Ben S Bernanke: The implementation of Basel II - some issues for cross-border
banking
Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve
System, at the Institute of International Bankers' Annual Breakfast Dialogue, Washington DC,
4 October 2004.
* * *
I am pleased to join this discussion of international banking regulation. Larry Uhlick asked me to focus
my comments on international aspects of the evolving new capital accord, Basel II, and I am happy to
comply. I should say at the beginning that the views I will express today are not necessarily those of
my colleagues at the Board of Governors of the Federal Reserve System.1
The implementation of Basel II will raise many practical issues, of course, but I thought it might be
most interesting for this audience if I focused on two areas important for internationally active banks:
(1) home-host supervisory cooperation, and (2) the proposed bifurcated application of Basel II in the
United States and the special issues it creates for cross-border banking. I hope to persuade you that
the U.S. banking agencies are quite aware of these issues and are proactively attempting to address
the potential problems that these facets of Basel II implementation may create for banks that operate
both in the United States and abroad.
Home-host: global banking, international consensus, and sovereign countries
Banks with significant cross-border operations have understandable concerns about the prospect of
each national supervisor asking different questions about Basel II implementation, demanding different
data, applying the rules differently, or taking other actions that increase cost or are inconsistent with
the principle of consolidated supervision. At the outset - and at the risk of feeding your worst fears - let
me remind you of the broad context in which we are working.
The Basel II capital accord is not a treaty; it is a consensus which the authorities in each national
jurisdiction will inevitably apply in their own specific ways reflecting their preferred approaches to bank
supervision and regulation. The large number of banks with cross-border operations will continue to
fall under the consolidated supervision of their home-country supervisors. But at the same time, each
host-country supervisor is charged by its own government with ensuring that, at least at the bank
subsidiary level, legal entities operating within its jurisdiction are operating in a sound manner with
adequate capital. Since 1975, the Concordat among national supervisors has recognized a division of
labor that holds the home country responsible for consolidated supervision and the host country for
supervision of the legal entities in its jurisdiction, whether domestic or foreign. The Concordat does not
rule out differences in the concerns and objectives of supervisors in different countries. For example, it
does not matter to a host supervisor that the consolidated entity has sufficient capital if, in a period of
duress, that capital is not available to the legal-entity subsidiary in that host country. Put somewhat
differently, the combination of global banking and sovereign states has, for some time, produced what
we may delicately call "tensions".
Such tensions have existed for years under Basel I. Three aspects of Basel II may raise the level of
tension experienced by internationally active banks still further: (1) Basel II is more complex, (2) it
includes requirements for capital to cover operational risk, and (3) it has all the uncertainties of the
new and untested. Host-country supervisors face the costs of adjusting to differences in the manners
in which foreign banks will implement Basel II, while the banks and home-country supervisors worry
about host-supervisor intrusions, questions, and special rules. These concerns are quite
understandable. One might choose to be philosophical and accept that there are inevitable costs of
doing business as a global bank, and of supervising global banks, in a world of sovereign states.
Fortunately the situation - as Mark Twain said about Wagner's music - is "better than it sounds". A
variety of efforts are underway to mitigate the potential problems of the new system.
As you may know, the Basel Supervisors' Committee has established the Accord Implementation
Group, or AIG, headed by the vice chairman of the Basel Committee, Canada's superintendent of
financial institutions, Nicholas Le Pan. The AIG consists of senior line supervisors from Basel member
countries, who gather regularly to share best practices and develop ways to foster consistent
application across national jurisdictions. Among its efforts is a series of case studies, in which home
and host supervisors review how the banks under study plan to implement Basel II. To date, a dozen
case studies have been launched, and more are planned. Of course, the usefulness of each case
study depends on how far along the subject bank is in its own Basel II implementation plan.
In the United States, for example, a case study focusing on Citigroup involves the United States and a
panel of about ten host-country supervisors from jurisdictions in which Citigroup has important
operations. The panel of supervisors is developing a common understanding of how Citigroup has
established its risk management structure and risk measurement systems, and how the entity will use
the various statistical inputs and methodologies for determining its minimum regulatory capital
requirements under Basel II. The host-country participants are active in the process and, importantly,
all involved are working collaboratively under the principles articulated by the Basel Supervisors'
Committee. As the home-country supervisor in the Citigroup exercise, we are organizing an outreach
program to inform other host countries, not participating in the case study, of the efforts. In addition,
U.S. supervisors are involved in many other case studies in which we are acting as the host supervisor
for foreign banks' U.S. operations. In short, efforts to ensure effective cross-border supervisory
coordination are under way, and we are committed to making them successful.
The objective of the home-host exercises is to understand what has to be done, what information has
to be shared, and what understandings have to be developed to make host supervisors comfortable
with the operations of foreign banks in their jurisdictions, as well as to reduce the need for host
supervisors to duplicate the work of the home-country consolidated supervisor. Please note that the
operative word is reduce, not eliminate, but our hope is that the reduction will be substantial. Just as
under Basel I, host supervisors will still examine the legal entities in their country. We hope to keep the
supervisors better informed about how operations outside their jurisdiction affect the entities they
supervise, and to do this with a minimum of burden on the consolidated organization.
The principles developed from these case studies are expected to be applied broadly. I expect that
they will include mechanisms for coordination among home and host supervisors in the development
of the work plan to be applied by the home country in its consolidated examination. Coordination
would also include the sharing of examination results with host-country supervisors to the extent
practicable. In addition, we will do our best to promote extensive home-host communication on a
continuous basis, not just in times of stress. Overall, the AIG effort should help to reduce home-host
coordination problems considerably, but, as with Basel I, there will inevitably be bugs to work out as
implementation proceeds. During that shakeout period, some of your concerns may turn out to be real
- although, I hope and expect that they will be less daunting or costly than you may fear.
I have focused so far on credit-risk aspects of Basel II. On the operational-risk side, however, the
home-host implementation challenges are knottier. In contrast to the treatment for credit risk, Basel II
allows both the consolidated and the individual legal entities to benefit fully from the risk reduction
associated with group-wide diversification. However, host countries charged with ensuring the strength
of the legal entities operating in their jurisdictions will not be inclined to recognize an allocation of
group-wide diversification benefits, given that capital among legal entities is simply not freely
transferable, especially in times of stress. The Basel Supervisors' Committee has thus proposed that
"significant" subsidiaries will have to calculate stand-alone operational-risk capital requirements that
may not incorporate group-wide diversification benefits. Other subsidiaries can use an allocated
portion of the group-wide requirements, requirements that may be calculated with diversification
offsets. Host-country supervisors, of course, have the right to demand more capital than may result
from such allocations. Thus, both the proposal for significant subsidiaries and the possible
hostsupervisor response for other subsidiaries may well result in the sum of the individual legal-entity
capital requirements being greater than the consolidated-entity requirements. Home country
supervisors of consolidated entities facing such capital demands are likely to be more tolerant of
double leverage or gearing in reflection of this reality.
In short, home-host issues under Basel II are quite real, and dealing with them effectively will require
extensive cooperation and communication. But we must acknowledge that these issues cannot be fully
avoided in a world of sovereign states; all we can do it try to minimize the resultant costs.
Bifurcated application of Basel II in the United States
Global banks have also voiced some concern about the implications of the planned application of
Basel II in the United States. As you know, in contrast to the rest of the world, this country has
proposed to offer only one option under Basel II: the Advanced Internal Ratings Based, or A-IRB,
method for credit risk and the Advanced Management Approach, or AMA, for operational risk. For
convenience, I will refer to them together as the "advanced approach". All U.S. home-country banks
and U.S. subsidiaries of foreign banks that meet certain size or foreign-exposure criteria will be
expected to adopt the advanced approach. Others domiciled or operating here would have the option
to adopt these versions of Basel II if they meet the infrastructure requirements. All other banks
operating in the United States will remain under the current U.S. regime, based on Basel I.
The global banks' concerns about the bifurcated U.S. application depend in part on whether they are
based here or abroad. For foreign banks the issue is the additional complexity and perceived inequity
they will face if they have chosen to operate in the rest of the world under the foundation approach for
credit risk, an approach which will not be permissible in the United States. (I am making the
reasonable assumption that the foreign banks whose U.S. subsidiaries would be required to use the
advanced approach, or who, for competitive or other reasons, choose the advanced approach in the
United States, will be operating in their home country under the foundation approach at least.) For
U.S.-based banks the fear is that foreign rivals may get a competitive edge for one year through lower
regulatory capital requirements in some markets; the potential head start for foreign banks arises
because the permissible start date for the foundation and standardized versions is the beginning of
2007, while the advanced approach, with its greater complexity for banks and supervisors, starts in all
markets at the beginning of 2008.
A foreign bank under the foundation approach at home but under the advanced approach in the
United States would have to determine two variables in the United States for its corporate exposures
that would not be required of its consolidated entity: loss given default (LGD) and exposure at default
(EAD). For its consolidated entity at home it would need to calculate only the probability of default. The
U.S. subsidiary might well find it a real challenge to gather the needed data and generate the LGD and
EAD parameters required in the United States; doing so would certainly add cost, even for an entity
using the full foundation approach at home.
The U.S. authorities did not make their decision to require the advanced approach lightly. Given the
structure and size of our markets, we believe it necessary that large entities operating here use
sophisticated techniques for risk measurement and management that rely on bank estimates of all the
risk variables required by the advanced approach. Nonetheless, we understand our global
responsibilities for cooperation. Both bilaterally and through the AIG, we will continue to work with U.S.
subsidiaries of foreign banks and their home supervisors on transition steps, where necessary,
although we expect to continue to require full implementation within a reasonable period of time.
These transition steps could involve, for example, relying on conservative estimates of the LGD and
EAD parameters when the bank in question is not yet prepared to provide estimates derived from its
own experience. For a limited period, we also may be willing to consider conservative methodologies
for allocating consolidated operational risk capital charges to the U.S. subsidiary. Although we will do
what we can to facilitate transition, let me be clear that, for both domestic and foreign banks, we
expect that plans for full adoption will be complete within a relatively short period. Moreover, any
shortfalls in systems will have to be disclosed under Pillar 3; and we reserve the right, under Pillar 2, to
require additional capital during the transition to full implementation.
It was a difficult decision for the Basel Supervisors' Committee to delay by one year, to 2008, the start
date for implementation of the advanced approach while retaining the 2007 target for the other
approaches. The delay reflected the realities that many banks that will be applying the advanced
approach needed more time and that the requirements in the United States for public comment and
review made it impossible for final U.S. rules to be promulgated before 2006. Thus, the earlier start for
the other approaches, along with the imposition of the 95 percent of Basel I capital floor for that first
year, 2007, seemed to all concerned to be a reasonable compromise, more practical than trying to
hold to the original schedule for all banks or delaying the start date for approaches not permitted in the
United States.
Under the circumstances, consistent with our agreement to have a single, worldwide start date for the
advanced approach, the U.S. authorities do not see any opportunity for implementation of the
advanced approach in the United States before 2008, regardless of any individual bank's ability and
readiness to do so.