Susan Schmidt Bies: A US perspective on Basel II implementation
Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve
System, at the Institute for International Bankers Seminar on the Impact of Basel II on Financial
Markets and Business Strategies, New York, 30 November 2006.
* * *
Good afternoon. Thank you for the invitation to participate in this seminar. We at the Federal Reserve
welcome all opportunities to discuss current regulatory proposals and to hear the banking industry's
comments about them. Today I plan to provide an overview of developments in the United States
relating to Basel II and the Market Risk Amendment, as well as offer some thoughts about
crossborder implementation of the New Accord.
The role of regulatory capital
Banking is, and should be, a business in which banks take and manage risks. 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. One of the most important jobs of bank
supervisors is to ensure that banks maintain an adequate capital cushion against losses, especially
during times of financial instability or stress. Minimum capital requirements are a major tool for
ensuring an adequate cushion. When developing minimum capital requirements, supervisors should
continue to promote approaches that minimize the negative consequences of risk taking by financial
institutions, particularly those institutions that could affect global financial stability. That is what we are
doing with the Basel II framework.
The Federal Reserve's main reason for pursuing the advanced approaches of Basel II is the growing
inadequacy of current Basel I regulatory capital rules for the large, internationally active banks that are
offering ever more complex and sophisticated products and services. We need a more risk-sensitive
capital framework for these particular banks, and Basel II is such a framework. In addition, Basel II
promotes risk-measurement and risk-management enhancements and improves market discipline,
while giving supervisors a more conceptually consistent and more transparent framework for
evaluating systemic risk, particularly through credit cycles. Basel II should establish a more coherent
relationship between regulatory measures of capital adequacy and day-to-day risk-focused
supervision of banks, enabling examiners to better evaluate whether banks are holding prudent levels
of capital given their risk profiles.
For similar reasons, U.S. supervisors support the recent Basel/IOSCO revisions to the 1996 Market
Risk Amendment (MRA). Since adoption of the MRA, banks' trading activities have become more
sophisticated and have given rise to a wider range of risks that are not easily captured in their existing
value-at-risk models. For example, more products related to credit risk, such as credit default swaps
and tranches of collateralized debt obligations, are now included in the trading book. These products
can create default risks that are not captured well in methodologies required by the current rule
specifying a ten-day holding period and a 99 percent confidence interval - thereby creating potential
arbitrage opportunities between the banking book and the trading book.
Recent US developments
As most of you know, over two months ago the U.S. banking agencies issued a notice of proposed
rulemaking (NPR) relating to Basel II. Concurrently, the agencies issued an NPR on revisions to the
MRA. Notably, in the United States the Basel II NPR and the revised market-risk NPR may or may not
necessarily apply to the same set of institutions. The proposed market risk NPR will continue to apply
only to banks with significant trading activity, whether they are on Basel I as amended or moved to
Basel II.
The U.S. banking agencies are eagerly awaiting comments on both proposals and expect the dialogue
with all interested parties to expand as we explore whether the proposals meet our stated objectives
and how the proposals can be improved. Specifically, I want to emphasize that you should not wait
until the end of the comment period to submit comments; our staffs are working diligently to review
them even now so that we will be ready to proceed in the development of a final rule. Therefore, even
if you might have additional comments later, it is still helpful to submit now any you may currently
have. We especially appreciate very detailed comments. Furthermore, it would be especially helpful to
us if in your comments you could differentiate between those that are relevant during the Basel II
transition period versus those that relate to features of the proposed framework that are more
permanent in nature. In addition to the written comments, the comment period has afforded us more
frequent interaction with industry groups, such as the Institute of International Bankers, which has
been very helpful and informative. For our part, the agencies hope to issue a set of proposed
supervisory guidance relating to Basel II soon that should be helpful as banks move forward with
implementation. We at the Fed hope that everyone who reviews our proposals relating to Basel II and
the MRA revisions understands that they are intended to promote the stability of the U.S. financial
system by ensuring the safety and soundness of the largest U.S. banks. Thus, as Chairman Bernanke
has noted, the ability of Basel II to promote safety and soundness is the first criterion by which these
regulatory capital proposals should be judged.
A key aspect of Basel II implementation in the United States relates to scope of application. In the
United States, Basel II is expected to apply to only a handful of large, complex organizations, which is
the principal reason why the U.S. agencies are proposing only the advanced approaches (A-IRB for
credit risk and AMA for operational risk). Perhaps the main difference between the implementation of
Basel II in the United States and the implementation in most other countries is that the U.S. banking
agencies plan to retain a revised form of the existing Basel I-based capital rules for the vast majority of
U.S. banks; most other countries are replacing Basel I entirely and will apply Basel II to the entire
banking system. Notably, the initial U.S. Basel II proposals, issued in an advance notice of proposed
rulemaking (ANPR) in August 2003, suggested that only the advanced approaches be used in the
United States; comments on the Basel II ANPR did not indicate any opposition to the agencies'
proposed approaches.
It should also be noted that, based on the latest information, apparently none of the large, complex
organizations in other Basel-member countries plan to adopt the standardized approach for credit risk.
Therefore, our proposal that large, complex U.S. banking organizations use the advanced approaches
of Basel II seems generally consistent with approaches to be used by large, complex organizations in
other countries.
The U.S. agencies remain open to considering the full set of possibilities for Basel II, so the Basel II
NPR specifically seeks comment on whether some form of the Basel II standardized approach for
credit risk should be adopted in the United States. When deciding whether our large, internationally
active banks should have access to a standardized approach, the agencies will need to consider a
number of important issues: whether such an approach would accommodate the risks those banks
take, now and in the future; whether it would provide adequate risk sensitivity; whether it would be
useful to have a transition period in order to give some banks more time to prepare to use the
advanced approaches, and whether other transition arrangements are available; whether taking the
time needed to develop an appropriate U.S. version of the standardized approach would unduly delay
the Basel II implementation process; and, finally, whether the marketplace would find such an option
for those banks meaningful and acceptable.
In developing U.S. proposals for Basel II implementation, the agencies did not think it would be
appropriate to replace the existing Basel I capital rules for small, noncomplex banks in this country
with the Basel II standardized rules. The agencies concluded, based in significant part on input from
small community banking organizations, that the implementation costs of such an overhaul generally
would exceed its regulatory benefit. Instead, the agencies intend to propose, through a notice of
proposed rulemaking, a simpler, more modest set of revisions to our existing Basel I-based capital
rules for smaller U.S. banks - revisions known as Basel IA.
Basel IA
As noted, we anticipate that only one to two dozen institutions would move to the U.S. version of Basel
II in the near term, meaning that the vast majority of U.S. institutions would continue to operate under
Basel I-based rules. The U.S. Basel I framework has already been amended more than twenty-five
times since its introduction, in response to changes in banking products and the financial services
marketplace. In October 2005, the agencies issued an ANPR for Basel IA, which discussed possible
changes to increase the risk sensitivity of the U.S. Basel I rules and to mitigate competitive distortions
that might be created by introducing Basel II. We have reviewed comments on the ANPR and are
working on a notice of proposed rulemaking, which we hope to have out very soon. In drafting all of
these regulatory capital proposals, we continue to consider the balance between risk sensitivity and
regulatory burden, since more risk-sensitive capital requirements generally imply greater burden.
Thus, we are mindful that amendments to the Basel I rules should not be too complex or too
burdensome for the large number of small- and mid-sized institutions to which the revised rules might
apply. Indeed, a number of those commenting on the ANPR advocated leaving existing rules
unchanged.
As noted, the agencies are taking into account potential competitive effects that Basel II might create
between those institutions that would adopt Basel II and those that would not. Indeed, we recognize
that many of the thousands of depository institutions that would remain under the current capital rules
may be concerned about the potential uncertainty surrounding Basel II. As part of our efforts to
analyze and address these concerns, the Federal Reserve published a series of research papers
focused on potential competitive effects in areas such as small business lending, mergers and
acquisitions, and residential mortgage markets. The agencies have been taking into account the
issues raised in those papers in drafting the Basel IA NPR.
With regard to both the Basel II proposals and the proposed Basel I amendments, we understand the
need for full transparency. For that reason, we expect the comment periods for the Basel II NPR and
the NPR for the proposed Basel I amendments to have some overlap so that all interested parties may
have adequate time to compare, contrast, and comment on both proposals. Accordingly, either of our
proposals could change as a result of comments received or new information gathered. And as I
stated earlier, we encourage you to submit your comments early rather than waiting until the end of
the comment period.
Implementing Basel II across countries
Having covered the status of U.S. Basel II proposals, I now want to offer a few thoughts about the
implementation of Basel II around the globe. As you know, the U.S. agencies participate with other
national supervisors in the Basel Committee on Banking Supervision and in other groups to identify
differences in implementation and discuss possible ways to harmonize rules and thereby reduce
burden on cross-border banking organizations. At the recent Accord Implementation Group meeting,
there was a very fruitful exchange of ideas and dialogue among the member nations, as well as the
EU and Committee of European Banking Supervisors, on approaches that countries are considering to
address capital adequacy beyond regulatory minimums. Of course, we recognize that the national
discretion allowed under Basel II means that there will be adoption of different approaches to Basel II
by various countries. We recognize that this may create challenges for banking organizations that
operate in multiple jurisdictions and are working to try to minimize both the differences and the
difficulties wherever possible. But it is good to remember that cross-border banking has always raised
specific challenges, even before Basel II, and supervisors from various countries have worked hard to
address and mitigate those difficulties.
Let me assure all bankers here that the Federal Reserve is aware that the process of adopting
national versions of Basel II has heightened concerns about home-host issues. We are committed to
working with other international supervisors in resolving home-host issues. Indeed, the Federal
Reserve and other U.S. agencies have, for many years, worked with international counterparts to limit
the difficulty and burden that have arisen as foreign banks have entered U.S. markets and as U.S.
banks have established operations in other jurisdictions. Throughout the Basel II process, we have
been engaged in dialogue with our international counterparts through various avenues such as
supervisory working colleges to share ideas and tackle specific issues as they arise. Some of these
issues are very institution- and country-specific, and are therefore better addressed through individual
conversations with an institution and their relevant supervisors.
The Federal Reserve continues to be an active participant in supervisory working groups for all large
U.S. and foreign banking organizations in the U.S. and we are encouraged by the level of cooperation
and pragmatism coming out of these efforts. For example, supervisory planning efforts for U.S.-based
banking organizations for the upcoming year are reviewed with foreign supervisory authorities to
ensure that, regardless of Basel II timing issues, information pertaining to ongoing supervisory
judgments of risk management practices is available. We have also been encouraged by the dialogue
with our foreign colleagues regarding their desire to provide flexibility in transitional arrangements. I
would add that we have benefited from the numerous meetings and exchanges we have had with
groups such as yours to help us identify the most critical areas to examine for further convergence
globally. We will be evaluating all of that input closely as a part of our rulemaking process. As always,
we encourage bankers who have questions and concerns about home-host issues to communicate
promptly with their regulators in all jurisdictions so that the issues can be addressed.
Another key point, when talking about differences across countries, relates to findings from recent
Basel II quantitative impact studies (QIS4 and QIS5). Interestingly, the two exercises identified a
number of similar issues, some in areas in which institutions were not able to provide adequate data
(especially for downturn scenarios). In the United States, QIS4 was conducted before the release of
the Basel II NPR, while in Europe, QIS5 was conducted only after the passage of EU legislation
implementing Basel II. Therefore, much of what was learned by U.S. supervisors in QIS4 is included in
the NPR, such as the supervisory mapping function for downturn estimates of loss given default.
European supervisors, on the other hand, did not have the benefit of information from QIS5 when they
were drafting their rules. While I cannot speak for my European counterparts, no doubt some of the
issues raised in QIS5 will be addressed during implementation in Europe.
It is possible that differences in Basel II implementation may mean that the U.S. version of Basel II is
in some aspects more conservative than other countries' versions. In other areas, the U.S. proposals
may be less conservative. But, as I noted, national differences in capital regulation are not unique to
the Basel II capital regime. Over the years, the U.S. agencies have consciously chosen to maintain a
more conservative stance in some aspects of Basel I, as applied in the United States, compared with
versions of Basel I adopted by other countries. For example, the U.S. banking agencies currently
impose a supplemental leverage ratio, and risk-based capital is linked to our prompt-corrective-action
framework. However, we do not believe that elements of conservatism in existing U.S. capital rules,
relative to other countries' rules, have been a barrier to the financial success of our banks, nor have
they constrained foreign banks from participating in our markets. On the contrary, we believe that
capital strength and the resilience it demonstrates offer some competitive advantages and instill
market confidence. That is a key reason that most of the world's largest banks hold capital in excess
of minimum regulatory standards. Creditors and counterparties will always consider capitalization
when assessing the risks associated with these banks. Indeed, many factors other than minimum
regulatory capital requirements - including domestic and international tax policies, economies of scale
and scope, risk-management skills, and the ability to innovate - also affect competition and profitability.
On balance, the Federal Reserve believes that an appropriately conservative approach to capital
adequacy serves the United States' interest in maintaining the safety, soundness, and resiliency of our
banking system. However, we also recognize the impact that differences among countries can have
and that it is worthwhile to minimize them whenever possible. As Chairman Bernanke noted earlier this
fall, before issuing a final rule we intend to review all international differences to assess whether the
benefits of rules specific to the United States outweigh the costs. Of course, that will include a review
of whether U.S.-specific rules are having an adverse impact on the competitiveness of U.S. banks
visà-vis foreign counterparts.
Conclusion
I believe that forums such as this one are very useful places to discuss actual and potential differences
in capital requirements across countries. As supervisors, we must always strive to minimize these
differences and reduce burden on bankers as they conduct business across national borders.
However, bankers must also realize that national boundaries still matter, and that some differences in
capital requirements across countries will remain. While there may be opportunities here and there to
reduce burden through broad policy changes, generally the most productive way to address
crossborder issues is on a case-by-case basis. In most cases, blanket assurances are neither feasible nor
realistic. Therefore, I continue to encourage bankers to present issues to their supervisors so that the
issues can be raised in bilateral or multilateral discussions of specific topics - the process by which
issues have been addressed in the past.