Roger W Ferguson, Jr: Basel II - discussion of complex issues
Testimony by Mr Roger W Ferguson, Jr, Vice Chairman of the Board of Governors of the US Federal
Reserve System, before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate,
18 June 2003.
* * *
Chairman Shelby, Senator Sarbanes, members of the Committee, it is a pleasure to appear before
you this morning on behalf of the Board of Governors to discuss Basel II, the evolving new capital
accord for internationally active banking organizations. After five years of discussion, the proposal is
entering its final stage of public comment and review, although there still remain additional steps to the
process.
Why is a new capital standard necessary?
The banking supervisors in this country believe that Basel I, the current capital regime adopted in
1988, must be replaced for the largest, most complex banks for three major reasons: (1) Basel I has
serious shortcomings as it applies to these large entities, (2) the art of risk management has evolved
at the largest banks, and (3) the banking system has become increasingly concentrated.
Shortcomings in Basel I
Basel I was a major step forward in capital regulation. Indeed, for most banks in this country Basel I,
as we in the United States have augmented it, is now - and for the foreseeable future will be - more
than adequate as a capital framework. However, for the small number of large, complex,
internationally active banking organizations, Basel I has serious shortcomings which are becoming
more evident with time. Developing a replacement to apply to these banking organizations is
imperative.
Basel I is too simplistic to address the activities of our most complex banking institutions. The
framework has only four risk categories, and most loans receive the same regulatory capital charge
even though loans made by banks encompass the whole spectrum of credit quality. The limited
differentiation among the degrees of risk means that the calculated capital ratios are too often
uninformative and might well provide misleading information for banks with risky or problem credits or,
for that matter, with portfolios dominated by very safe loans.
Moreover, the limited number of risk categories creates incentives for banks to game the system
through capital arbitrage. Capital arbitrage is the avoidance of certain minimum capital charges
through the sale or securitization of bank assets for which the capital requirement that the market
would impose is less than the current regulatory capital charge. For example, credit card loans and
residential mortgages are securitized in volume, rather than held on banks' balance sheets, because
the market requires less capital, in the form of bank credit enhancements, than Basel I requires in
capital charges. This behavior by banks is perfectly understandable, even desirable in terms of
economic efficiency. But it means that banks that engage in such arbitrage retain the higher-risk
assets for which the regulatory capital charge - calibrated to assets of average quality - is on average
too low.
To be sure, through the examination process supervisors are still able to evaluate the true risk position
of the bank, but the regulatory minimum capital ratios of the larger banks are becoming less and less
meaningful, a trend that will only accelerate. Not only are creditors, counterparties, and investors less
able to evaluate the capital strength of individual banks from what are supposed to be risk-based
capital ratios, but regulations and statutory requirements tied to capital ratios have less meaning as
well. Basel I capital ratios neither adequately reflect risk nor measure bank strength at the larger
banks.
The evolving state of the art
Risk measurement and management have improved significantly beyond the state of the art of fifteen
years ago, when Basel I was developed. Banks themselves have created some of the new techniques
to improve their risk management and internal economic capital measures in order to be more
effective competitors and to control and manage their credit losses. But clearly banks can go
considerably further. One objective of Basel II is to speed adoption of these new techniques and to
promote the further evolution of risk measurement and management by harnessing them to the
regulatory process.
Increased heterogeneity and concentration in banking
Market pressures have led to consolidation in banking around the world. Our own banking system has
not been immune; it, too, has become increasingly concentrated with a small number of very large
banks operating across a wide range of product and geographic markets. The operations of these
large banks are tremendously complex and sophisticated, and they have markedly different product
mixes. At the same time, significant weakness in one of these entities has the potential for severely
adverse macroeconomic consequences. Although their insured liabilities have been declining over
time as a share of their total funding, these organizations, with their scale and role in payment and
settlement systems and in derivatives markets, have presented the authorities with an increasing
moral hazard. It is imperative that the regulatory framework should encourage these banks to adopt
the best possible risk-measurement and management techniques while allowing for the considerable
differences in their business strategies. Basel II presents an opportunity for supervisors to encourage
these and other large banks to push their management frontier forward.
Basel II
The proposed substitute for the current capital accord, Basel II, is more complex than its predecessor
for very good reasons. First, the assessment of risk in an environment of a growing number of
instruments and strategies with subtle differences in risk-reward characteristics is inevitably
complicated.
Second, the Basel II reform has several objectives: U.S. supervisors are trying to improve risk
measurement and management both domestically and internationally; to link to the extent that we can
the amount of required capital to the amount of risk taken; to further focus the supervisor-bank
dialogue on the measurement and management of risk and the risk-capital nexus; and to make all of
this transparent to the counterparties that ultimately fund - and hence share - these risk positions.
To achieve all these objectives, the framework for Basel II contains three elements, called Pillars 1, 2,
and 3. The most important pillar, Pillar 1, consists of minimum capital requirements - that is, the rules
by which a bank calculates its capital ratio and by which its supervisor assesses whether it is in
compliance with the minimum capital threshold. As under Basel I, a bank's risk-based capital ratio
under Basel II would have a numerator representing the capital available to the bank and a
denominator that would be a measure of the risks faced by the bank, referred to as "risk-weighted
assets". The definition of regulatory capital in the form of equity, reserves, and subordinated debt and
the minimum required ratio, eight percent, are not changing. What would be different is the definition of
risk-weighted assets, that is, the methods used to measure the "riskiness" of the loans and
investments held by the bank. It is this modified definition of risk-weighted assets, its greater
risksensitivity, that is the hallmark of Basel II. The modified definition of risk-weighted assets would also
include an explicit, rather than implicit, treatment of "operational risk."
Pillar 2 addresses supervisory oversight; it encompasses the concept that well-managed banks should
seek to go beyond simple compliance with minimum capital requirements and perform for themselves
a comprehensive assessment of whether they have sufficient capital to support their risks. In addition,
on the basis of their knowledge of industry practices at a range of institutions, supervisors should
provide constructive feedback to bank management on these internal assessments.
Finally, Pillar 3 seeks to complement these activities with stronger market discipline by requiring banks
publicly to disclose key measures related to their risk and capital positions. The concept of these three
mutually reinforcing pillars has been central to the Basel II effort.
Scope of application in the United States
The U.S. supervisory agencies will propose that most banking organizations in this country remain
under the existing Basel I-type capital rules and would continue to have no explicit capital charge for
operational risk. Earlier I emphasized that Basel I had outlived its usefulness for the larger banking
organizations. How then did we conclude that most of our banks should remain under rules based on
the old accord?
Banks remaining under current capital rules
To begin with, most of our banks have relatively straightforward balance sheets and do not yet need
the full panoply of sophisticated risk-management techniques required under the advanced versions of
Basel II. In addition, for various reasons, most of our banks now hold considerable capital in excess of
regulatory minimums: More than 93 percent have risk-weighted capital ratios in excess of 10 percent -
an attained ratio that is 25 percent above the current regulatory minimum. No additional capital would
likely have to be held if these institutions were required to adopt Basel II.
Moreover, U.S. banks have long been subject to comprehensive and thorough supervision that is
much less common in most other countries planning to implement Basel II. Indeed, U.S. supervisors
will continue to be interested in reviewing and understanding the risk-measurement and management
processes of all banks. Our banks also disclose considerable information through regulatory reports
and under accounting rules and requirements of the Securities and Exchange Commission; they
already provide significant disclosure - consistent with Pillar 3 of Basel II.
Thus, when we balanced the costs of imposing a new capital regime on thousands of our banks
against the benefits - slightly more risk sensitivity of capital requirements under, say, the standardized
version of Basel II for credit risk, and somewhat more disclosure - it did not seem worthwhile to require
most of our banks to take that step. Countries with an institutional structure different from ours might
clearly find universal application of Basel II to benefit their banking system, but we do not think that
imposing Basel II on most of our banks is either necessary or practical.
Banks moving to Basel II
We have an entirely different view for our largest and most complicated banking organizations,
especially those with significant operations abroad. Among the important objectives of both Basel I
and the proposed Basel II is to promote competitive consistency of capital requirements for banks that
compete directly in global markets.
Another important objective has been to encourage the largest banking organizations of the world to
continue to incorporate into their operations the most sophisticated techniques for the measurement
and management of risk. As I have noted, these entities use financial instruments and procedures that
are not adequately captured by the Basel I paradigm. They have already begun to use - or have the
capability to adopt - the techniques of modern finance to measure and manage their exposures; and
because substantial difficulty at one of the largest banking organizations could have significant effects
on global financial markets, all of the largest banks should be using these procedures. In our view,
prudential supervisors and central bankers would be remiss if we did not address the evolving
complexity of our largest banks and ensure that modern techniques were being used to manage their
risks. The U.S. supervisors have concluded that the advanced versions of Basel II - the Advanced
Internal Ratings Based (A-IRB) approach for measuring credit risk and the Advanced Measurement
Approaches (AMA) for measuring operational risk - are best suited to achieve this last objective.
Under the A-IRB approach, a banking organization would have to estimate, for each credit exposure,
the probability that the borrower will default, the likely size of the loss that will be incurred in the event
of default: and - where the lender has an undrawn line of credit or loan commitment to the borrower -
an estimate of what the amount borrowed is likely to be at the time a default occurs. These three key
inputs - probability of default (PD), loss given default (LGD), and exposure at default (EAD) - are
inputs that would be used in formulas provided by supervisors to determine the minimum required
capital for a given portfolio of exposure. While the organization would estimate these key inputs, the
estimates would have to be rigorously based on empirical information, using procedures and controls
validated by its supervisor, and the results would have to accurately measure risk.
Those banks that are required, or choose, to adopt the A-IRB approach to measuring credit risk, would
also be required to hold capital for operational risk, using a procedure known as the Advanced
Management Approach (AMA) to establish the size of that charge. Under the AMA, banks themselves
would bear the primary responsibility for developing their own methodology for assessing their own
operational risk capital requirement. To be sure, supervisors would require that the procedures used
are comprehensive, systematic, and consistent with certain broad outlines, and must review and
validate each bank's process. In this way, a bank's "op risk" capital charge would reflect its own
environment and controls. Importantly, the size of the charge could be reduced by actions that the
bank takes to mitigate operational risk. This provides an important incentive for the bank to take
actions to limit their potential losses from operational problems.
Determining Basel II banks
To promote a more level global playing field, the banking agencies in the United States will be
proposing in the forthcoming Advance Notice of Proposed Rulemaking (ANPR) that those U.S.
banking organizations with foreign exposure above a specified amount would be in the core set of
banks that would be required to adopt the advanced versions of Basel II. To improve risk management
at those organizations whose disruption would have the largest effect on the global economy, we
would also require the same of banks whose scale exceeds a specified amount. That is, banks
meeting either the foreign exposure criterion or the asset size criterion would be required to adopt the
advanced versions of Basel II, although most banks meeting one criterion also meet the other.
Ten U.S. banks meet the proposed criteria to be core banks and thus would be required, under our
proposal, to adopt A-IRB and AMA to measure their credit and operational risks, respectively. As they
grow, other banks could very well meet the criteria and thus shift into the core group in the years
ahead. We would also permit any bank that meets the infrastructure requirements of A-IRB and AMA -
the ability to quantify and develop the necessary risk parameters on credit exposures and develop
measurement systems for operational risk exposures - to choose Basel II. Banks that choose to use
AIRB and AMA would need to consider several factors, including the benefits of Basel II relative to its
costs, the nature of their operations, the capital impact, and the message they want to send their
counterparties about their risk-management techniques. We anticipate that after conducting such a
review, about ten or so large banks now outside the core group would choose to adopt Basel II in the
near term. Thus we expect about twenty banks to adopt the advanced version of Basel II before or
shortly after the initial implementation date.
Over time, other large banks, perhaps responding to market pressure and facing declining costs and
wider understanding of the technology, may also choose this capital regime, but we do not think that
the cost-benefit assessment would induce smaller banks to do so for a very long time. Our discussions
with the rating agencies confirm they do not expect that regional banks would find adoption of Basel II
to be cost effective in the initial implementation period. Preliminary surveys of the views of bank equity
security analysts indicate that they are more focused on the disclosure aspects of Basel II rather than
on the scope of application. To be clear, supervisors have no intention of pressuring any of the banks
outside the core group to adopt Basel II.
The ten core banks that would be required to adopt Basel II, together with the approximately ten
selfselecting banks that we anticipate would adopt it before or shortly after the initial implementation date,
today account for 99 percent of the foreign assets and two-thirds of all the assets of domestic U.S.
banking organizations, a rate of coverage demonstrating the importance of these entities to the U.S.
and global banking and financial markets. These data also underscore our commitment to international
competitive equity and the adoption of best-practice policies at the organizations critical to our financial
stability while minimizing cost and disruption at our purely domestic, less-complicated organizations.
Issues
Bankers have identified three key areas of concern: cost, competitive equity, and Pillar 1 treatment of
operational risk.
Cost
Implementing A-IRB and AMA in this country is going to be expensive for the small number of banks
for which it will be required, for other banks choosing it, and for the supervisors. For the banks, the
greatest expense would be establishing the mechanisms necessary for a bank to evaluate and control
its risk exposures more formally. The A-IRB approach would not eliminate losses: Banks are in the
business of taking risk, and where there are risks, there will be losses. But we believe that the better
risk-management that is required for the A-IRB and AMA would better align risk and return and
thereby provide benefits to bank stakeholders and the economy. And, more risk-sensitive capital
requirements would assist in ensuring that banks would have sufficient capital to absorb losses when
they do occur. The cost-benefit ratio looks right to the supervisors.
This ratio is further enhanced because attributing to Basel II all the costs associated with the adoption
of modern, formal risk-management systems is a logical fallacy. The large banks that would be
required, or that would choose, to adopt A-IRB and AMA must compete for funding in a global
marketplace and thus already have adopted many of these processes and would continue to develop
them even without Basel II. The new accord may well appropriately speed up the adoption process,
but overall, the costs of adopting these processes are being forced on these banks not by Basel II but
by the requirements of doing business in an increasingly complex financial environment. In any event,
the ANPR will include questions designed to quantify the cost of implementing Basel II.
Competitive Equity
A second key concern is competitive equity. Some are concerned that the U.S. supervisors would be
more stringent in their application of Basel II rules than other countries and would thereby place U.S.
banks at a competitive disadvantage. To address this concern, the Basel agreement establishes an
Accord Implementation Group (AIG), made up of senior supervisors from each Basel member country,
which has already begun to meet. It is the AIG's task to work out common standards and procedures
and act as a forum in which conflicts can be addressed. No doubt some differences in application
would be unavoidable across banking systems with different institutional and supervisory structures,
but all of the supervisors, and certainly the Federal Reserve, would remain alert to this issue and work
to minimize it. I also emphasize that, as is the case today, U.S. bank subsidiaries of foreign banks
would be operating under U.S. rules, just as foreign bank subsidiaries of U.S. banks would be
operating under host-country rules.
Another issue relates to the concern among U. S. Basel II banks of the potential competitive edge that
might be given to any bank that would have its capital requirements lowered by more than that of
another Basel II bank. The essence of Basel II is that it is designed to link the capital requirement to
the risk of the exposures of each individual bank. A bank that holds mainly lower-risk assets, such as
high-quality residential mortgages, would have no advantage over a rival that held mainly
lowerquality, and therefore riskier, commercial loans just because the former had lower required capital
charges. The capital requirements should be a function of risk taken, and, under Basel II, if the two
banks had very similar loans, they both should have a very similar required capital charge. For this
reason, competitive equity among Basel II banks in this country should not be a genuine issue
because capital should reflect risk taken. Under the current capital regime, banks with different risk
profiles have the same capital requirements, creating now a competitive inequity for the banks that
have chosen lower risk profiles.
The most frequently voiced concern about possible competitive imbalance reflects the "bifurcated"
rules implicit in the U.S. supervisors' proposed scope of application: that is, requiring Basel II through
A-IRB and AMA for a small number of large banks while requiring the current capital rules for all other
U.S. banks. The stated concern of some observers is that the banks that remained under the current
capital rules, with capital charges that are not as risk sensitive, would be at a competitive
disadvantage compared to Basel II banks that would get lower capital charges on less-risky assets.
The same credit exposure might have a lower regulatory minimum capital charge at a Basel II bank
than at a Basel I bank. Of course, Basel II banks would have higher capital charges on higher-risk
assets and the cost of adopting a new infrastructure, neither of which Basel I banks would have. And
any bank that might feel threatened could adopt Basel II if they would make the investment required to
reach the qualifying criteria.
But a concern remains about competitive equity in our proposed scope of application, one that could
present some difficult trade-offs if the competitive issue is real and significant. On the one hand is the
pressing need to reform the capital system for the largest banks and the practical arguments for
retaining the present system for most U.S. banks. Against that is the concern that there might be an
unintended consequence of disadvantaging those banks that would remain on the current capital
regime.
We take the latter concern seriously and will be exploring it through the ANPR. But, without prejudging
the issue, there are reasons to believe that little if any competitive disadvantage would be brought to
those banks remaining under the current capital regime.
The basic question is the role of minimum regulatory capital requirements in the determination of the
price and availability of credit. Economic analysis suggests that regulatory capital should be
considerably less important than the capital allocations that banks make internally within their
organization, so-called economic capital. Our understanding of bank pricing is that it starts with
economic capital and the explicit recognition of the riskiness of the credit and is then adjusted on the
basis of market conditions and local competition from bank and nonbank sources. In some markets,
some banks will be relatively passive price takers. In either case, regulatory capital is mostly irrelevant
in the pricing decision, and therefore unlikely to cause competitive disparities.
Moreover, most banks, and especially the smaller ones, hold capital far in excess of regulatory
minimums for various reasons. Thus, changes in their own or their rivals' minimum regulatory capital
generally would not have much effect on the level of capital they choose to hold and would therefore
not necessarily affect internal capital allocations for pricing purposes.
In addition, the banks that most frequently express a fear of being disadvantaged by a bifurcated
regulatory regime have for years faced capital arbitrage from larger rivals who were able to reduce
their capital charges by securitizing loans for which the regulatory charge was too high relative to the
market or economic capital charge. The more risk-sensitive A-IRB in fact would reduce the regulatory
capital charge in just those areas where capital requirements are too high under the current regime. In
those areas, capital arbitrage has already reduced the regulatory capital charge. The A-IRB would
provide, in effect, risk-sensitive capital charges for lower-risk assets that are similar to what the larger
banks have for years already obtained through capital arbitrage. In short, competitive realities between
banks might not change in many markets in which minimum regulatory capital charges would become
more explicitly risk sensitive.
Concerns have also been raised about the effect of Basel II capital requirements on the competitive
relationships between depository institutions and their nondepository rivals. Of course, the argument
that economic capital is the driving force in pricing applies in this case, too. Its role is only reinforced
by the fact that the cost of capital and funding is less at insured depositories than at their
nondepository rivals because of the safety net. Insured deposits and access to the Federal Reserve
discount window (and Federal Home Loan Bank advances) let insured depositories operate with far
less capital or collateralization than the market would otherwise require of them and far less than it
does require of nondepository rivals. Again, Basel II would not change those market realities.
Let me repeat that I do not mean to dismiss competitive equity concerns. Indeed, I hope that the
comments on the ANPR bring forth insights and analyses that respond directly to the issues,
particularly the observations I have just made. But, I must say, we need to see reasoned analysis and
not assertions.
Operational risk
The third key area of concern is the proposed Pillar 1 treatment of operational risk. Operational risk
refers to losses from failures of systems, controls, or people and will, for the first time, be explicitly
subject to capital charges under the Basel II proposal. Neither operational risk nor capital to offset it
are new concepts. Supervisors have been expecting banks to manage operational risk for some time,
and banks have been holding capital against it. Under Basel I both operational and credit risks have
been implicitly covered in one measure of risk and one capital charge. But Basel II, by designing a
risk-based system for credit and operational risk, separates the two risks and would require capital to
be held for each separately.
Operational disruptions have caused banks to suffer huge losses and, in some cases, failure here and
abroad. At times they have dominated the business news and even the front pages. Appendix 1 to this
statement lists the ten largest such events of recent years. In an increasingly technology-driven
banking system, operational risks have become an even larger share of total risk; at some banks they
are the dominant risk. To avoid addressing them would be imprudent and would leave a considerable
gap in our regulatory system.
A capital charge to cover operational risk would no more eliminate operational risk than a capital
charge for credit risk eliminates credit risk. For both risks, capital is a measure of a bank's ability to
absorb losses and survive without endangering the banking and financial system. The AMA for
determining capital charges on operational risk is a principles-based approach that would obligate
banks to evaluate their own operational risks in a structured but flexible way. Importantly, a bank could
reduce its operational-risk charge by adopting procedures, systems, and controls that reduce its risk or
by shifting the risk to others through measures such as insurance. This approach parallels that for
credit risk, in which capital charges can be reduced by shifting to less-risky exposures or by making
use of risk-mitigation techniques such as collateral or guarantees.
Some banks for which operational risk is the dominant risk oppose an explicit capital charge on
operational risk. Some of these organizations tend to have little credit exposure and hence very small
required capital under the current regime, but would have significant required capital charges should
operational risk be explicitly treated under Pillar 1 of Basel II. Such banks, and also some whose
principal risks are credit-related, would prefer that operational risk be handled case by case through
the supervisory review of buffer capital under Pillar 2 of the Basel proposal rather than be subject to an
explicit regulatory capital charge under Pillar 1. The Federal Reserve believes that would be a mistake
because it would greatly reduce the transparency of risk and capital that is such an important part of
Basel II and would make it very difficult to treat risks comparably across banks because Pillar 2 is
judgmentally based.
Most of the banks to which Basel II would apply in the United States are well along in developing their
AMA-based capital charge and believe that the process has already induced them to adopt
riskreducing innovations. Presentations at a conference held late last month illustrated the significant
advances in operational-risk quantification being made by most internationally active banks. The
presentations were made by representatives from most of the major banks in Europe, Asia, and North
America, and many presenters enthusiastically supported the use of AMA-type techniques to
incorporate operational risk in their formal modeling of economic capital. Many banks also
acknowledged the important role played by the Basel process in encouraging them to develop
improved operational risk management.1
Overall capital and an evolving Basel II
Before I move on to other issues, I would like to address the concern that the combination of credit
and operational risk capital charges for those U.S. banks that are under Basel II would decline too
much for prudent supervisory purposes. Speaking for the Federal Reserve Board, let me underline
that we could not support a final Basel II that we felt caused capital to decline to unsafe and unsound
levels at the largest banks. That is why we anticipate that the U.S. authorities would conduct a
Quantitative Impact Study (QIS) in 2004 to supplement the one conducted late last year; I anticipate at
least one or two more before final implementation. It is also why CP3 calls for one year of parallel
(Basel I and II) capital calculation and a two-year phase-in with capital floors set at 90 and 80 percent,
respectively, of the Basel I levels before full Basel II implementation. At any of those stages, if the
evidence suggested that capital were declining too much the Federal Reserve Board would insist that
Basel II be adjusted or recalibrated, regardless of the difficulties with bankers here and abroad or with
supervisors in other countries. This is the stated position of the Board and our supervisors and has not
changed during the process.
Of course, capital ratios are not the sole consideration. The improved risk measurement and
management, and its integration into the supervisory system, under Basel II, are also critical to
ensuring the safety and soundness of the banking system. When coupled with the special U.S.
features, such as prompt corrective action, minimum leverage ratios, statutory provisions that make
capital a prerequisite to exercising additional powers, and market demands for buffer capital, some
modest reduction in the minimum regulatory capital for sound, well managed banks could be tolerable.
And, I note that banks with lower risk profiles, as a matter of sound public policy, should have lower
capital than banks with higher risk profiles. Greater dispersion in required capital ratios, if reflective of
underlying risk, is an objective, not a problem to be overcome.
I should also underline that Basel II is designed to adapt to changing technology and procedures. I
fully expect that in the years ahead banks and supervisors will develop better ways of estimating risk
parameters as well as better functions that convert those parameters to capital requirements. When
they do, these changes could be substituted directly into the Ba