Laurence H Meyer: Basel II - Moving from concept to implementation
Remarks by Mr Laurence H Meyer; Member of the Board of Governors of the US Federal Reserve
System, at the Bank Administration Institute's Conference on Risk Management, New York,
15 October 2001.
* * *
Thank you for giving me the opportunity to discuss the bank capital reform process that continues to
be developed under the auspices of the Bank for International Settlements in Basel. It is a particular
pleasure to review developments with this audience of bank treasury, investment, and
risk-management practitioners that has been assembled by the Bank Administration Institute to
analyze the implications of Basel II.
Perhaps I should begin by noting that this has been, and continues to be, a long and difficult process.
Many important parts of the proposal have not yet been announced or are in the process of
modification. I hope today to clarify the reasons the process is taking longer than we had expected it
would. I hope that by reviewing our objectives and the challenges we all face--virtually all of which
reflect the sheer complexity of modern commercial banks--we might gain a better understanding of the
future schedule and more support for the process. We need your support. And I believe that the U.S.
banking system will be even stronger if we can develop an effective process for improving
internal-ratings-based systems at our banks and then key our capital and supervisory processes and
procedures to such systems. That is what the Basel proposal is all about.
I. The vision
It is, I think, too easy, as we contemplate the complexities and the resultant apparent slowness of the
process, to lose sight of the point I've just made and to forget what we're trying to do. Let me underline
that our ultimate objective is a safer and sounder banking system through better risk management at
banking organizations. The tools are risk-based capital (pillar I), risk-based supervision (pillar II), and
disclosure of risks to enhance market discipline (pillar III). The approach is to incorporate within the
regulatory and supervisory processes some of the quantitative risk-management tools that large
complex banking organizations (LCBOs) now use, or will be using by the time the enhanced Accord is
implemented, to evaluate and manage their own risk positions. This requires--and it is essential to our
vision--that both supervisors and banks focus on the same positions, controls, and objectives. In the
process, not only would other LCBOs be required to improve their risk-management, but, in addition, a
system would be established that can evolve naturally as risk management practices themselves
evolve.
For the most part, these new quantitative techniques are designed to address risk at LCBOs. They
involve highly detailed and comprehensive management information systems. Such systems are cost
effective for LCBOs, but they simply do not apply to the vast majority of banks in this country or, for
that matter, to smaller and regional banks any place in the world. For this reason we do not intend that
the hallmark of Basel II--the harnessing of internal-ratings-based systems for use in the supervisory
process--be applied in this country to any but the largest and most complex banking organizations.
Indeed, the internal-ratings-based, or IRB, approaches explicitly assume within their risk-weight
formulas a high degree of portfolio diversification that very few banks can achieve.
As you know, there are two versions of the IRB approach: Foundation and Advanced. The Foundation
version has a high degree of built-in conservatism, under which rigid supervisory rules would establish
many of the credit-risk parameters that would determine bank capital requirements. That is because
the Foundation approach is designed to address either banks in the early stages of developing their
risk-management systems or those operating in a supervisory environment that is not yet prepared to
validate and enforce the sound-practice standards applicable to banks under the Advanced IRB
approach. In this country, the Foundation version may be useful as a transition for banks that have not
yet developed the ability to estimate all of the necessary credit parameters or have not convinced their
supervisors that they can both do so and use those parameters in making credit decisions. The
Foundation version may also be useful for large organizations that have relatively limited business
lines.
But we would expect--and we believe the market would as well--that the LCBOs will switch quite
rapidly to the Advanced version of IRB. These entities, by their very nature, will be expected to have
implemented the risk-management systems required by the Advanced version. If they do not,
supervisory pressures and market realities will bring very strong inducements indeed upon such
organizations to change their procedures.
The Standardized approach to Basel II is extremely close to the current Basel I and should ultimately
involve quite modest changes on the part of most non-LCBO U.S. banks. Indeed, it may not even be
cost effective to apply the Standardized approach in this country, with only modest revisions to the
current Basel I suggested for most, certainly all smaller, banks. It is, of course, not an option for
LCBOs in the United States, given our risk-management objectives.
We expect significantly different impacts across the small number of large U.S. entities that will use
the Advanced IRB approach. That is because the intention is not to develop a cookie-cutter,
one-sizefits-all set of requirements. Rather, each bank is to develop meaningful, empirically based risk
classifications across its credit portfolios and sub-portfolios. For each sub-portfolio of loans, each bank
will estimate the probability of default, the expected loss given default, exposure at default, and the
associated capital to meet selected solvency standards. The supervisors will evaluate the
riskclassification and risk-estimation processes at each bank using the Advanced IRB approach of Basel
II, and if the processes are found to be acceptable, those classifications and associated capital needs
will be the basis for the minimum regulatory capital requirements. To ensure the credibility of this
process, we will expect those same risk classifications and quantifications of default probabilities and
loss severities to be used for pricing, reserving, internal capital allocation, and other management
purposes. Not doing so would raise doubts about using these data at that bank for establishing capital
requirements. We want our supervisory standards to be based as closely as possible on the
information managers use to run the bank.
We expect a wide distribution of minimum regulatory requirements across the individual LCBOs,
reflecting the differences in their portfolios and risk preferences. We anticipate, however, that the
average minimum regulatory requirement will decline under the Advanced IRB capital structure. It is
less clear that the amount of capital held will adjust quite as much, for several reasons. Pillar II of the
proposed new Accord, enhanced supervision, might call for additional capital at individual institutions,
depending on the supervisors' evaluation of controls, management, individual risk structures, and so
forth. These variables are difficult to capture in pillar I through formal capital regulations. Pillar II will
also address those risk areas--such as interest rate risk--for which it is not optimal to develop a single
pillar I rule applicable to all banks. Pillar III, as you know, calls for enhanced disclosure of risk
exposures to the public. And we expect that market and supervisory discipline will ensure that banking
organizations maintain sufficient capital above the regulatory minimums as a prudent sound-banking
practice. That has certainly been the case under the current capital regime.
Pillars II and III have not, I think, received the attention they deserve by the industry. Perhaps it is
because of the challenge of developing a new regulatory regime. Perhaps, also, banks in the United
States believe that they are already subject to supervisory oversight (pillar II) and already engage in
sufficient disclosure (pillar III). But both pillars are critical modifications for several important reasons.
As I noted, pillar II is designed to avoid the need to design rules for everything and to give supervisors
the flexibility to adjust to fit individual cases. Pillar III, by harnessing market discipline as another form
of oversight, is also critical to avoiding an increase in regulation that would otherwise come as
organizations become more complex. More disclosure--especially on risk exposures--is going to be
necessary.
Pillars II and III are also extremely important for ensuring that banks here and abroad are treated
consistently. In the United States and in other countries, pillar II supervision is essential to ensuring,
on an ongoing basis, that banks are implementing pillar I in a disciplined way. The pillar III disclosures
are equally important in ensuring a level playing field among internationally active banks. Those banks
in this country that argue that disclosure will create an uneven playing field vis-à-vis domestic
nonbanks should consider whether they might not be better served by disclosure rules for their foreign
bank competitors.
The combination of pillars I, II, and III is necessary to build a structure consistent with the increasingly
important process of internal capital allocation at banks and to achieve what economists call
incentivecompatible regulation. By that we mean a regime in which the regulatory rules and processes induce
behavior that is consistent with the banks' own systems, objectives, and processes. Such a structure
forces supervisors to view the internal capital-allocation process consistently with bank managers. It
may well be that the supervisors' role in the oversight of economic capital determination and the
markets' review of banks' risk exposure and management may be more important than the
establishment of regulatory capital minimums.
II. The process
As any manager knows, the process of converting a vision to reality is difficult for reasons varying from
unacceptable costs to conflicting visions. We have been working to revise the Basel Accord--trying to
give birth to Basel II--for half a decade. And I think it important to underline that we have made
tremendous progress. Many things have been decided to enhance the risk sensitivity of the revised
Accord and many of the proposals that needed modification have been revised. Perhaps most
important, the Basel discussions have clearly begun to move the regulators and the banking industry
to focus more on risk management and its relationship to capital, to analyze the issues, and to collect
the data needed for better quantification.
Nonetheless, it is important to understand why the process of converting vision to reality has
necessarily been a long one. There are three reasons. One is the need to develop consensus among
nations with different banking systems, different supervisory structures, and different supervisory
philosophies. That takes time, and cutting corners would inevitably lead to undesirable imbalances and
competitive inequities. It would be a mistake to underestimate the importance of this difficulty.
Compromises have been made, and more will be necessary on all sides.
Candor requires that I say that another reason for the slow progress is that the banking industry was
less far along developing its risk-management tools and processes than we had anticipated. As a
result, regulators working closely with the industry, have had to do more of the original research and
data development than we had thought would be necessary. And while in some areas, industry
practices are clearly converging, in other areas a wide diversity of market practices still prevails. This
has forced supervisors to devise a regulatory approach that accommodates innovation while providing
an adequate degree of consistency.
Beyond the difficulty of reaching an agreement and the challenge of identifying emerging sound
practices, the most important reason for delay is the sheer complexity of moving from concept to
application. The state of practice is dynamic--indeed, the efforts to develop a Basel II, as I said, have
themselves accelerated advances in risk-management practices. But all of us are facing issues that
either we had erroneously thought were relatively simple or we had not at first considered. It has taken
time to work through these issues. Moreover, we should not lose sight of the fact that large, complex
banking organizations--for whom the real innovations at Basel are designed--are themselves, well,
complex. Capital regulations cannot be extremely simple and at the same time appropriately sensitive
to the multifaceted operations and risks of the LCBOs. We could try to apply simple rules to complex
organizations, but the result could be easily predicted: We would not solve the problems of capital
arbitrage and risk sensitivity, and the rules would treat some operations at some banks unfairly. As in
medicine, the first principle should be, "Do no harm." And that means that the rules will be complex in
order both to be fair and to avoid unintended consequences.
One of the complexities of unbundling risk-related capital charges is, in the view of many Basel
Committee members, the need for an explicit capital charge for operational risk. Devising such a
charge has proved extremely difficult because of a lack of both an agreed-upon methodology and
credible industry data. This has required the adoption of a strategy to permit banks to use their own
internal measurement approaches--subject to quantitative and qualitative criteria and, on a transitional
basis, to a minimum or floor capital charge. Sound-practice guidelines are also being developed for
the pillar II supervisory review process. The interval before final implementation in 2005 provides time
for both the industry and supervisors to develop the database and to develop explicit operational risk
charges better linked to the real risk at each bank.
The Federal Reserve, and I believe the other U.S. agencies, have been, and will continue to be,
committed to developing and applying a truly risk-based capital framework and supervisory process for
both operational and credit risks. As with any such massive effort, timetables are required in order to
motivate and to coordinate broad organizational efforts. But we have a prior commitment, one that
discussions with the industry suggest that you share. That commitment is: To get it right. If we
imposed a flawed structure on the industry, we would be doing a disservice to the banking industry
and shirking our public responsibilities. Thus, we will continue to try to get it right, even if it means
more delay and modification to time schedules than either group wants. Of course, we also
understand that the capital framework will continue to evolve as market practices change and
supervisors learn more about the strengths and weaknesses of what we develop. Getting Basel II right
does not mean that it can or will be perfect, even on the day the initial rule becomes final.
Critical to getting it right is a genuine interaction of the regulators and the banking system. We simply
cannot develop Basel II correctly without your help. That does not mean dropping every feature that
some entity believes is too costly or too burdensome or would put a crimp in a particular activity. But it
does mean that, given our objective of creating a risk-based capital system to promote better risk
management and a safer banking system, we need your operational skills and counsel. The industry's
initial assistance and subsequent comments on this year's January consultative document were, by
and large, exactly in that vein. They were extensive and exceptionally thoughtful, and most were
genuinely designed to produce a better system to address both private and public needs. We have
taken them seriously, and responding to them has been time consuming. You will, I think, see the
result in the next consultative document which I hope will be published early in 2002. But we need
continued assistance from an even broader range of institutions.
I trust that when the 2002 consultative document is published early next year, the banking industry will
provide us with thoughtful feedback, and especially information, to help us gauge the overall
quantitative effect of the proposals on your respective institutions. This must be an iterative process
involving supervisors and the banking industry, and there must be mutual trust if it is going to work
effectively. It is not necessarily our intention to avoid rules that an individual bank may find costly or
inconvenient, but rather to avoid unintended consequences that raise costs beyond their benefits.
Moreover, we hope that your comments will be preceded by an understanding that our wider objective
is to develop a safer and sounder banking system by strengthening risk management at banking
organizations.
I would like to underline that as extensive as our database is, as large as the data collection burden is
for you, we simply do not have the individual bank information to estimate accurately the effect of
alternative proposals on your capital requirements; it is up to you to tell us. We are, as I have said,
trying to get it right.
The comment process will continue to be extensive. I already mentioned the BIS third consultative
document, which is expected early next year. At some stage, as the proposal becomes more
definitive, the U.S. agencies will have to go through the U.S. rule-making process, with an additional
request for comment. And any final rule would have a delayed effective date to allow both the industry
and the regulators sufficient time to implement what will, by necessity, be a complicated rule. But
between now and the effective date of the new rules, as our mutual needs and mutual capabilities
change, we cannot remain idle. Large banks need to continue to enhance their internal risk
classification systems, develop empirically based techniques for risk-classification of pass loans, and
strengthen the process for calculating their internal economic capital requirements. For our part, we
have begun to train our examination staffs to evaluate banks' internal systems. Since we will also be
living with the current Accord for some years before Basel II can be implemented, we are also shoring
up the present capital rules, such as the treatment of recourse and other retained interests in
securitization transactions.
The effort to improve capital rules and develop better risk management is thus multifaceted. I would
not, however, like to lose sight of the fact that the establishment of pillar I is, at least for the next few
months, the Prince in this production of Hamlet, or the centerpiece of Basel II for the non-English
majors in the audience. Thus, much depends on both pillar I's level and how it's interpreted. That
raises the issue of calibration.
III. Problems of calibration
The single biggest problem in developing a final proposal for Basel II is the calibration of the absolute
level of the minimum required regulatory capital. You might think of the calibration process as
establishing the average amount of capital to be minimally required in the banking system,
understanding that in a risk-sensitive system, the required level can be expected to vary across
individual banks. The January 2001 proposal was criticized for setting the absolute level of capital too
high, and it may well have been too high. But we--and the banking industry--are struggling with three
related challenges in determining the right level. These challenges are, first, reaching agreement
about the right number in a stable world; second, making whatever adjustments are needed because
we live in a world with crises and business cycles; and third, making sure the different approaches
offered in the new Accord fit together properly.
Let's begin with establishing the right level of minimum regulatory capital in a stable world, or as
Sherlock Holmes might pose the question, "Is 8 percent the right solution?"
Many risk managers might respond to the search for the "right" average capital requirement by arguing
that one should develop and implement portfolio risk models and use the answers, allowing
appropriate margins for model error. At the beginning of the Accord revision process, many risk
managers assured regulators that the art of credit-risk modeling was advanced and that there was
broad consensus. However, upon further investigation, regulators--and I believe many practitioners
themselves--have discovered that there is less rigor and less consensus than had appeared to be the
case initially. Such diverse views and practices reflect the ugly fact that the devil is in the details of
model parameter values. This lack of agreement, together with the associated uncertainty, is not just a
problem for the regulators. To the extent that banks and market participants rely on such models for
internal pricing, capital allocations, and other decisionmaking purposes, this is a problem for us all.
The fact is that we--both supervisors and bankers--do not yet know the right answers with high
confidence. In these circumstances, the Basel II process could lose momentum unless we can agree
to go forward with something that seems reasonable and with the understanding that reasonable
people may differ and that changes may be needed as we gain experience.
The problem becomes even more complex when we recognize that market economies are cyclical and
have crises. In a risk-sensitive system, we expect that the risk measures in the capital formula will
have worse values at the trough than at the peak, so capital requirements will move somewhat as
macroeconomic conditions change. This is often called the problem of procyclicality of capital
requirements. If the minimum capital requirements rise as the economy weakens, it can be argued that
a system of risk-sensitive capital requirements may lessen credit availability at just the wrong time.
The jury is still out on just how procyclical the Basel II framework ultimately will be, or whether it may,
in fact, be less procyclical than the current system in which the lack of rigor in credit evaluations itself
creates a procyclical pattern of reserving and charge-offs. We have already taken some steps to
address procylicality concerns since issuance of the January 2001 consultative package. For example,
we've improved the proposal's treatment of expected losses--and other measures are in train.
Finally there is the problem of making the pieces of the new Accord fit together. The Basel Committee
has said it wants modest capital relief incentives for large, international banks to move from the
Standardized to the Foundation version of the IRB approach and similar, perhaps larger, additional
incentives to move from the Foundation to the Advanced version. But as I noted, these approaches
and versions were designed for banks of very different levels of complexity and sophistication and for
different regulatory regimes. The basic risk-weight functions are the same across the Foundation and
Advanced versions of the IRB approach. Because of the conservatism built into the Foundation
version, capital requirements for a given bank under the Advanced version, at least in this country,
could be considerably less than under the Foundation version. If the revised Standardized approach is
calibrated to yield capital similar to that of the current Accord and Advanced requirements are far
below Standardized requirements, in the United States there may well be a very large reduction in
capital requirements relative to today's levels for the banking system as a whole. This is because we
expect virtually all LCBOs to choose--or to be induced to choose--the Advanced approach.
I must tell you frankly that regulators here and abroad would be quite uncomfortable if Basel II resulted
in a substantial shedding of capital by the world's megabanks. At least until we have more experience,
I think you should expect that we will have transition rules designed to limit the amount of actual
reduction in capital that will be permitted, at least until we have time to evaluate the actual experience
under Basel II. That is part of the necessary requirement to be sure we've got it right before errors
become irreversible.
I suppose that too little capital is more of a challenge for regulators than for banks. But this problem
arises from features of the real world that none of us can ignore. Supervisory philosophies and
resources differ quite a bit across countries, and we must have a regulatory capital regime that can
accommodate such differences. At the same time, we all believe that there must be competitive equity,
and that banking systems must be well-enough capitalized to be stable. As I noted earlier, perhaps
pillars II and III and market realities will blunt the problem of excessively low capital. But you will
understand, and I hope respect, our need for caution.
IV. Summing up
I am sure of one thing: The next Accord will be imperfect no matter how hard we all try. The
challenges are daunting, and I doubt we can meet them all at the outset. But I believe we will develop
a set of rules and policies that will be a substantial improvement over the current framework and--most
important--that the new groundwork will spur important further progress in risk management and in
banking supervision. Indeed, if the effort does nothing but improve risk management at banks and
improve the risk focus of supervisors, it will be worth the time and resources we have all expended.
But if you will help us with your comments and suggestions, I think we can come closer than that to the
vision I described. To do so is in the interest of us all.