Laurence H Meyer: Capital standards and community banks
Remarks by Laurence H Meyer, member of the Board of Governors of the US Federal Reserve
System, at the Ohio Bankers' Day Conference, Columbus, Ohio on 15 March 2001.
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I am pleased to be here today to discuss capital standards at community banks. This topic does not
reflect any apparent problem with the current capital standard for such organizations. The system has
worked well for both supervisors and community banks. With some minor exceptions, it continues to
work well. Nonetheless, the issue calls out for discussion because of the new Basel Capital Accord
proposed in mid-January as well as the banking agencies' advance notice of proposed rule-making
last October on possible revisions to community bank capital rules.
By way of background, you may recall that the original Basel Accord, reached in 1988, was designed
for large, internationally active banks. Nonetheless, regulators in the United States applied it
universally to all domestic commercial banks and bank holding companies. Other countries took a
similar approach.
Technology and banking practices have advanced since 1988, and especially for the large, complex
banking organizations, the rule has developed serious shortcomings. Risk-measurement techniques
have improved; the costs of generating, maintaining, and analyzing data have declined; and capital
markets have become more tightly intertwined. As a result, the current accord that worked well before
these developments has proven to be far too crude for practices today, particularly practices at large,
complex banking organizations.
Supervisors in industrial nations have concluded that they need a capital measure for these large
banks that is both more risk-sensitive and more compatible with current market practice than the
current accord. My focus today is on what all of this means for the overwhelming majority of U.S.
banks, specifically community banks.
The new Basel proposal clearly applies to all of the institutions we supervise under our program
dealing with large, complex banking organizations. But that program covers only about twenty
domestic entities of the nearly 9,000 U.S. banks, almost all of which have assets exceeding $40
billion. The vast majority of banks in this country are neither large nor complex and seem to be unlikely
candidates for a high-maintenance capital standard that requires costly and extensive
riskmanagement systems. More than 98 percent of U.S. commercial and savings banks, for example,
have assets of less than $5 billion, and 95 percent have assets of less than $1 billion.
Last fall, in anticipation of the Basel proposal, the U.S. banking agencies asked for public comment on
possible alternative standards for noncomplex banks, simpler than anything in the Basel proposal. I
will be discussing the various "simpler" options--both from our advance proposal last fall and from the
new Basel framework proposed in January. One outcome after considering these options may be to
retain the current system, or tweak it only modestly, for most noncomplex, non-internationally active
banks.
Innovations in the new proposal
The Basel proposal represents a watershed in supervisory policy, redefining the regulatory approach
to bank supervision for some banks and providing others with new incentives to improve their
riskmeasurement procedures. Let me call your attention to some of the most important innovations in the
new proposal and, at the same time, explore whether these innovations would be appropriate for
community banks.
Three pillars. The Basel Committee's approach rests on three so-called pillars: (1) the new capital
standard itself; (2) increased supervisory review of banks' internal assessments of their own capital
adequacy; and (3) additional public disclosure of bank risk profiles. In contrast, the original Basel
Accord rested on a single pillar, a regulatory minimum for capital.
Pillars 1 and 2 in effect distinguish two concepts of capital adequacy: regulatory minimum capital set
by pillar 1 and the supervisor's evaluation of banks' internal calculations of their economic capital
under pillar 2. By "economic" capital I mean the amount of capital that management has determined is
required to reflect the risks, strategy, and objectives of its individual bank, regardless of the regulatory
structure. The regulatory minimum, in effect, provides a threshold for early intervention by supervisors.
The procedures and assumptions embedded in the internal measure of economic capital drive
business decisions of the bank by permitting management to gauge the capital costs of, and better
establish the price for, credits of varying degrees of risk. Using pillar 2, supervisors would plan to
evaluate the internal capital- allocation process for integrity and economic sense, and to ensure that
the underlying processes and assumptions used to measure economic capital are reasonable and
consistent with the principles in pillar 1. Finally, pillar 3 looks to market discipline to supplement and
reinforce the effectiveness of pillars 1 and 2 in disciplining the risk-taking of banking organizations.
In principle, the three-pillar approach applies to community banks as well as to LCBOs. In practice,
however, the relative importance and detailed application of the three pillars would clearly be quite
different at LCBOs and at community banks. It would be difficult and expensive to develop and
maintain the risk-management infrastructure necessary to evaluate a customer's creditworthiness with
the precision and internal quality controls necessary to use the more-advanced capital approaches in
the Basel proposal. More to the point, virtually all of these techniques and procedures seem currently
unnecessary for most U.S. banks, and they will remain so unless the economics and the nature of
community banking substantially change. The scale and operations of community banks neither
separate the management from credit decisions nor involve the complexity that characterizes the
process at larger entities. As a result, a simpler approach for defining the regulatory minimum capital is
likely to continue to work well for community banks, even as we need to move to a more complex and
more risk-sensitive approach for LCBOs.
In the United States, supervisory oversight--pillar 2 under the new proposal--has long been an integral
part of our regulatory framework, both for LCBOs and community banks. For both sets of institutions,
supervision has evolved to a more formal, risk-focused approach, with our exams increasingly
emphasizing the adequacy of internal processes and controls.
Since long before the risk-focused approach was formalized, however, examiners have been rating a
bank's capital based on their assessment of the risk of the institution. For example, a bank with stated
capital ratios well in excess of minimum requirements--or in excess of the "well capitalized" threshold
under today's standard--may still be assigned a less-than-satisfactory rating for the capital component
of the CAMELS rating if, in the opinion of the supervisor, the risk at that institution warrants such a
rating. In 1991, with the passage of the Federal Deposit Insurance Corporation Improvement Act, the
Congress formally recognized the role of supervisory oversight in assessing capital adequacy of banks
in relation to risk, permitting federal bank regulators to reclassify a bank's capital category under
certain conditions. Thus, for example, a federal bank regulator may reclassify a "well capitalized" bank
to the "adequately capitalized" category if the bank is in unsafe and unsound condition or if it fails to
correct unsafe and unsound practices. The supervisory oversight of capital adequacy, to be sure, is
more intense and continuous in the case of large, complex institutions, but what is now being called
pillar 2 has long been, and will continue to be, an integral part of the framework for community banks.
Market discipline (pillar 3), however, may be particularly problematic for community banks, since such
institutions are often closely held and not rigorously and continuously evaluated by market analysts
and investors. Even if they are traded on a regional basis, the depth of the trading is likely to be
inadequate to provide timely signals to supervisors and discipline to management. So, though pillar 3
is not irrelevant for community banks, it is unlikely to be as effective as it is for large, complex banks.
Multilayered approach. As I have noted, the proposed Basel capital standard is highly complex, but
for good reason. The proposal contains overlapping options that offer several approaches to
accommodate banks with varied resources, expertise, and risk profiles. The question is whether the
differentiation goes far enough for the U.S. banking structure.
The most basic approach under the proposed accord is the so-called standardized method. The
standardized approach is conceptually the same as the current capital accord, but more risk-sensitive
in some respects. Under all the Basel approaches, a bank, as now, would allocate a risk-weight to
each of its assets and off-balance-sheet positions and calculate a sum of the risk-weighted asset
values. The capital requirement remains 8 percent of the institution's risk-weighted assets. The
primary change, under the standardized approach, would be to base the asset risk-weights for
exposures to sovereigns, other banks, and corporations on the borrower's external credit ratings,
when possible. The proposal would also give more recognition to a bank's efforts to mitigate risk
through guarantees, collateral, credit derivatives, and netting agreements.
Those changes may be attractive to many institutions; however, the clear focus of the new Basel
proposal is the basing of regulatory capital requirements on a bank's own internal credit ratings, the
so-called internal rating based or IRB approach. There are two variants of the IRB approach: the
"foundation" and "advanced" options. Both were designed for banks with the resources and expertise
to build and maintain sophisticated risk-management systems and for which the current capital
standard more seriously mismeasures risk.
The difference between the two IRB methods is that the foundation approach is designed for banks
with systems that do not permit full reliance on internal risk estimates for calculating capital
requirements. Under the foundation approach, missing risk parameters would be supplied by the
supervisor and would be set conservatively. If banks believe these conservative estimates are
inappropriate or too large, they can invest in the research and systems to prove the point and pursue
the advanced IRB approach. Banks using the advanced approach would have more freedom, but their
methodologies would first be closely reviewed and approved by the supervisor.
This multilayered structure offers a flexible approach that could apply to a wider group of banks, not
just to large, internationally active banks. The key question for U.S. community banks and their
regulators is whether any of the options in the new Basel proposal--especially the standardized
approach--is a good match for community banks. Another question is whether competitive pressures
would provide incentives--perhaps overwhelming incentives--for community banks to pursue an IRB
approach. Would such an allocation of resources by community banks and supervisors be desirable
and efficient? Finally, if not one of the Basel alternatives, what capital standard would be most
appropriate for community banks in the United States?
Although originally portrayed as dealing only with credit risk, the
Comprehensive treatment of risk.
standard covers, in effect, virtually all banking risks through the experience-based, but unscientific,
capital charge of 8 percent. That is, although the current standard was structured on the basis of credit
risk alone, its level was set higher than warranted for just credit risk, in effect incorporating a "buffer"
that could be used to cover "other risks."
As we get more precise in measuring credit risk, we lose some of the buffers previously built into the
standard to cover operational and other risks. Explicitly or implicitly, we now need to make judgments
regarding the respective correlations of different risks. Are they additive or independent, and to what
degree are they one or the other? Can the same capital cover all of them, or do banks need capital for
each one? But again the question is whether the current approach, with its less precise measurement
of credit risk and its buffers for other risks, is working well enough for community banks and should be
left as it is.
The bifurcation alternative: the interagency advanced notice of proposed rulemaking
As I have mentioned, community banks in the United States have, besides the new Basel proposal,
another capital proposal to consider. I am referring to the advance notice of proposed rulemaking
issued last October by the U.S. banking and thrift agencies that explores alternatives for simplifying
the capital standard for noncomplex, non-internationally active U.S. depository institutions. This is the
so-called bifurcated approach. The advance proposal suggested three possible ways to structure a
capital standard for non-complex banking organizations. The first option would combine a risk-based
ratio with a leverage ratio. This option would retain much of the current approach while tailoring capital
charges to the size, structure, and risk profile of less- complex banking organizations. The second
option would use only a leverage ratio. Taking an approach not unlike the primary capital standard we
used throughout the 1980s, it would drop any semblance of a risk-weighted measure and base a
bank's capital requirements only on the ratio of its capital to total assets. The third alternative is simply
a modified leverage ratio that would add the exposures arising from loan commitments and other
offbalance-sheet transactions to total bank assets.
Reflecting its early stage of development, the proposal presents more questions than answers and
does not flesh out any of the three alternatives it presents. One important question relates to how
noncomplex institutions would be defined. The proposal suggests basing the decision on a bank's
asset size, the nature of its activities, and its risk profile--for example, assets less than $5 billion,
moderate amounts of off-balance-sheet transactions that are mostly loan commitments, and a focus
on traditional banking activities. In effect, the size threshold would be the determining factor for most
banks, permitting all but a few hundred of the nearly 9,000 federally insured commercial and savings
banks to calculate their capital requirements using a simple approach. Almost all thrifts as well would
likely qualify for the simpler approach.
This seems to be the proper time to consider a simpler approach for community banks as we
undertake major revisions to the Basel Accord. However, to be consistent with the spirit of Basel, the
agencies proposed that a simpler system should also be more conservative, requiring at least a
slightly higher minimum capital charge. Such a higher minimum would still, however, be below the
actual (or economic) capital now maintained by virtually all community banks.
The higher capital ratios now maintained at smaller banks reflect certain economic realities. These
banks generally carry greater risk than larger banks because of their greater concentrations in
exposures and funding sources, byproducts of their limited geographic scope and scale. In addition,
because of their more limited access to capital markets, community banks have fewer options for
augmenting capital when it is needed. The higher capital ratios at community banks, compensating for
these greater risks, result as much from bank managers' tolerance for risk and market expectations for
banks' capital as from the influence of bank supervisors. Bank management, the market, and the
supervisors all understand that the current capital standard sets minimum capital requirements, not the
economic levels that are required for prudent operations.
For all these reasons, community banks have consistently maintained higher capital ratios than larger
banks since long before a regulatory capital standard was implemented. At the end of 2000, for
example, banks with total assets of less than $1 billion had an average tier 1 leverage ratio of almost
10 percent and an average total risk-based capital ratio of almost 15 percent--both about double the
minimum standard. In contrast, banks with assets greater than $10 billion had average ratios of about
7 and 11.5 percent, respectively. These and often larger differences extend back as far as data are
available.
Despite having capital ratios typically well above any minimum that regulators would require,
community banks appear to have little interest in the advance proposal for noncomplex banks. In the
small number of comment letters we have received, community banks did not express a clear
preference for gaining a simpler regulatory capital measure in exchange for potentially higher
minimum capital requirements--requirements still well below their economic or maintained capital. The
gains in simplicity were apparently not viewed as offsetting the costs of changing from the current set
of rules to a purportedly simpler system. The intent of the proposal, by the way, was to reduce
regulatory burden on smaller banks while ensuring that their capital remains at prudent levels.
Key questions
I hope my comments have clarified that the new Basel and interagency proposals raise some
important questions about the appropriate capital standard for U.S. community banks. If community
banks want to shape the outcome, they must convey their views on several key questions.
A crucial question that we should consider is which banks or types of
Who is under what standard?
banks will pursue which alternative capital standards. Clearly, all or almost all of the truly global
institutions, worldwide, would be expected to use an IRB approach, with most of them moving to the
advanced approach, if they are not there at the outset. Most other large banking organizations, such
as the large U.S. regional banks, are also likely to pursue that approach, at least eventually.
Supervisory and market pressures, alone, would presumably force the global and large regional banks
in that direction. Given the systemic risk posed by implications and sheer complexity of many of our
largest institutions, supervisors worldwide should at least be urging these firms in that direction.
However, if the standard is designed and calibrated properly, the incentives should include both a
carrot and stick. Institutions that meet the demanding risk-management and public-disclosure
standards required under the IRB approach deserve some consideration in the form of regulatory
minimum capital charges more accurately reflecting the underlying risks. The IRB banks'
riskmeasurement and management processes will be strengthened, and capital markets will have more
information with which to judge risks and arguably assert more discipline, if risks appear to rise. The
key is to align the incentives--capital charges and costs--just right and to ensure, largely through the
supervisory process, that the required operating standards are met.
Perhaps the larger question
Is the standardized approach a good fit for community banks?
relates to which alternative most community and smaller regional banks will choose. Most of them, I
suspect, would opt for the standardized approach, or a still-simpler method, as suggested in the
bifurcated approach proposals of last fall. Or, as noted, many might just prefer the existing rule in
order to avoid transition costs. Of course, transition costs should be balanced against the resultant
regulatory burden and capital charges. If, for example, the incentives for banks to move to
moreadvanced standards are exceptionally attractive, a larger number of community and regional banks
may choose to bear these costs. My own judgment is that will not be the case for most community
banks. From the supervisors' point of view, any incentives to move to the more-advanced approaches
should be commensurate with the identified risks and should not materially disrupt the terms of
competition.
Although the alternative was not specifically highlighted, is remaining on the current capital
The standardized approach is
standard a reasonable option to consider for community banks?
only a modest change from the current system, and many of the other changes are not relevant to
community banks. Community banks, for example, presumably do not have many externally rated
credits, nor do they generally lend to foreign governments. Does it make sense then to require them to
change their system to be compatible with the standardized approach, resulting in some costs, when
the benefits may be minimal?
One possible solution may be to think of the current system as one of the simpler regimes for
noncomplex banks--that is, simpler than the new Basel options. This would allow community banks to
remain under today's system with the same regulatory capital minimum.
Would the current system need to be tweaked to minimize competitive pressures? I have heard
some community bankers say that competitive pressures would force them to follow larger banks to an
IRB standard. That is certainly not our intent, and I am not convinced that result is inevitable. If it is, we
need to look more closely at how well the incentives are balanced.
The few respondents to the interagency advance proposal for noncomplex banks suggested some
revisions to the current standard. Specifically, they suggested reduced requirements on certain assets,
such as low loan-to-value mortgages and certain collateralized consumer loans. In such cases, they
claimed, much less capital is needed than is required, and most supervisors would probably agree.
The difficulty is that the respondents did not also suggest which exposures, in turn, should get higher
capital requirements, or how high-risk exposures could be as easily and objectively identified in
community banks. Simply cherry-picking a bank's best assets to receive lower requirements is not
workable. Indeed, since supervisors do not believe that overall capital requirements are excessive,
you should not expect to be offered lower risk-weights for low-risk assets without also accepting higher
risk-weights for higher risk activities. At the very least, that might mean a higher risk-weight--possibly
far higher on the basis of the historical record--for classified assets. It could also mean a higher
riskweight for subprime and generally riskier loans.
Conclusion
In closing, I would emphasize that the current standard appears to be working well for community
banks. As with any change in regulation, an appropriate cost-benefit analysis must be undertaken.
That is, do the benefits from any new standard more than outweigh the added costs of any increase in
complexity as well as the one-time cost of adjusting to a new system? The proposed Basel Accord
appears to be well designed to remedy the deficiencies of the current standard for large, complex
banking organizations. The U.S. banking agencies, however, will have to give careful thought as to
whether any of the options in the Basel proposal are a good fit for U.S. community banks. If they are
not, we need to consider what simpler standard would be more appropriate. That was the rationale for
the advanced notice of proposed rulemaking. Remaining on the current standard (with or without some
minor modifications) is an option we will need to consider for community banks. And we need to hear
your views.