Susan Schmidt Bies: Financial stability benefits and implementation
challenges of Basel II
Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve
System, at the Central Bank of the Republic of Turkey's International Conference on Financial Stability
and Implications of Basel II, Istanbul, 17 May 2005.
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I want to thank the Governor and the Central Bank of Turkey for the invitation to speak at this
prestigious conference. The sharing of ideas among policymakers, academics, and bankers at venues
such as this benefits all involved and, I believe, helps us assess important issues relating to the
strength and stability of banking and financial markets. I hope that my remarks today will contribute to
that overall objective.
This conference on financial stability and implications of Basel II is certainly timely. As you know,
members of the Basel Committee on Banking Supervision are working diligently to implement the
framework issued last June. At the same time, we are all dedicated to maintaining financial stability in
our respective jurisdictions, and in global banking and financial markets as a whole. In this light, Basel
II should not be seen as an end in itself, but a means to promote broad stability and enhance safety
and soundness of financial institutions.
Today I want to address three issues. First, I will describe the challenges facing bank regulators as
they strive to improve financial stability. Then I will briefly describe some of the Basel II issues in the
United States that were covered in the recent interagency press release and in last week's
congressional hearing. Finally, I want to describe the challenges bank supervisors face in effectively
implementing Basel II.
Financial stability
As a central banker, I realize how vital it is to have a strong, stable financial system to support
effective monetary policy. Excessive volatility in financial markets can significantly raise the cost of
capital for business investment and adversely affect real economic expansion. History has
demonstrated that a weak financial sector can significantly impede the monetary transmission
mechanism when the central bank is trying to stimulate the economy. Since banks are the core of the
financial system, efforts to improve their risk management can help mitigate the impact of shocks on
financial markets and real economic performance. With effective risk management, banks are better
able to plan alternatives to mitigate risks when they exceed predetermined risk exposure levels. It is
important to emphasize that the normal fluctuations in asset prices that result from dynamic demand
and supply conditions, and even some increase in uncertainty, do not usually generate financial
instability. Put differently, financial stability implies that key institutions in the financial system are
operating without significant difficulty and markets are generally functioning well.
Bankers implicitly accept risk as a consequence of providing services to customers and also take
explicit risk positions that offer profitable returns relative to their risk appetites. The job of bank
supervisors is to ensure that bank capital represents an adequate cushion against losses, especially
during times of financial instability or stress. Basel II is yet another step to minimize the negative
consequences of risk-taking by financial institutions, particularly those institutions that could contribute
to financial instability.
This is reflected in the use of unexpected loss to calibrate capital. The assumption is that normal
volatility should be covered by normal operating earnings. For losses beyond the normal range of
expectations, capital should be in place to absorb the loss and leave the financial institution stable and
able to continue operating effectively. Thus, financial institutions with weaker profit margins, or with
customers with more varied ability to meet their obligations, should have more capital. It is important
here to distinguish between higher expected losses, for which bankers raise prices to cover risk, and
greater volatility of results, which requires additional capital.
Greater sensitivity of regulatory capital to risk has taken on increased significance as virtually all
banking markets have become considerably more concentrated, with some companies - by their very
size alone - posing the potential for systemic risk. Also, the advanced approaches of Basel II better
align regulatory capital to the risks presented by sophisticated financial instruments and to the
complexity of large, internationally active financial institutions. The current Basel I framework is more
focused on credit risk for balance sheet assets. But sophisticated financial institutions carry fewer of
their potential exposures on their books. Rather, after credit- and market-risk mitigation, it is often the
process of managing risks or laying off exposures that has created earnings surprises in recent years.
Basel II is intended to mitigate potential disruptions in banking markets by improving risk measurement
and management; establishing a better link between risk and minimum capital ratios; and providing
more information to bankers, supervisors, and other market participants.
But we should also remember that the increased sensitivity to risk in Basel II carries with it the
possibility that minimum capital ratios could actually be more volatile than they are today. As my
colleague Bill Rutledge pointed out yesterday, that is what we expect, since those ratios will be more
responsive to changes in risk. The Basel Committee has attempted to reduce procyclicality effects in
the new framework, incorporating factors such as estimates of loss severities that focus on downturns.
These are wise decisions intended to obviate the need for institutions to raise large amounts of capital
at the trough of a downturn - something that can be quite difficult and add to financial market
instability. But I think we could all agree that Basel II should not be unresponsive to changes in risk, for
example when the obligor rating distribution at an institution shifts to poorer-quality borrowers. In my
view, we want these signals of changes in risk reflected in regulatory capital levels. But by being
careful about the extent that capital levels respond to cyclicality, we are trying to make sure that risk
signals do not on their own generate added instability. This requires some balancing.
Greater responsiveness of regulatory capital ratios to risk is something that institutions will have to
learn to manage under Basel II. Given the potential for increased volatility in their capital ratios, I
expect that institutions operating under Basel II will maintain a certain cushion above their minimum
ratios since they must have the capital in place before the date of measurement of risk.
Indeed, Pillar 2 of the Basel framework (supervisory review) requires banks to develop a viable
internal
process for assessing capital adequacy that helps determine the amount of capital actually
needed for their particular business mixes and risk profiles. Explicit assumptions are built into Pillar 1
(minimum capital requirements), such as the idea that portfolios are well-diversified and do not contain
geographic or sectoral concentrations - assumptions that are not true in the case of many institutions.
Supervisors must remind institutions that it is initially the banks' job to address any deviations from
Pillar 1 assumptions, as well as any additional factors that affect the risk of the individual bank, and
adjust their capital accordingly. Under Pillar 2, supervisory authorities, in turn, will review these
adjustments by banks and could ask them to take additional steps to ensure that all risks have been
addressed.
There are additional reasons why I expect that well-run financial institutions will maintain capital ratios
above the regulatory minimums, as they have under the existing Basel I framework. Some markets
and customers will require their banks to have a stronger credit rating than that implied by the Basel I
or II minimum capital frameworks. Banks will also continue to be opportunistic in pursuing mergers and
new business expansion, and this requires capital above the regulatory minimum to be able to
respond promptly to new initiatives. Finally, bankers who are using economic capital models such as
RAROC (risk-adjusted return on capital) recognize that Basel II does not take into consideration some
forms of unexpected losses, for example, higher charge-offs that occur when new products are
introduced, information technology systems change, merger integrations occur, and internal control
processes occasionally prove ineffective.
Implementation efforts in the United States
The U.S. banking agencies' reaction to the results of the fourth Quantitative Impact Study - known as
QIS4 - shows how seriously we are taking Basel II implementation. In a statement issued on April 29,
the U.S. banking agencies indicated that the minimum regulatory capital changes resulting from QIS4
were more variable across institutions and capital dropped more in the aggregate than the agencies
had expected. This was the impetus for deciding to delay issuance of our next round of proposals for
Basel II.
These unexpected results show the continued benefit of conducting periodic quantitative impact
studies. They serve as a milestone to help us calibrate the progress of the framework and the bankers
as we move to Basel II. We now must determine the reasons for the unexpected results from QIS4. Do
they reflect actual differences in risk among respondents when prior supervisory information
suggested more similarity in credit quality? None of the participating banks has completed their
databases and models for all of their risk areas. In some cases, this created results that would not be
reliable for implementing Basel II. For example, for some portfolios, expected losses reflected only the
last year or two of results. Thus, the strong credit performance of recent experience was not balanced
by higher losses at other points of the credit cycle. Were there limits of the QIS4 exercise itself? Is
there a possible need for adjustments to the Basel framework itself? Analyzing the data used in QIS4
is vitally important, because ultimately the success of Basel II will depend on the quantity and quality
of data that banks have to use as inputs to the framework. I am sure that those of you working on
Basel II - particularly the advanced approaches - are facing the same types of issues in your own
countries.
For those of you who will be conducting QIS5 or similar exercises, I strongly suggest that you include
qualitative responses from the participants as well as quantitative data. We are finding this very useful
as we review the results and have follow-on discussions with bankers.
U.S. regulators expect to provide additional information on the lessons we learn from the QIS4 review
in the near future. The notice of proposed rulemaking for Basel II will incorporate what we learn from
this exercise. But we really are caught in a process dilemma. Bankers cannot complete their models
and collect the necessary data until they know what the specific requirements will be. Regulators, on
the other hand, will have to develop these requirements before seeing the actual results of these
models and robust databases. The process we have for vetting Basel II in the United States is
probably similar to those followed in many other countries. We are putting forward proposals and
seeking comment from the industry, our legislature, and other interested parties. Given what a vast
undertaking Basel II is, this seems entirely appropriate and beneficial.
In addition to what we learn from the work on QIS4 results, we will also assess the trading and
banking book comments of the Basel Committee on Banking Supervision and the International
Organization of Securities Commissions. We will incorporate the latest proposal into the notice of
proposed rulemaking and hope to complete our efforts in a timely manner.
Challenges for supervisors
In preparing for Basel II, supervisors realize that they must address their own capital needs - that is,
human capital. Throughout Basel II implementation in the United States, it has become strikingly
apparent that supervisors will need a higher degree of knowledge, skill, and experience. Even just our
preliminary work on Basel II, which includes writing regulations, drafting guidance, and evaluating
preliminary estimates from banks, has consumed substantial resources within the Federal Reserve
System. We are in the process of training existing staff members and recruiting new ones, and that
itself takes time and resources. We are aware that to implement a framework of the complexity and
scope of the advanced approaches of Basel II, we need highly qualified supervisors. As we have
learned over the past few years, many aspects of Basel II will require a considerable amount of
judgment and experience. That is, as supervisors engage in the qualification of institutions for Basel II
and then conduct ongoing monitoring, they will need to become intimately familiar with many technical
aspects of the framework and have the ability to assess each institution in context. We want to ensure
that in all Basel II discussions, bankers will sit across the table from supervisory staff who understand
the framework and how it applies to individual institutions.
This does not pertain just to Basel II, specifically, but also to supervision of evolving risk-measurement
and -management practices more generally. As they have in the past, supervisors must keep pace
with the latest developments in the industry and be able to differentiate among them in terms of
appropriateness. One of the many attractive characteristics of the Basel II framework is its flexibility for
incorporating new best practices without having to be fundamentally restructured. It provides a useful
and credible basis for improving bank practice today and allowing for future improvements - which
could include actual modifications to the framework. We consider this vitally important because
banking will remain a highly dynamic industry. Supervisors will have to be especially attentive to
changing best practices and ensure that Basel II does not inhibit adoption of new banking practices
and financial instruments.
Conclusion
Maintaining financial stability in global banking and financial markets continues to be an important
objective of regulators, bankers, and other market participants, particularly because of the negative
impact that financial instability has on economies as a whole. Basel II, in my view, will help improve
financial stability. The new framework will enable bank regulatory capital ratios to be more responsive
to changes in risk and will foster additional disclosures by banks about their risk-measurement and
management systems. And even though minimum regulatory capital ratios are likely to be more
volatile under Basel II, this reflects greater risk sensitivity. Perhaps most important, Basel II will
encourage banks to develop their systems to measure and manage risk as part of the investment
needed to support strategic initiatives. The greater volatility in measured risk, coupled with strategic
capital planning, should encourage bankers to continue to maintain actual capital levels above
regulatory minimums.
In the United States, we are working very hard on Basel II implementation and are taking the
appropriate, measured steps to ensure that we get it right. I expect that those in other Basel member
countries are doing the same, and facing similar challenges. Of course, certain non-Group of Ten
countries are looking to see if adapting Basel II is the best choice for them in the near term. For all of
us engaged in Basel II work, it is helpful to remember that certain prerequisites have to be met -
particularly for the advanced approaches - including the development of qualified and experienced
staff to oversee banks' adoption of the new framework.