Susan Schmidt Bies: The Basel II Accord and House Resolution 1226
Testimony of Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve
System, before the Subcommittee on Domestic and International Monetary Policy, Trade, and
Technology and the Subcommittee on Financial Institutions and Consumer Credit, Committee on
Financial Services, US House of Representatives, Washington, 11 May 2005.
* * *
Chairman Bachus, Chairman Pryce, and members of the Subcommittee on Financial Institutions and
Consumer Credit and the Subcommittee on Domestic and International Monetary Policy, Trade, and
Technology: It is a pleasure to join my colleagues from the other banking agencies to discuss the
current status of Basel II in this country, as well as the Federal Reserve's views on H.R. 1226. The
continued discussion among the Congress and the regulators - and, of course, the banking industry
and other members of the public - is critical to the final implementation of the new capital accord.
The focus of recent attention has been the agencies' announcement that they will delay the notice of
proposed rulemaking (NPR) for Basel II, originally scheduled for midyear 2005. In my remarks today, I
will discuss the reasons for the delay and the Board's views regarding the timetable for implementation
of Basel II in this country. But, first, I believe it may be useful to remind the members of the
subcommittees why the agencies thought it wise to explore and then develop a modernization of the
current capital accord; those factors have become, if anything, more important than they were when
we began the process.
Our banking system is becoming more concentrated, with a number of very large entities operating
across multiple business lines and national boundaries, each entity with positions and exposures that
are both complicated and difficult for third parties to understand. These entities have outgrown the
current regulatory capital regime, which is still adequate for most banks. But the current rules simply
cannot keep up with the complex business of the global banking organizations toward which Basel II
and its infrastructure prerequisites are directed. These organizations represent significant risks to the
financial system should they develop substantial problems in a period of stress. Basel II offers the
opportunity to work with these large entities to develop quantitative risk-measurement and
risk-management systems that can both measure their risk more accurately and become the basis for
more risk-focused capital requirements and prudential supervision. We would also require, as part of
the Basel II approach, more public disclosures to improve market discipline and supplement
supervisory efforts.
Many internationally active U.S. banks apparently agree that we should work toward Basel II. Indeed,
we and the industry have already seen some benefits from work on Basel II implementation in that
market participants and bank supervisors have developed a common language for inputs into
risk-management processes.
Earlier this year, twenty-six banking organizations provided us with internal measures of credit risk as
part of the fourth quantitative impact study, or QIS4. The agencies have now reviewed the risk
parameter estimates provided and are discussing with individual participants their approaches to
developing the required inputs. These discussions, which are ongoing, have significantly changed
some of the data provided, and some modifications are still coming in.
Nonetheless, even with these revisions, two conclusions are already clear. First, the dispersion among
the banks in their estimates of the key parameters that would be used to calculate Basel II capital
requirements was quite wide - much wider than expected. Second, the implied reductions in minimum
regulatory capital were often substantial - far more than previous quantitative impact studies, both here
and abroad, had suggested. As responsible and prudent regulators, we believe it is appropriate to
improve our understanding of these results and to see whether changes might be needed in our
proposals.
From the outset of our participation in the development of Basel II, the U.S. agencies have clearly and
consistently stated that the final adoption of the new capital rules in the United States would occur only
after (1) we had reviewed all public comments and incorporated any needed adjustments to address
legitimate concerns, and (2) we were satisfied that Basel II was consistent with safe and sound
banking in this country. Throughout this process we have stressed that, should we become concerned
about the level of overall capital in the banking system or the capital results for individual portfolios, we
would seek to modify the framework, including possibly recalibrating the regulatory capital formulas
that translate an individual bank's risk parameters into required capital. The agencies' current review
and study is consistent with our historical position at Basel.
All of the agencies want to have a better understanding of QIS4 data and results. Does the dispersion
reflect different risk profiles? Different model assumptions? Different estimates of risk for the same
kind of asset? Different kinds of internal rating systems with some looking "through the cycle" and
others being "point in time"? Different stages of institutions' implementation efforts? Limitations of
current data bases? Some other factor? We hope that further analysis and discussion with
respondents can provide some answers to such questions. All the agencies believed that the prudent
approach was to delay the NPR to gain better understanding of the reasons for the unexpected
results.
Still, this decision presents the U.S. banking agencies with a dilemma. There is good reason to delay
the NPR and related supervisory guidance, but those very documents are needed to provide more
complete blueprints for what banks will need in terms of the databases and systems to implement
Basel II. We are not saying that these large entities today have inadequate risk-management systems.
Rather, they do not yet have the systems for producing Basel II inputs that meet the standards set
forth in the Basel II proposal. Until the banking organizations have the NPR, many just will not be able
to provide us the inputs we need to assess how banks would operate under Basel II. The dilemma can
be solved only by first issuing the NPR. But, we must then have a prudent and flexible way to make
adjustments should the resultant data produce results that we, as supervisors, are not comfortable
with. The plans developed before the delay in the NPR offer just such an opportunity.
Under those plans, institutions required or planning to move to Basel II would, after the adoption of a
final rule, decide when to start their parallel run - with the first opportunity in January 2007. During the
required parallel run, each bank would continue to calculate its required capital under the current
capital regime and simultaneously calculate its Basel II capital statistics for review by its primary
supervisor. When the supervisor believes that the bank has produced four quarters of credible Basel II
estimates, the bank would be able to enter a minimum two-year transition run, the earliest in 2008
under these plans. During this transition run, the bank would be under Basel II capital rules, but it
could not reduce its capital below 90 percent of what the current capital rules would require in the first
year or below 80 percent in the second year. The length of either the parallel run or the transition run
could be extended if the primary supervisor had doubts about the bank's Basel II system or the
prudence of the resulting minimum regulatory capital level. Only after a minimum two-year transition
run and only if its primary supervisor had no objection could a U.S. bank operate fully under Basel II
capital rules.
This phase-in plan has been designed to ensure that bank inputs are reasonable and consistent with
sound risk-management practices and that supervisors are comfortable with the safety and soundness
of Basel II before it goes fully "live" in the United States. Please note that only when we get into the
parallel run period will the agencies be able to accurately assess the aggregate capital effects as well
as the effects on individual institutions from the new accord. Only then will banks' systems provide
risk-parameter inputs that comport with the operational requirements of Basel II, and only then can the
U.S. authorities be confident that the resultant capital calculations are reliable estimates of what will
happen when Basel II is fully implemented. Such data would be far superior to those obtained through
the four QIS exercises that we have conducted to date, which, as I have noted, have been carried out
by banks on a best-efforts basis using systems that do not yet meet the standards required under
Basel II. Once we have data from the parallel run period, the agencies can then consider the need, if
any, for a recalibration of the Basel II parameters or other actions to ensure more-accurate risk
sensitivity and a prudent level of overall capital.
This deliberate process provides multiple safeguards to help the agencies move to the final adoption
of the new framework in the United States only when doing so is clearly appropriate. In other words,
our implementation strategy has been designed to be both prudent and flexible enough to move banks
from Basel I to Basel II as their own systems mature and they can provide reasonably accurate
assessments of their credit and operational risks. The agencies' analysis of and reaction to QIS4
results show how those safeguards work: We saw results that gave us concern, and so we are
investigating further before we go to the next stage. Additional, future safeguards - such as the NPR
process and the minimum one-year parallel run and the minimum two-year transition period, with
options to extend either - will also ensure ample opportunity to recalibrate or seek other adjustments if
necessary.
But, for now, we believe that after a certain point, further analysis of QIS4 is likely to reap little or no
additional benefit. We should, of course, try to learn what we can from these data and particularly look
for indications of the need to modify the Basel II proposal where necessary. However, as soon as we
have learned what we can, we should promptly return to the development of the joint NPR and related
supervisory guidance. These documents are essential so that core and opt-in banks can continue to
develop the databases and systems that they would need to operate under the Basel II capital rules
and that would provide more-accurate risk parameter estimates than those in QIS4.
Recall that there have already been three rounds of U.S. public comments on the Basel II consultative
papers between 1999 and 2004; an advance notice of proposed rulemaking (ANPR) in 2003; and
numerous agency discussions with congressional committees, banking groups, and individual banks.
All have resulted in significant modifications to the proposal. Once published, the NPR and the
supervisory guidance will once more elicit comments that could result in further revisions. Particularly
given its delayed issuance, the NPR must solicit feedback from core and potential opt-in banks as to
whether the current timeline for implementing Basel II in this country needs to be delayed or can be
retained.
Looking forward, I agree with my colleagues at this table that it is prudent to delay the NPR in order to
see what we can learn from further review of QIS4 data, recognizing at the outset that final answers
will not be forthcoming because the requisite databases and risk-management systems are not yet in
place. I hope that we can return to the NPR before midyear, present it to the Office of Management
and Budget for its review, as our OCC and OTS colleagues must do, and release the NPR in the fall.
With such a schedule, one might hope that the parallel running period, currently scheduled for 2007,
need not be delayed. But, as I noted earlier, it is important for the agencies to get feedback on this
issue during the NPR comment period. The views of banking organizations will provide critical insights
into the feasibility of the scheduled 2008 start date for the transition run. Once we have the views of
the banking organizations, the agencies will be in a better position to reach a consensus on the
timeline.
Basel II has the potential to be an important supervisory step forward. The Basel I framework is being
arbitraged aggressively and provides us with less and less reliable measures on which to base a
regulatory capital requirement for our largest and most complex banking organizations. Moreover,
banks have spent tens of millions of dollars preparing for the U.S. implementation of Basel II and have
contracts for further investment. They are awaiting the NPR, the guidance, and the final rules. Their
global competitors are proceeding, and U.S. banks will be eager to avoid being placed at a
competitive disadvantage. I might add that, as supervisors, we believe that the core risk-measurement
and risk-management improvements contained in Basel II are appropriate, regardless of how the
future accord is finally structured and calibrated. So it is, in our view, a good idea for banks to continue
their current trajectory of making risk-management investments.
While the regulatory capital requirements ultimately produced by Basel II would be, we believe,
considerably more risk sensitive than the current capital regime, importantly this is not the only capital
regulation under which U.S. institutions would operate. Over a decade ago, the Congress, as part of
the Federal Deposit Insurance Corporation Improvement Act's Prompt Corrective Action (PCA)
regime, defined a critically undercapitalized insured depository institution by reference to a minimum
tangible-equity-to-asset requirement, a leverage ratio. The agencies have also used other leverage
ratios to define other PCA capital categories because experience has suggested that there is no
substitute for an adequate equity-to-asset ratio, especially for entities that face the moral hazard that
accompanies the safety net. The Federal Deposit Insurance Corporation (FDIC), responsible to the
Congress for the management of the critical deposit insurance portion of the safety net, has underlined
the importance of that minimum leverage ratio and PCA as part of a prudent supervisory regime.
The Federal Reserve concurs in the FDIC's view. We need, for reasons I have given, the
risk-measurement and risk-management infrastructure and risk sensitivity of Basel II; but we also need
the supplementary assurance of a minimum equity base. The market and the rating agencies will
continue to require exactly that kind of base, and a regulatory minimum is prudentially desirable.
Even though the market and the rating agencies, not to mention bank management, will still require
banking organizations to carry capital considerably above regulatory minimums, many of the
thousands of depository institutions that will remain under the current capital rules are concerned
about the impact of Basel II on their businesses. This concern is often voiced as a general disquiet
about broad competitive feedbacks but also about competitive implications in specific markets. The
Federal Reserve has published a series of research papers investigating such concerns voiced in
public comments on the previous ANPR on Basel II. These studies have indeed suggested that there
are potential effects that should be addressed in the small business and residential mortgage markets.
For this reason, as well as to continue to modernize the current capital regime, the agencies are
developing, simultaneously with the Basel II proposal, a proposal to revise the current capital rules for
non-Basel II banks to make those rules more risk sensitive and to blunt any unintended harm that
Basel II might impose on non-adopters. Our intention is to keep these proposed changes simple to
minimize any costs imposed on the many non-adopters. We plan to issue these proposals for public
comment concurrently with or soon after the NPR on Basel II, to allow the banking community to
comment on a combined package of proposed changes. However, these revised Basel I rules would
not be an adequate substitute for the necessary capital reforms for the large, complex, global banks
operating in this country because they would not provide the incentives for banks to adopt the
more-sophisticated risk-measurement and risk-management techniques envisioned by the Basel II
proposal.
Chairman Bachus and Chairman Pryce, I would also like to present the Federal Reserve's views on
H.R. 1226, a bill setting up a committee of the four banking and thrift regulators to reach a common
U.S. position on Basel issues and authorizing the Secretary of the Treasury, as its chairman, to
determine a common position on any issue about which the regulators could not agree. The Federal
Reserve believes that the bill does not fully reflect the existing process used by the four agencies to
develop and modify Basel II and we would counsel that Congress not enact it.
Staff members of the four agencies have held frequent and comprehensive discussions about Basel II
throughout the process. Certainly, the agencies have sometimes disagreed on specific issues, and we
will sometimes disagree in the future. But we have in the past been able to find a common position
that we can all support at Basel, and we will do so in the future. The salient fact is that any one of us
has a veto over the entire proposal because we all realize that different rules cannot be applied to
similarly situated insured depository institutions. That fact forces us to develop consensus positions on
which all of us can agree. We have done so in the past because we understand that if the agencies
cannot reach a collective agreement at Basel, the Basel II reforms will not be implemented in the
United States while they go forward in the rest of the world. Communication, compromise, and comity
are the prerequisites for agreement among the agencies.
Further, the ability of the U.S. agencies to negotiate effectively at Basel would be severely constrained
if our foreign counterparties knew that we had to return to a committee before we could agree. The
formalized "decision by committee" approach of H.R. 1226 would not advance U.S. interests in the
complex and dynamic Basel negotiation process. The U.S. banking agencies need to preserve our
current flexibility to respond to Basel issues if we are to develop a set of capital rules that are useful
and productive for U.S. banks and thrifts. Moreover, it is possible that the agencies are more likely to
implement effectively an agreement that they helped shape than they would be one that was imposed
on them and for which they did not understand fully the rationale. While we urge the Congress not to
move forward on this bill, we look forward to keeping Congress fully informed as the Basel process
continues.
I will be pleased to answer your questions.