexander, Esq., Arnold & Porter LLP 

Ms. Nancy L. Perkins, Esq., Arnold & Porter LLP 

Mr. Andrew Shipe, Esq., Arnold & Porter LLP 

16 
417 


79691.332

SUSP>-N COLLiNS 

United ~tates ,Senate 

The Honorable Ben S. Bemanke 

Chairman 

WASH1NGTON. DC 20510~1804 

November 26, 2012 

Board of Governors of the Federal Reserve System 

20th Street & Constitution Ave., N. W. 

Washington, D.C. 20551 

TIle Honorable Martin J. Gruenberg 

Acting Chairman 

Federal Deposit Insurance Corporation 

550 17th Street, N. W. 

Washington, D.C. 20551 

The Honorable Thomas}. Cuny 

Comptroller 

Department of the Treasury 

Office of the Comptroller of the Currency 

250 E Street, S.W. 

Washington, D.C. 20219 

RE: Regulatory Capital Rules: Regulatory Capital, Implementation ofBaselllI, Minimum 

Regulatory Capital Ratios, Capital Adequacy, Transition Provisions, and Prompt 

Corrective Action (RlN 30M-AD95) 

Regulatory Capital Rules: Standardized Approach for Risk-weighted Assets; Markel 

Discipline and Disclosure Requirements (RlN 3064-AD96) 

Regulatory Capital Rules: Advanced-Approaches Risk-Based Capital Rule; Market Risk 

Capital Rule (RlN 30M-AD87) 

Dear Chairman Bemanke, Acting Chairman Gruenberg, and Comptroller Curry: 

I am writing to comment on the proposed rules implementing the BaselllI regulatory 

capital framework. 

As the author of Section 171 (the "Collins Amendment") of the Dodd-Frank Act, I 

believe strongly that capital requirements must ensure that firms have an adequate capital 

cushion in difficult eeonomic times, and provide a disincentive to their becoming 'too big to 

fail.' To achieve this, Section 171 requires that large bank holding companies be subject, at a 

minimum, to the same capital requirements that small community banks have traditionally faced. 

During consideration ofth. Dodd-Frank Act, I supported modifications to the final 

language to Section 171 to enSure a smooth transition to increased capital standards. Among 

these modifications were provisions to delay, for tlve years, the application of new capital 

requirements for savings and loan holding companies ("SLHCs"), and for certain foreign-ov>11ed 
418 


79691.333

bank holding companies. See subsections (b)(4)(D) and (E) of Section 171. These modifications 

were intended to allow these entities the time they need to adjust their balance sheets and capital 

levels in order to come into compliance with the new capital standards. The proposed rules 

implement the five year delay provided to foreign-owned bank holding companies by Section 

171 (b)(4)(E), but neglect to implement the nearly identical delay for SLHCs provided by 

Section 171 (b)(4)(E). I do not understand why the proposed rules fail to implement this 

provision, as required by Congressional intent and the clear language of the statute. 

I am hopeful, too, that in crafting final rules, you will give further consideration to the 

distinctions between banking and insurance, and the implications of those distinctions for capital 

adequacy. It is, of course, essential that insurers with depository institution holding companies 

in their corporate structure be adequately capitalized on a consolidated basis. Even so, it was not 

Congress's intent that federal regulators supplant prudential state-based insurance regulation 

with a bank-centric capital regime. Instead, consideration should be given to the distinctions 

between banks and insurance companies, a point which Chairman Bemanke rightly 

acknowledged in testimony before the House Banking Committee this summer. For example, 

banks and insurers typically have a different composition of assets and liabilities, since it is 

fundamental to insurance companies to match assets to liabilities, but this is not characteristic of 

most banks. [believe it is consistent with my amendment that these distinctions be recognized in 

the final rules. 

I am hopeful you will keep these concerns in mind as you continue to implement the 

Dodd-Frank Act and the proposed rules referenced above implementing the Basel III regulatory 

capital framework. 

Sincerely, 

--,lU4k--

UNITED 

Susan M. 

STATES 

Collins 

7t1 

SENATOR 

~ 
419 


79691.334

FDIC 

Speeches & Testimony 

Back to Basics: A Better Alternative to Basel Capital Rules; Thomas M. Hoenig, Director, 

Federal Deposit Insurance Corporation, delivered to The American Banker Regulatory 

Symposium; Washington, D.C. 

September 14, 2012 

Introduction 

I have been involved in central banking and financial supervision my entire career. I understand 

the importance of having the right market conditions and regulatory framework for an economic 

system to thrive. And most certainly I know that the foundation of a strong financial system is 

strong capital. For these reasons I wish to add my perspective on today's discussion regarding 

Basel III. After reading the entire I,OOO-plus page proposal, I would encourage the Basel 

Committee and the international regulatory community to step back and rethink the Basel capital 

standards. 

It may be helpful here to recall how Basel has evolved. Following the implementation of Basel I, 

many in economics and finance and many of the world's largest banks wanted a more 

sophisticated and flexible risk-based capital standard. The U.S. chaired the Basel II Committee 

then and with others agreed that such change was necessary for the largest finns to remain 

globally competitive. Basel II and III were also given the task of satisfying various national 

interests, adding more complexity. As a result, the number of Basel risk weights evolved from 

five to thousands. 

Basel III is intended to be a significant improvement over earlier rules. It does attempt to 

increase capital, but it does so using highly complex modeling tools that rely on a set of 

subjective, simplifying assumptions to align a finn's capital and risk profiles. This promises 

precision far beyond what can be achieved for a system as complex and varied as that of U.S. 

banking. It relies on central planners' detennination of risks, which creates its own adverse 

incentives for banks making asset choices. 

The poor record of Basel I, II and 11.5 is that of a system fundamentally flawed. Basel III is a 

continuation of these efforts, but with more complexity. It also is more prolific since it applies 

across all banking finns. Directors and managers will have a steep learning curve as they attempt 

to implement these expanded rules. They will delegate the task of compliance to technical 

experts, and the most brazen and connected banks with the smartest experts will game the 

system. In private discussions I find a good deal of uneasiness about Basel Ill's ability to be more 

effective than previous Basel efforts; however, there is a sense that we cannot go back. I suggest 

that we not only can go back, we must. In my remarks to follow, I will set out my views on the 

role of capital and the flaws of Basel Ill, and then will suggest a simpler alternative that takes us 

back to the basics. 

Capital, the Safety Net and Markets 
420 


79691.335

Capital is the foundation on which a bank's balance sheet is built. There can be no fortress 

balance sheet without fortress capital. In a market economy, capital insulates a firm from 

unexpected shifts in risk and from losses on loans and investments gone bad. A reliable capital 

measure facilitates the public'S and the market's undcrstanding and judgment of the financial 

condition of a finn and industry. And finally, while essential to the health of a firm, capital has 

its limits. Even high levels of capital cannot save a firm from bad management or save an 

industry from the cumulative effccts of excessive risk taking. 

In judging the role of capital, it is useful to look back at bank capital levels in the U.S before the 

presencc of our modem safety net. Prior to the founding of the Federal Reserve System in 1913 

and the Federal Deposit Insurance Corporation in 1933, bank equity levels were primarily market 

driven. In this period the U.S. banking industry's ratio of tangible equity to asscts ranged 

between 13 and 16 percent, regardless of bank size. Without any internationally dictated standard 

or any arcane weighting process, markets and the public required what would scem today to be 

excessively high capital levels. 

With the introduction and expansion of the safety net of deposit insurance, central bank loans 

and ultimately taxpayer support, the markct's capital demands changed. While the safety net 

protects depositors from loss and promotes stability in the system, its secondary effect has been 

to erode the market's role in disciplining banks. Depositors and other creditors have come to 

understand that the safety net protects them far more importantly than does bank capital or good 

management. 

It is important to ask where these changes have taken us. One of the most significant results has 

been that bank supervisors rather than the market have been left the difficult task of determining 

adequate capital for the industry. Unfortunately this has led to a systematic decline in bank ' 

capital levels. Between 1999 and 2007, for example, the industry's tangible equity to tangible 

asset ratio declined from 5.2 percent to 3.8 percent, and for the 10 largest banking firms it was 

only 2.8 percent in 2007. More incredible still is the fact that these 10 largest firms' total riskbased capital ratio remained relatively high at around II percent, achieved by shrinking assets 

using ever more favorable risk weights to adjust the regulatory balance sheet. 

It is no coincidence that the financial industry in 2008 was unable to withstand the pressures of a 

declining market nor bear anywhere near the losses that the taxpayer eventually assumed. It turns 

out that the Basel capital rules protected no one: not the banks, not the public, and certainly not 

the FDIC that bore the cost ofthe failures or the taxpayers who funded the bailouts. The complex 

Basel rules hurt, rather than helped the process of measurement and clarity of information. 

Basel III introduces a leverage ratio and raises the minimum risk-weighted capital ratios, but it 

does so using highly arcane formulas, suggesting more insight and accuracy than can possibly be 

achieved. Where the markets assess, demand and adjust intrinsic risk weights on a daily basis, 

rcgulators using Basel look backwards and never catch up. For cxample, people knew well in 

advance of the recent financial crisis that the risk on home mortgages had increased during the 

period between 2005 and 2007, yet no changes were made to the risk weights. Basel III still 

looks backward as demonstrated by the few changes made regarding the weights assigncd to 

sovereign debt. 
421 


79691.336

Finally, it is noteworthy to observe how much the industry's capital level diverges depending on 

which Basel measure is reported. For the 10 largest U.S. banking organizations as of the second 

quarter of2012, total Tier I equity capital was $1.062 trillion. Total adjusted tangible equity 

capital was $606 billion. In a crisis, which number counts? 

Given the questionable performance of past Basel capital standards and the complexities 

introduced in Basel III, the supervisory authorities need to rethink how capital standards are set. 

Starting over is difficult when so much has been committed to the current proposal. The FDIC is 

no different from other U.S. and international regulatory agencies where committed staff has 

devoted enormous effort to drafting and implementing Basel III. However, starting over offers 

the best opportunity to produce a better outcome. 

An Alternative to Basel 

How might we better assess capital adequacy? Experience suggests that to be useful, a capital 

rule must be simple, understandable and enforceable. It should reflect the finn's ability to absorb 

loss in good times and in crisis. It should be one that the public and shareholders can understand, 

that directors can monitor, that management cannot easily game, and that bank supervisors can 

enforce. An effective capital rule should result in a bank having capital that approximates what 

the market would require without the safety net in place. 

The measure that best achieves these goals is what I have been calling the tangible equity to 

tangible assets ratio. Tangible equity is simply equity without add-ons such as good will, 

minority interests, deferred taxes or other accounting entries that disappear in a crisis. Tangible 

assets include all assets less the intangibles. 1 

This tangible capital measure docs not remove the complexities from the balance sheet. It does 

not attempt to differentiate risks among assets. It does not tier the measure into any number of 

refined levels. There is no governmental ex-ante endorsement of risk assets or capital allocations. 

Instead, this tangible capital measure is a demanding minimum capital requirement within which 

management must allocate resources within the overall capital constraint. This simple measure 

accepts that firms quickly shift their allocation of assets to take advantage of changing risks and 

rewards. This simpler but fundamentally stronger measure reflects in clear terms the losses that a 

bank can absorb before it fails and regardless of how risks shift. It provides a consistent and 

comparable measure across firms. 

Since the federal safety net is the current substitute for capital in protecting the depositor, it also 

is reasonable that the supervisor should expect the same minimum capital as would the market 

without the safety net. As noted earlier, the equity ratio for the banking industry before the safety 

net was implemented ran between 13 and 16 percent. Therefore, the starting point for any 

discussion of an acceptable level of tangible equity for all banking firms should be well above 

the 3 114 percent level now implied by the Basel III proposal. 

Finally, under this simpler approach there remains the challenge of more precisely assessing 

individual institutional risk and judging whether this minimum capital is adequate. That 
422 


79691.337

judgment should be determined through the periodic examination process, which for the largest 

banks has become deemphasized in favor of stress tests. It is the often ignored Pillar II of the 

Basel standards. 

This is no simple task. However, it is through this process, properly conducted, that supervisors 

can best assess a financial firm's fundamental operations, liquidity, asset quality and risk 

controls. Some disregard it perhaps because they claim regulatory capture. My own experience is 

that commissioned examiners as a rule are highly skilled professionals, able to effectively assess 

bank risk. lfthe financial supervisors' record needs improvement, we must hold accountable the 

leadership of the regulatory agencies. The examination process, effectively conducted, holds the 

best potential to identify firm-specific risks and adjust capital levels as needed. 

Can Simpler be Better? 

Some argue that a simple measure with a relatively stronger minimum capital level would reduce 

liquidity in the market, constrain loan growth and undermine the economy. I offer a different 

perspective. 

First, experience tells us that economies compete best from a position of strength, and a strong 

economy will always have banks with strong capital and balance sheets. The recent recession 

and credit crunch were made worse because banks had too little capital as they entered the crisis. 

They were forced to sell assets and shrink their balance sheets in the absence of a strong capital 

cushion to absorb losses. The U.S. economy would have been significantly less harmed had the 

financial industry been holding adequate capital in 2008. 

Second, the term "increased liquidity" is often used when the objective is really "increased 

leverage." In the growth phase of an economic expansion, borrowing is readily available, and 

firms and individuals easily borrow funds. Some describe this as a liquid market. A more 

appropriate description is leveraging up. Liquidity is the ability to convert assets to cash without 

loss. Leverage is expanding the balance sheet using debt. It is therefore often the case that greater 

balance-sheet leverage results in less balance-sheet liquidity. This is especially true in a crisis. 

Third, a reasonable capital level does not inhibit economic growth. It sustains it. For example, a 

10 or higher percent tangible capital to tangible asset ratio, depending on exam findings, allows a 

dollar of capital to support as much as 10 dollars of loans and other assets. Leverage is permitted, 

and credit is available and supportive oflong-term growth. Sustainable growth is enabled. 

Excessive growth is impeded. 

Finally, a simple, understandable and enforceable capital standard when measured consistently, 

not subject to manipulation, and enforced uniformly across the industry provides for equitable 

treatment of all firms within the industry, from smallest to largest. 

In contrast, the Basel Accord would permit a commercial bank to be judged as "adequately" 

capitalized having a Tier 1 leverage ratio of 4 percent, which implies an even lower tangible 

equity ratio, so long as the total risk weighted capital ratio is above 8 percent, and the Tier 1 risk 

weighted risk capital ratio is above 6 percent, and the common equity Tier I risk weighted capital 
423 


79691.338

ratio is above 4.5 percent. This is more complicated than simple, more confusing than clear and 

more easily gamed than not. 

A Final Observation 

In reading the Basel proposal, I am convinced that much of its complexity derives from the 

complexities and conflicts embedded in the combination of commercial banking and 

broker/dealer activities. The safety net's enormous subsidy encourages ever-greater risk taking as 

firms attempt to achieve a higher return on equity than would otherwise accrue from operating 

the payments system and serving as a financial intermediary. In other words, from what they 

would earn from commercial banking. The safety net's subsidy facilitates the use of leverage and 

provides an incentive toward higher risks that are hidden in opaque instruments, in trading 

activities and in derivatives. It bestows an advantage to subsidized firms not afforded others. 

Solving this problem requires a fundamental restructuring that separates banking from trading 

activities. J 

Now, in the mistaken beliefthat the subsidy can be neutralized, and that risks and shifting risks 

can be captured, measured and properly and quickly capitalized using financial models, we get 

Basel Ill. It's time we acknowledge that no Basel model can accomplish this objective. Markets 

move too quickly, and human nature is too dynamic. 

Basel III will not improve outcomes for the largest banks since its complexity reduces rather than 

enhances capital transparency. Basel III will not improve the condition of small- and mediumsized banks. Applying an international capital standard to a community bank is illogical, 

particularly when models have not supplanted examinations in these banks. To implement Basel 

III suggests we have solved measurement problems in the global industry that we have not 

solved. It continues an experiment that has lasted too long. 

We would be wise to acknowledge our limits, to simplify the system, to confine the subsidy, and 

to reduce the taxpayers' exposure to an enormous future liability. It is time for international 

capital rules to be simple, understandable and enforceable. 

I understand where the proposal stands today and how much has been invested in drafting Basel 

III, but I believe the Committee should agree to delay implementation and revisit the proposal. 

Absent that, the United States should not implement Basel III, but reject the Basel approach to 

capital and go back to the basics. By doing so, we can focus on efforts that will create a wellmanaged, well-capitalized, well-regulated financial system that actually supports economic 

gro",1:h. 

1 The measure of tangible equity and tangible assets used here differs from the GAAP measures, 

which excludes intangible assets such as goodwill, by also excluding deferred tax assets. 

Deferred tax assets are excluded because they are not available for paying off creditors when a 

bank fails, that is, they are "going concern" assets but not "gone concern" assets. 

I My proposal to limit activities supported by the public safety net by restricting commercial 

banking organizations to traditional banking activities and limited other intermediation activities 
424 


79691.339

can be found at http://www.fdic.gov/aboutileam/board/Restructuring-the-Banking-System-05-

24-II.pdf 

The views expressed are those of the author and not necessarily those of the FDIC. 
425 


79691.340

November 29, 2012 

Testimony of Daniel T. Poston 

On behalfof 

Fifth Third Bank, as Representative ofthe Regional Bank Working Group 

before the 

Subcommittee on Financial Institutions & Consumer Credit 

and 

Subcommittee on Insurance, Housing and Community Opportunity 

of the 

Committee on Financial Services 

United States House of Representatives 

November 29, 2012 

Chairman Capito, Ranking Member Maloney, Chairman Biggert, Ranking Member Gutierrez, 

and members oftbe subcommittees, my name is Dan Poston and I am the Chief Financial Officer of 

Fifth Third Bancorp, a regional bank based in Cincinnati, Ohio witb retail brauches in 12 states 

including West Virginia and Illinois. We were invited to speak with the Subcommittees on tbe 

impact on regional banks like Fiftb Third and tbe banking industry of the proposed Basel III capital 

requirements as well as the risk-weighting rules proposed in the new Standardized Approach. We 

appreciate this opportunity. 

This testimony supplements the testimony made by Fifth Third on matters common to all banks 

ou behalf of the American Bankers Association. We believe our ABA testimony addressed key 

substantive aspects of the proposals as they relate to regional banks, which would generally be 

iropacted by tbe rules in manners similar to other banks of various sizes. 

This supplemental testimony focuses on aspects of the proposals and related matters which are 

special interest and concern to regional banks, particularly those with traditional banking models 

like Fifth Third. There are few fundamental differences among traditional regional banks, whether 

large or small, which are specifically related to size. However, over the past several years, Fifth 

Third has participated in a working group of regional banks that have between $50 billion and 

approximately $300 billion in assets, formed in response to the differential impact of new rules that 

have been applied to banking organizations with more than $50 billion. A number of tbese banks 

----\nFIFTH THIRD BANCQRP 2 
426 


79691.341

November 29,2012 

submitted a joint comment letter on these capital proposals', and we have worked with them in 

preparation for our testimony before the House. We and other members of this group were also 

active contributors to the comment lettcr jointly submitted by the ABA and othcr trade groups2 

I. The nature and role of regional banks like Fifth Third 

Regional banks like Fifth Third are traditional banking organizations, domestically focused, 

and serving our local communities by providing traditional banking services-primarily deposits, 

loans, and trust and asset managenlent services. These banks are not complex, interconnected, or 

internationally active, and do not have large trading or capital markcts businesses. 

Most regional banks like Fifth Third are banks between $50 billion and $250 billion in assets, 

which are not subject to the Advanced Approaches framework that applies to internationally active 

banks or "core" banks above $250 billion. We would note that three traditional regional banks with 

characteristics similar to our bank and other regional banks have approximately $300 billion of 

assets, making them also subject to the Advanced Approaches. 

Individual banks of this size play an important role in their communities, but are small in the 

context of the total U.S. banking system, ranging from approximately 0.5 percent to 2.5 percent of 

total deposit market share, and with assets that are one-seventh to one-fortieth the size of the largest 

U.S. banks. While relatively small individually, the regional banks in this size range represent about 

20 percent of U.S. deposits collectively and likely a similar share of lending. We have tens of 

millions' of customers, who would be impacted by the proposed rules, particularly the Standardized 

Approach. Banks in this size range have over 500,000 employees as well in totaL 

Regional banks of our size tend to be geographically diversified, have traditional banking 

business models, and tend not to have asset risk concentrations that can produce especially outsized 

losses during crisis periods. While we all experienced challenges, this group as a whole per/armed 

I Letter jointlr submitted by Comerica Bank, Capita! One, Huntington ~ari()nal Bank, Keycorp, SunTnISt Bank);, Fifth 

ThUd Bank, and Ref.,rions Fmancial Corp. 

~ Letter jointly iiubmittc.d by the ~\merican H'd.nkers :\~socia6on, the Securities Industry and Financial )..farkers. . \ssociation 

anJ the rinancial Se1\>ices Roundtable. 

1 For rc~i[)naJ banb herween 550 biJlion and $350 billion in ::t:(s('.ts, a rcasnnable a~rt~~te for their total cu:;rOIncrs might hr: 

ab(JUt 100 million. 

-m-. 

FiFTH THIRD BANc:ORP 
427 


79691.342

November 29,2012 

relatively well during the recent crisis, did not stand out as presenting unusual risks, and none 

failed! 

In tenns of our own capital position, Fifth Third is strongly capitalized and we believe our 

capital position exceeds all proposed capital requirements, even those that would not come into full 

etTcct in 2019. We believe the vast majority of other regional banks in the above size range would 

also currently exceed such requirements as well. Based upon our evaluation of other banks' 

published estimates oflhe impact of the proposed rules, we do notbelicve that Fifth Third would be 

disproportionately affected by them, although the rules would have a significant impact on us as 

they would all banks. 

II. Simpler generally applicable rules, appropriate for all banks, small and 

large, would be fully appropriate for regional banks like Fifth Third 

The Basel III Capital NPR and Standardized Approach NPR are proposed to apply to all U.S. 

banks whether or not they are internationally active. This approach - that there should be a unifonn 

set of common capital rules that apply to all U.S. banks operating domestically - is consistent with 

the current approach which has applied to such banks for decades. All banks use the same basic 

definitions for each type of eapital, are governed by the same U.S. capital requirements, and, for a 

given type of risk, each bank is required to hold the same amount of capital for that risk. These 

factors make it critical that a generally applicable risk attribution system be appropriately designed; 

be relatively simple and aligned with risk; and be one that all banks can implement. 

A regulatory capital system should also be consistent in its attribution of risk and in ensuring 

that banking institutions have sufficient capital to support their risks. Capital rules that do not apply 

broadly where risks are similar would inevitably lead to concentration of risks where the rules do 

not apply. This potential to shift capital and risk applies both across asset classes and across 

institutions. Additionally, if risk-weightings are not truly correlated with actual risks, risks would 

shift inappropriately among banks or to and from the banking industry to the "shadow banking" 

sector that is less regulated and more difficult to regulate. 

Any change to the gencrally applicable rules should represent an appropriate change and an 

improvement on Basel I, and work for all banks of all sizes. We believe a more risk-sensitive risklOne regional bank of rhis size u:as sufficiently: challen,l,>-eJ at the rcak of the crisis that it found it necessary to underrake a 

:;ak to anorbef fegion:1l bank, af nD cost til the FDIC, inJu:-:try ()f taxpayers. 

4 
428 


79691.343

November 29, 2012 

weighting framework would be valuable in the U.S., but if mis-calibrated it could be very 

damaging. Such a proposal should be consistent with risk, be careful not to over-ascribe risk, and 

not be overly complex or difficult to implement. We believe the design of previous Standardized 

approach proposals in the U.S. was much more consistent with these goals. 

Banks of all sizes, from the largest banks to community banks, have cxpressed remarkably 

consistent concerns with these proposals. They would affect all banks, and the customers of all 

banks, significantly. They would be very burdensome administratively, largely driven by the sheer 

complexity of the way the rules operate. As large as the administrative burden would be, however, 

that burden would pale in comparison to the impact on business activities and customer disruption 

for any bank to which they applied, as it tried to manage conflicts where there is high attributed risk 

and much lower actual risk. 

The rules were developed in the U.S. to replace Basel I for all domestic banks. However, due 

perhaps to their complexity, they have been commonly characterized as rules that were designed 

overseas, for large or internationally active banks, which are being applied to domestic traditional 

banks. Furthermore, it has been suggested that the proposals are so complex that if applied they 

should only apply to banks greater than $50 billion, which would include traditional regional banks 

like Fifth Third. 

We do not believe the rules as proposed should be applied to anyone. There is absolutely no 

reason that the proposed rules would be appropriate for banks of our size (or larger), and only such 

banks, in the absence of any demonstrated special propensity for taking risks or holding risk 

concentrations. Traditional regional banks do not have special need for a new or different set of 

risk-weightings to reveal risk. Banks of our size, as well as the largest banks, already are subject to 

extensive and detailed scrutiny of our risk, in granular detail, through stress-testing and other 

processes. By rule, these data reporting, capital planning and stress testing processes are far more 

strenuous than will ever be required for smaller institutions. [n short, institutions that have $50 

billion in assets are already subject to very significant regulatory "cliff effects," despite the small 

size of our institutions relative to the banking sector or economy, and despite our traditional 

banking focus. We do not see a basis for adding another. 

There is no reason to introduce a new generally applicable approach is not generally applicable 

and certainly not to have a new approach that operated concurrently with two other approaches, 

while being very different in its operation from the other approaches. If multiple risk weighting 

frameworks were created and applied based on size alone, it should first be demonstrated that 

FlnH 

~ THIRD BAN-CORP 
429 


79691.344

November 29, 2012 

institution-specific risk is differentiated based on size alone. We don't believe this is the case, or 

that traditional regional banks of our size have demonstrated such a propensity to accumulate risks. 

Historical experience clearly demonstrates that banks of any size may take more or less risk, 

including in traditional banking businesses such as mortgage or commercial real estate lending. The 

purpose of risk-weighting assets is to reveal risk concentrations where they are not evident from 

looking at a bank's balance sheet, and then to require them to be appropriately capitalized. Ifbanks 

take risks, and hold risks, they should be required to hold similar capital for similar risks. This is 

fundamental to a safe and sound banking system. 

The significant and disruptive effects that would result from the introduction of multiple, 

concurrently operating, risk weighting frameworks can be understood by considering how each 

approach works. The current generally applicable approach, Basel I, has a relatively simple risk 

weighting system. This approach enables banks to evaluate risks, price for them, take the 

undem-Titing of a loan and the circumstances of the borrower into account, and determine whether a 

loan should be made and held on its balance sheet The Advanced Approaches framework, which 

applies to larger or internationally active banks, enables such banks to manage risk to their own 

measurements, and we believe would be much less punitive in its treatment of mortgages and 

particularly home equity lines of credit5 fn contrast, the Standardized Approach prescribes risk, in 

ways that we do not believe are aligned with actual risk, particularly for mortgages and home 

equities. To implement the Standardized Approach, but only for some banks, would be to single out 

a certain group of banks for prescriptive and punitive treatment in terms of their lending activities, 

while other banks would operate under risk weighting frameworks that do not prescribe what types 

of loans are considered risky. This would create a severe and unjustified competitive disadvantage 

, It is not clear that the orcratioll of the "Collins Amendment" tlOot would lead to alJ lLS. hanks having effectively the ~amc 

n:;k-weighting const.raints on their domestic tD.J.ditional banking busine~s like mort6'1lge or commercial real estate lending. 

(Dodd-Frank Act Sectinn 171 (b)(2)). The "Collins ,\mcndment" floor j" intended to ensure that .,,\unnced .\rproaches 

institutions rnaintrun capital that i, at least as high as required umler generally applicabl~ ruJes (i.e., the propo:;Ctl 

Standacdizt:d .\.pproach). "n1is flo()r applies at the a/-t..t;rei-,rate balance shtCi leYt~I, for capital tati()s, measured against Prompt 

Corrective .\ction minimums (rather than the buffcred minimums that would Serve a~ the effective carital minimums for 

C.S. banb). ,\ lar~e capir.alrn.."1rkets business could abo be the cause of the _\Jvanced ,\pproaches producing tht 

cunsrraining rano, Data should bc collected rt'f,'Ilromg (he impact of each approach on L'S institurinns, in order to ensure 

that domestic competitiyc balance I:; mamtainetl, part.icularly in critical traditional banking husines:;es ami for computation 

of the various minimum capital requin:ments. \X'(" uo not believe rhat b:mb under either .\pproach should he sif.,rnificantly 

aJvanta\!,cu rdativt' to dlC other, or thar their ability to offer similar pmuucrs ro their customers shnulu be: affect~·J, :;imply 

due to these {Efferent risk-wt:lghnng approaches. 

6 
430 


79691.345

November 29,2012 

for any banks so affected, and would be damaging to those banks' customers who have made the 

choice to bank with them6 

We fully recognize and appreciate that banking regulators understand these issues, which they 

have articulated and which formed the foundation of their making the proposals generally 

applicable to all banks. 

We certainly sympathize with smaller banks with respect to the burden of these rules and the 

impact they would have on their activities. We would also experience these burdens. We believe 

that appropriate and simpler rules should not be, and do not need to be, so burdensome to any bank. 

Effective rules should build on and reinforce effective risk management practices whose costs 

institutions are already bearing, which would significantly mitigate the additional burden. 

In summary, we fully agree that the rules as proposed are overly complex and should be 

simplified and aligned with risk so that they can provide a common risk framework that would work 

for all banks. The rules are not complex hecause they were designed for, or are especially 

appropriate for, complex institutions or for traditional regional banks larger than $50 billion. They 

are complex primarily because they include a risk attribution framework that has never been 

identified or proposed previously, and the interactive effects of critical aspects of the rules 

(especially between home equity and mortgage loans). 

We believe the appropriate way to address these issues is for the rules to be withdrawn, studied 

and, if necessary, re-proposed, in a simpler form more directionally and proportionally aligned with 

risk. Until such rules are identified and applied that would work for all banks, small and large, we 

believe the current Basel I rules should remain in place for all banks. Traditional regional banks of 

our size have not shown a higher risk propensity than banks smaller than us, or larger than us. 

Therefore, a generally applicable replacement for Basel I that works for smaller banks would work 

just as well for larger banks, including regional banks, for all of the reasons outlined above. 

Summary 

;; If borh a StandardizeJ . \pproach and a different generally applicable approach were in place, we believe banks under rhe 

StanJan.1ized Approach wouJd not be able to dem{jn~tratt' !o"'l,,·cr capital re,-/uiremt'nts using the morlC risk semitlve approach, 

even though thl' ri:;k weights unJcr each approach \\"cre as::;i14DcJ by banking re;,,'ularnr~. The Collins _-\mendm('ot /loor, as 

currently written, dne!> not aliO"'l"ir a b,mk's c:aplt .. l ft:ljUlri:mems to be Jess than woulJ be computl'd unJer the gl"nctally 

applicable aprn)::Ich. 

-m---- FlFTM THIRD BANCORP' 
431 


79691.346

November 29,2012 

Fifth Third supports a more risk-sensitive system of generally applicable rules, one that works 

well and applies broadly, that identifies risks where and as they are, and that treats similar risks with 

similar capital treatment. There are nearly 7,000 banks in the United States, the vast majority of 

which are community banks. Therefore, any generally applicable approach must start by working 

for those banks. We believe that such an approach would be entirely appropriate for traditional 

regional banks and the risks they take as well. 

Banks large and small have voiced very strong and remarkably consistent concerns about the 

operation of the Standardized Approach, its complexity and burdens. They have noted the 

differences in its tisk attribution for mortgage, home equity, and commercial real estate loans - in 

comparison with Basel! and the Advanced Approaches; in comparison with previous standardized 

approach proposals; and in comparison with their risk experience. We very much appreciate that the 

banking agencies have indicated they will carefully consider the industry's observations and 

concenlS. 

Lawmakers, banking regulators, and bank employees are all under incredible pressure to 

implement many changes in the way banks are regulated in the U.S. Careful study to ensure 

consistent and workable rules for all is absolutely critical. Replacing the generally applicable rules 

for risk-weights is a complex process, and we believe it requires that regulators and the industty 

communicate and work together to calibrate risk-sensitive rules appropriately and to have the time 

to study and align them. This approach would better ensure that resulting impacts to credit flows 

and economic activities are desirable and appropriate in both direction and scope. For these reasons, 

we believe that changes to generally applicable risk-weightings should not be required to follow the 

same time-line as proposed changes in minimum capital requirements, especially given that this 

Standardized Approach proposal is not required to be implemented under any Basel agreement. 

Fifth Third appreciates the opportunity to present our views to the Subcommittees for your 

consideration. 

~m--. FIFtH THIRD BANCQRP 

o