Mark W Olson: Basel II - its implications for second-tier and community-size
banks
Speech by Mr Mark W Olson, Member of the Board of Governors of the US Federal Reserve System,
at the 2003 Banking Institute, Center for Banking and Finance, University of North Carolina, Charlotte,
10 April 2003.
* * *
As important as the Gramm-Leach-Bliley Act has been to American banking--codifying the new
realities of the marketplace--I would argue that the 1988 Basel Capital Accord brought about an even
more dramatic change in banking rules of the game. In the late 1980s, as the Congress struggled
unsuccessfully to reach agreement on a plan for managing interstate banking, the banking regulators
of the Group of Ten (G-10) countries were able to develop a common set of rules for bank capital.
What is referred to now as Basel I established a competitive balance among the banking systems of
the major industrialized countries. It made the international competitive climate considerably more fair,
and it greatly improved bank safety and soundness worldwide.
Let me elaborate briefly on the advances embodied in Basel I before I discuss the limitations that have
become more evident in the years since it was implemented. In the mid-1980s, it was a major step
forward to acknowledge, for example, that residential mortgage lending carried substantially less credit
risk than did automobile lending and that certain state and municipal bond issues carried less of a
credit risk than home mortgage loans. As a result, when Basel I allowed for loans and investments to
be grouped into four "buckets" with risk weightings of 0 percent, 20 percent, 50 percent, and
100 percent, respectively, banks were allowed for the first time to allocate and maintain capital in a
manner somewhat consistent with the risk profile of the asset side of their balance sheets. Also,
overwhelmingly, banks of all sizes in the United States now had risk capital ratios significantly in
excess of their leverage capital ratios. Though the risk buckets were limited and did not fully reflect the
range of risk sensitivities in the 100 percent bucket, their implementation represented a significant
improvement.
The banking industry has changed in many ways, however, since Basel I was implemented in 1988.
Two specific areas of change--the expanded use of securitization and derivatives in secondary
markets and vastly improved risk-management systems--have significant implications for Basel I.
The use of secondary markets and the sophistication of risk-management systems correlate
significantly with bank size. While second tier banks and community size banks have also increased
their access to secondary markets and have made great strides in managing their risk exposures, the
changes implemented by these banks have not threatened the relevance of Basel I. However, the
same cannot be said about the nation's largest international banks. The largest institutions use the
secondary markets for securitizing loans of all types and for a variety of other liquidity and investment
needs. The largest institutions also use enhanced technology resources and risk-management tools to
more carefully and specifically measure risks of all types.
For banks that operate on a global scale in virtually all financial markets, Basel I has become
outdated. The current capital regime has not kept pace with either the complex nature of the
operations of the largest banks or the substantial changes in both the concepts and technology of risk
management. The current capital rules at these banks have been further undermined by arbitrage
between regulatory and market measures of risk mainly through the use of derivatives and
securitizations in the secondary markets.
Given these developments, the G-10 bank supervisors have been designing a much more
risk-sensitive regulatory framework that takes into account the evolution of the art of risk management.
The latest version of the proposal (Basel II) will be published by the Basel supervisors committee in a
few weeks and an advance notice of proposed rulemaking by the U.S. supervisors is due by
midsummer at the latest. An effective date of 2007 is now contemplated.
The details of Basel II were described by my colleague, Roger Ferguson, Vice Chairman of the
Federal Reserve Board, in a presentation to a congressional committee in February. I have some
copies with me today and can make others available. Today, I thought it might be useful to provide a
U.S. supervisors' view of how Basel II should be applied in this country and to address some of the
concerns we have heard about the scope of application.
Given the needs of countries with a far different banking and regulatory structure than ours, Basel II
contains three alternative approaches, which are described in the Vice Chairman's testimony.
Supervisors in this country have for some time contemplated that only the most risk-sensitive
approaches, the Advanced Internal Ratings Based (A-IRB) option for credit risk and the Advanced
Measurement approach (AMA) for operational risk, would be applied in the United States. These
advanced approaches would be required for only our largest and most complex, internationally active
banking organizations--about ten U. S. banks. However, any other bank that meets the qualifying
internal infrastructure standards for risk measurement and management could choose to apply these
versions of Basel II. We anticipate another ten or so large banks may opt to do so voluntarily because
of the greater risk sensitivity it affords. These banks may also make this choice for prestige or
competitive reasons, as counterparties look for indications of technical risk measurement skills at the
large banking entities with which they deal.
U.S. authorities have agreed to implement only the most advanced Basel II options and to limit the
number of required participants. First and foremost, the decision reflects a balancing of costs and
benefits. Any change is expensive, and the advanced approaches are very costly to implement. The
overwhelming majority of banks in this country are well capitalized and well managed under the
current modified Basel I, and smaller banks are forced by markets to hold capital considerably above
the well-capitalized level, so the cost-benefit ratio of requiring more of our banks to adopt some
version of Basel II is tilted, for most banks, very strongly against the desirability of change. When we
then add to the equation the fact that it is primarily the megabanks whose operations seem
inconsistent with the current capital regime, the decision to limit the scope of application appeared
even more clear-cut.
Moreover, with our concern about shortfalls of the current regime focused on the complex, large,
internationally active banks--and the desirability, on grounds of safety and soundness and
macroeconomic stability, to see the best practice risk-management techniques applied to these
entities--the decision to deploy only the most sophisticated version of Basel II also seemed obvious to
us. You may also recall that an important objective of both Basel I and Basel II is to create
cross-border competitive equality, reducing in our minds the necessity of requiring Basel rules to be
applied to smaller banks that do not compete in international markets.
Although U.S. regulators have for some time signaled that Basel II would apply only to the largest
banks, questions have been raised about the implication for those banks that are not A-IRB
candidates. Let me share with you our evaluation of what the implications may be for banks that will
not be required to adopt Basel II and that opt to remain under Basel I.
No bright line marks the separation between the groups of institutions that we refer to as large,
complex, internationally active banks (those that would be required to follow the advanced Basel II),
other large, complex banks (some of which we think are likely to be opt-in banks), large regional
banks, and community banks. Some of the banks in the large regional group--let's say those between
the 25th and 100th largest--have voiced the concern that even though they are well capitalized and
well managed, they will be forced by market pressures, and especially by the rating agencies, to bear
the high costs of moving to Basel II.
The risk-management practices embedded in Basel II did not, of course, originate with the Basel
committee or with any of the G-10 bank regulators. Rather, to a significant extent, they represent the
best practices of risk-management approaches developed in the marketplace. These practices are
now being used by some banks in the tier just below the largest organizations. Improved
risk-management technology, supplemented by the adoption of Basel II advanced approaches at the
largest banks, will accelerate the advance in risk-management sophistication that counterparties will
increasingly expect to see at their banks. This market-driven change would have occurred without
Basel II--in fact, it is already in progress--but Basel II will surely speed things up. In the near term,
however, the cost-benefit ratio I referred to must be considered, and we believe that the benefits for
most regional banks do not yet exceed the costs. It is our understanding that this is also the view of
the rating agencies. The cost-benefit calculus may well change in the future, but, in the years
immediately ahead, I do not believe that regional banks will be required by the market to adopt the
more advanced approaches.
We are also aware of concerns that the current competitive balance between Basel I banks and Basel
II banks might be upset in certain loan markets. The specific worry of the Basel I banks is that the
advanced approaches will yield lower capital charges for residential mortgage, retail, and small
business loans.
These arguments, it seems to me, require some careful thought. My own experience as a banker is
that loan pricing and profitability--and that must be what the issue is about--are influenced little by
regulatory capital levels. Rather, rate setting on credits is determined by a complex web of factors,
including local market competition from banks and other lenders, the cost of funds, the specifics of the
bank-customer relationship, and internal capital allocation practices. For many types of retail loans, but
particularly residential real estate loans, secondary market pricing has the strongest influence on rate
setting. When capital is considered, it is the internal allocation decisions--what the Basel proposal
refers to as economic capital--that is relevant, particularly because, as I noted earlier, U.S. banks
operate so far above regulatory minimums and can easily change their own regulatory requirements
by loan sales and securitizations.
On the subject of Basel II, let me, in conclusion, make a few summary observations. First, if you
accept the fact that Basel I had a significant effect on international competitiveness and economic
stability, then it stands to reason that an update is necessary to make that accord reflect changes in
markets and risk-management techniques.
Second, the U.S. banking industry represents banks of varying size and complexity; it would be as
inappropriate to require our smallest banks to adopt techniques designed for megabanks as it would to
limit the largest banks on the basis of the capacity and capability of the smallest.
Third, certain basic fundamentals regarding capital measurement and capital adequacy will not
change. The provisions of the Federal Deposit Insurance Corporation Improvement Act (FDICIA)
requiring prompt corrective action still mandate regulatory responses based on levels of capital
adequacy.
Finally, just as Basel I has been modified on numerous occasions to accommodate new financial
instruments or a new recognition of risk weighting, we anticipate that the current and prospective
Basel rules will accommodate future changes in risk measurement and risk taking.