Susan Schmidt Bies: Basel II and commercial real estate
Testimony of Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve
System, before the Subcommittee on Financial Institutions and Consumer Credit, Committee on
Financial Services, US House of Representatives, Washington, DC, 14 September 2006.
* * *
Chairman Bachus, Representative Sanders, and members of the Subcommittee on Financial
Institutions and Consumer Credit, I thank you for the opportunity to discuss the developments relating
to bank regulatory capital requirements in the United States, including the U.S. implementation of
Basel II and updates to regulatory capital rules for market risk, as well as the regulatory agencies'
proposed guidance on commercial real estate (CRE) concentration risk.
Developments related to regulatory capital requirements in the United States
As Subcommittee members may know, last week there were some very positive developments in the
process to revise regulatory capital requirements for large, internationally active U.S. banking
institutions. First, the Federal Deposit Insurance Corporation board approved the Basel II notice of
proposed rulemaking (NPR) on the advanced capital adequacy framework, commonly referred to as
Basel II. At the same time, the FDIC board approved an NPR that would update the U.S. regulatory
capital rules for market risk exposures. The Office of the Comptroller of the Currency and the Office of
Thrift Supervision took similar actions on the same day. Together with the Federal Reserve's approval
of the draft Basel II NPR in March and the market risk NPR in August, these steps complete all
necessary approvals for the two NPRs to be published in the Federal Register for formal public
comment. Proposed templates for regulatory reporting requirements associated with the two NPRs will
be published in the Federal Register for comment at the same time.
Regarding market risk exposures, that NPR is based on a set of revisions developed jointly by the
Basel Committee and the International Organization of Securities Commissions (IOSCO) in 2005 to
update the Market Risk Amendment (MRA), developed a decade ago by the Basel Committee. These
amendments would apply to any banking organization that has significant trading book activity,
whether it stays on Basel I or moves to Basel II in the United States. The market risk NPR is intended
to improve the risk sensitivity of the market risk capital framework. Further, it will serve to level the
playing field between U.S. banking organizations and securities firms that are subject to similar capital
requirements.
Moving to the main focus of today's hearing, the Basel II framework represents an important effort by
supervisors to integrate modern risk-management practices with regulatory capital requirements. We
are pleased that the four federal banking agencies have reached consensus to move ahead with the
process for Basel II and the market risk update. We recognize the significance of this development to
the industry, the Congress, and others who have waited for greater specificity about U.S. efforts to
implement Basel II. It has taken quite a bit of work to reach this point. I would like to thank my
colleagues here at this table and their staffs, as well as the Fed's own staff, for their tireless efforts.
Overview of proposed rulemakings
The Basel II NPR is designed to improve the risk sensitivity of U.S. bank regulatory capital
requirements and to enhance the risk-measurement and -management practices of large,
internationally active U.S. banking organizations. The NPR is based on the 2004 capital adequacy
framework released by the Basel Committee on Banking Supervision. That framework contains the
now-familiar "three pillars" of minimum capital requirements for credit and operational risk (Pillar 1),
supervisory review (Pillar 2) and public disclosure (Pillar 3). As you are aware, the agencies propose
to adopt all three pillars in the United States. In Pillar 1 as proposed by the Basel II NPR, only the most
advanced internal ratings-based approach (A-IRB) for credit risk and the advanced measurement
approaches (AMA) for operational risk would be available, and the framework as a whole would be
required only for the largest, most complex, internationally active U.S. institutions. In contrast, in many
other countries all banking organizations are required to adopt Basel II because Basel I will be
dropped when Basel II takes effect. To make Basel II appropriate for the wide variety of financial
institutions, three credit risk and three operational risk approaches were developed in the 2004
framework.
The A-IRB approach for credit risk in the Basel II NPR requires institutions to estimate key risk
parameters for each type of credit exposure, subject to supervisory review, and to calculate a capital
requirement by using those risk parameters as inputs. The AMA approach for operational risk requires
institutions to calculate a capital requirement based on their individual operational risk profile - again,
subject to supervisory review. The Basel II NPR also specifies, as part of Pillar 2, that each institution
must develop a rigorous internal process for assessing its overall or total capital adequacy in relation
to its risk profile for other types of risk and through economic cycles. These internal assessments will
enable each institution to determine the appropriate level of capital for its unique long-term business
strategy. These internal capital assessments are, we believe, critically important, and are also subject
to supervisory review. Finally, institutions must publicly disclose key information relating to credit and
operational risks, under Pillar 3, to ensure adequate transparency for market participants, customers,
and counterparties, so that market discipline can also work effectively to differentiate risk exposures
among banking organizations. I would like to stress that the Basel II framework has three Pillars and
note that Pillars 2 and 3 are critical components of the overall framework. They should not be
overlooked.
Federal
To accompany the Basel II and market risk proposals, the agencies plan to publish in the
Register reporting requirements for institutions planning to adopt Basel II and the updated market risk
rules in the United States. Each institution that qualifies for and applies the Basel II capital rules and
the updated market risk rules would file quarterly regulatory data, some of which would remain
confidential, for the agencies' use in assessing and monitoring the levels and components of each
reporting entity's risk-based capital requirements and the adequacy of the entity's capital. These data
also would support the agencies' efforts to analyze the quantitative impact and competitive
implications of the Basel II capital rules and the updated market risk rules on individual reporting
entities and on an industrywide basis. In addition, the reporting schedules will help clarify for these
entities our expectations surrounding the systems and other infrastructure necessary for
implementation and validation of the two proposals. The submitted data would supplement on-site
examination processes, and the data released publicly would provide other interested parties with
information about banks' risk profiles and capital adequacy.
Importance of the regulatory capital proposals
While our reasons for moving to Basel II have not changed since we began this endeavor, I believe
they are worth reiterating. Our core reason is that the current Basel I framework is inadequate for the
largest, most complex U.S. banking organizations. The current Basel I capital requirements simply are
not able to capture the full array of risks facing these organizations. For example, they do not explicitly
recognize the operational risk embedded in many of the services from which the largest institutions
generate a good portion of their revenues today.
Further, Basel I does not differentiate the riskiness of assets within the major asset types based on
either borrower creditworthiness or the presence of collateral or other risk mitigants. This lack of
sophistication can lead to significant distortions and capital arbitrage. The capital required for the
various types of exposures should reflect the unique business strategy of each institution, rather than
be based on an assumed homogeneous risk position. As banks consciously choose to take higher risk
exposures, Basel II requires them to hold additional capital to reflect their business choice. Basel I
capital is fixed throughout economic and business credit cycles, and as such, does not require banks
to increase capital as their potential for losses rises. Basel II addresses this by including in Pillar 2 the
requirement that the bank have a plan in place to ensure that sufficient capital will be available in the
downturn of the economic cycle. Thus, for the largest organizations, we need to move beyond Basel I
to a more risk-sensitive and more comprehensive framework for assessing capital adequacy. Basel II
represents the concerted efforts of the international and U.S. supervisory community, in consultation
with banks and other stakeholders, to develop such a framework, drawing upon well-known economic
capital concepts that the largest banks already employ as part of their risk management efforts.
In addition to its supervisory authority, the Federal Reserve, as the nation's central bank, has
responsibility for maintaining stable financial markets and ensuring a strong financial system. That
responsibility mandates that we require banking organizations to operate in a safe and sound manner
with adequate capital that appropriately supports the risks they take. This is especially critical in
today's environment where we have a growing number of banking institutions with more than $1 trillion
in assets, complex balance sheets, opaque off-balance sheet transactions, and far-reaching
operations that pose significant risk-management challenges that are fundamentally different from
those faced by smaller institutions. Naturally, we must also ensure that our regulations and
supervisory oversight are in tune with bank practice, are able to identify the risks being taken by banks
today, and have enough flexibility that they will continue to be prudent and relevant in an
everchanging risk environment. As Chairman Bernanke has noted, a regulatory and supervisory system
that is not in tune with the financial marketplace may increase the costs of regulation, stifle efficiency
and innovation, and ultimately be less effective in mitigating the moral hazard problems associated
with the federal safety net.
The advanced approaches of Basel II are much more risk sensitive, cover more areas of potential risk
facing banking organizations, and provide incentives for these institutions to improve risk
measurement and management. In addition, Basel II provides supervisors with a more conceptually
consistent and more transparent framework for evaluating systemic risk in the banking system,
particularly through credit cycles. In sum, Basel II will establish a more coherent relationship between
regulatory measures of capital adequacy and day-to-day supervision of banks, enabling examiners to
better evaluate whether banks are holding prudent levels of capital given their risk profiles.
Continuing the implementation process
The agencies' proposed rulemakings, representing our view about how Basel II should be
implemented in the United States, are being published in the Federal Register for review by the
industry, the Congress, and the general public. The core goal of Basel II, as noted earlier, is to
promote the stability of the U.S. financial system by ensuring the safety and soundness of U.S. banks.
As Chairman Bernanke has said, the ability of Basel II to promote safety and soundness is the first
criterion on which the proposed Basel II framework should be judged. The agencies have presented
proposals and will now engage in a continuing dialogue with all interested parties as to whether those
proposals meet our stated objectives and can be improved.
During the entire process to develop our proposed rulemakings, the agencies have been engaged in a
dialogue with the industry, the Congress, and others about both the direction that U.S. Basel II
implementation should take and specific implementation details. Many of the comments received to
date have been incorporated into our proposals. In that respect, we have been carefully considering
comments received so far and discussing among ourselves how to address them. In addition, we have
conducted extensive analysis of other information we have been collecting, such as the results of
quantitative impact studies (QIS), and those results have helped shape the proposals as well. In
making adjustments to our proposals based on comments and new information, we have been as
transparent as possible. Going forward, we will seriously consider all comments on the proposals. For
example, the proposals contain a number of specific questions soliciting comments in key areas. With
these questions, the agencies are trying to highlight areas on which the agencies would like additional
information. The agencies will continue to carefully consider all comments received and thoroughly
analyze all relevant information as we work to develop a final rule for Basel II.
I also want to acknowledge that the agencies have received comments from several banks and other
parties suggesting that banks should have more choices with regard to both credit and operational risk
in Basel II in the United States. We have taken these comments seriously and the NPR now includes a
specific question on whether the U.S. version of Basel II should include a so-called "standardized"
approach to credit risk. We look forward to receiving detailed comments on this and all aspects of the
proposals.
The agencies' proposals contain certain transitional safeguards beyond what is contained in the 2004
framework. Indeed, these proposed safeguards reflect our intent to ensure that there are no material
weaknesses in our proposals prior to full operation. First, we continue to monitor institutions' progress
toward satisfaction of the Basel II risk-measurement and -management infrastructure standards. In
addition, our proposals contain a parallel-run period in which we will have the ability to analyze and
directly compare capital requirements under existing rules and those produced by Basel II while
institutions remain subject to the current rules. Beyond the parallel run, the agencies have proposed a
three-year transitional floor period, more stringent than that in the 2004 Basel II framework, to prevent
an unwarranted decline in capital levels. In addition, current supervisory safeguards, such as the
existing leverage ratio and prompt corrective action, will continue to provide an important backstop
against a potential unwarranted decline in bank capital levels. In general, if we at the Federal Reserve
see that the U.S. Basel II proposals are not working as intended, we will seek modifications to them.
Proposals to amend existing Basel I rules
At this point, I would like to say just a few words about ongoing efforts to revise the existing Basel I
regulatory capital rules for non-Basel II institutions. We expect only one or two dozen institutions to
move to the U.S. version of Basel II in the near term, meaning that the vast majority of U.S. institutions
will continue to operate under Basel I-based rules, which we intend to amend through a separate
rulemaking process. 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 banking environment
and as a result of a better understanding of the risks of individual products and services. The agencies
believe that now is another appropriate time to propose modifications to our Basel I rules. The
agencies have issued an advance notice of proposed rulemaking (ANPR) discussing 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 are now reviewing comments on the ANPR and
working on a notice of proposed rulemaking. 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.
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 to have overlapping comment periods for the
Basel II NPR and the NPR for the proposed Basel I amendments. In fact, we want all interested
parties to compare, contrast, and comment on the two proposals in overlapping timeframes.
Accordingly, either of our proposals could change as a result of comments received or new information
gathered.
Conclusion
From the Federal Reserve's perspective, the forthcoming publication of interagency proposals relating
to Basel II is a very positive development and demonstrates the ability of the agencies to work
cooperatively to modernize our regulatory capital framework. The Federal Reserve's commitment to
the Basel II process remains as strong as ever, even as we recognize that the proposals remain
subject to further comment and that there is likely much more work to be done. We encourage
comments from all interested parties and will give them careful consideration. I would like to
emphasize the Federal Reserve desires to ensure that the final rule for Basel II is a substantial
enhancement over existing Basel I rules, appropriately capturing the risks of our largest, most complex
banks, and encouraging continual improvement in risk-measurement and -management systems. We
look forward to working with the other agencies as we enter into the final rule phase of the Basel II
process.
We recognize that many institutions have been diligently preparing for Basel II implementation and we
understand our obligation, as supervisors, to support institutions wanting to adopt Basel II at the first
available date. We suggest that those institutions continue to move forward with implementation
planning, including identification of gaps in their own preparation.
Finally, I would like to assure the Subcommittee members that we at the Federal Reserve are pursuing
Basel II because we believe it will help to preserve the safety and soundness of our nation's banking
system. In our dual role as central bank and supervisor of banks, bank holding companies, and
financial holding companies, the Federal Reserve is committed to ensuring that the Basel II framework
delivers a strong and risk-sensitive base of capital for our largest and most complex banking
institutions. That is why we stand behind the additional safeguards contained in the Basel II NPR to
ensure strong capital levels during the transition to the new framework. We will remain vigilant, on an
ongoing basis, in monitoring and assessing the impact of Basel II on both individual and aggregate
minimum regulatory capital requirements and in employing rigorous and thorough analysis to support
our evaluation. By so doing, we believe that the proposals being discussed today can be implemented
responsibly and in a safe and sound manner.
Proposed interagency guidance on commercial real estate concentration risk
The four federal bank and thrift regulatory agencies issued joint proposed guidance in January 2006
on the sound risk management of commercial real estate concentrations. The comment period closed
in April. The proposed guidance generated significant interest. The Federal Reserve received more
than 1,600 comment letters on the proposed guidance. Typically, the comments raised concerns about
the intent and purpose of the proposed guidance. Over the past few months, the Federal Reserve and
the other federal banking agencies have been reviewing these comments carefully and have met with
industry trade groups and individual bankers.
In my testimony today, I would like to provide some perspective on why the agencies are concerned
about CRE concentrations and the risks they may pose, and why we saw the need to issue the
proposed guidance. I will also address the intent of the proposed guidance and some misconceptions
that have arisen.
First, I would like to explain how we define commercial real estate. For purposes of this guidance,
CRE loans include land development and construction loans (both commercial and 1- to-4 family
residential construction) and loans secured by raw land, multi-family property, or nonfarm
nonresidential property where the primary or a significant source of repayment is derived from rental
income associated with the property or the proceeds of the sale, refinancing, or permanent financing
of the property. The proposed guidance does not apply to owner-occupied CRE loans where the
majority of repayment comes from income from the borrower's business operations.
Over the past dozen years, the agencies have observed a material rise in CRE concentrations at
many banks. For small- to medium-sized banks, in particular, the growth in CRE concentrations has
been significant. This growth in CRE concentrations is understandable as community-based banks
have experienced increasing competitive pressure from larger banks and other financial services
institutions in other lending areas.
We recognize that asset concentrations can, on a practical basis, be difficult to avoid due to an
institution's marketplace, area of expertise, or competitive environment. However, as experience has
amply demonstrated, large and growing asset concentrations such as we are seeing today in some
banks can adversely affect banks' earnings and capital, and indeed banks' safety and soundness, if
not properly managed. For that reason, prudent banks have long understood the importance of
managing credit concentration risks - it is one of the basic tenets of banking that the Federal Reserve
has long emphasized.
So what exactly are concentrations of credit and what risks do they pose to institutions?
Concentrations of credit are generally defined as groups or classes of loans or other credit exposures
that share common risk characteristics or sensitivity to adverse economic, financial or business
developments. For a given concentration, when weaknesses develop in a common risk factor or
factors, loans within that concentration may be adversely affected, even if every individual loan has
been underwritten prudently. As bank supervisors, we have seen the dangers of credit concentrations
in previous CRE credit cycles.
Let me provide you with some details on the trend we have observed. CRE concentrations have
almost doubled between 1992 and 2005 for all commercial and savings banks with assets between
$100 million and $10 billion. During this period, for those banks with assets between $100 million and
$1 billion, CRE concentrations rose from 160 percent to 294 percent of capital, while for those with
assets between $1 billion and $10 billion, CRE concentrations rose from 143 percent to 266 percent of
capital.
Why are the agencies focusing on CRE concentration risk? The agencies are concerned that the high
CRE concentrations would make institutions more vulnerable to adverse changes in CRE markets.
CRE markets tend to be among the most cyclical, prone to boom and bust economic cycles. This is
because a poorly underwritten project or overbuilding in a market can have significant negative effects
on CRE loans that are soundly underwritten. To increase occupancy rates, weaker projects may lower
rents and provide more generous terms to attract tenants. This in turn can reduce cash flow to
stronger properties and put those credits at risk.
As you know, in the late 1980s and early 1990s, concentrations in CRE lending, coupled with weak
underwriting and depressed CRE markets, contributed to large credit losses at some banks, significant
numbers of bank failures, and financial stress at many other banks. After recovering from the severe
credit losses of that CRE downturn, most U.S. CRE markets have enjoyed very benign conditions. But
investment in CRE is again growing strongly, and we expect banks to assess the vulnerabilities of their
portfolios to loss in expectation of the next downturn.
Compounding our concern about rising CRE concentrations is feedback from our examiners that some
institutions' risk-management practices have not kept pace with the growth in their CRE
concentrations. Supervisory staff have found weaknesses in fundamental risk-management areas
such as board and management oversight, risk assessment, and monitoring. In addition, examiners
have observed that institutions have not always sufficiently addressed CRE concentration risk in their
strategic and capital planning.
We are also carefully monitoring underwriting standards. While the U.S. CRE market is generally
performing well, underwriting terms and conditions have been softening over the past couple of years,
albeit not to the extent seen in the late 1980s and early 1990s. Loosening loan covenants, expanding
interest-only periods, and extending amortizations are some examples of the weakening underwriting
terms that we are currently observing. Capitalization rates of CRE projects - which measure the
expected investor return on real estate investments - are also near historical lows, which raises
concerns about collateral values and loan-to-value ratios in the event capitalization rates should return
to historical mean levels.
Many bankers have argued that the agencies already have the supervisory tools available to address
concerns about concentrations at individual banks and that the guidance would add unnecessary
regulatory burden. Our current real estate lending guidelines were issued in 1993 under the Federal
Deposit Insurance Corporation Improvement Act. The issuance of guidance to banks and examiners is
one of our most important supervisory tools for focusing attention on emerging risk issues before they
become larger problems and for articulating supervisory expectations to our institutions. Given the
rising concentration levels, and the current stage of this CRE cycle, we believe that there is now a
need for additional CRE guidance to reinforce and build upon our existing guidance and to ensure a
consistent supervisory approach.
It is important to stress that the intent of the proposed guidance is not to restrict CRE lending but
rather to provide a framework for a safe and sound CRE lending program. The agencies recognize
that financial institutions play a vital role in providing credit to their communities. The main message in
the proposed guidance is that banking institutions need to identify and manage credit-concentration
risks appropriately.
Under the proposed guidance, we would expect banks to strengthen their management practices as
their concentration risks grow. The proposed guidance sets forth risk management practices that are
well within the capabilities of many institutions and, in fact, a number of institutions already have many
of these practices in place.
Not surprisingly, the establishment of explicit thresholds in the proposal has generated significant
controversy. Bankers have argued that the thresholds are arbitrary and will be viewed as hard lending
limits by examiners and the industry. I want to re-emphasize that the agencies' intent in proposing
these thresholds was not to limit an institution's CRE lending but to ensure that risk-management
practices are commensurate with this activity. Rather, the thresholds should be viewed as supervisory
screens that examiners should use to identify banks with potential CRE concentration risk. Examiners
would expect organizations to strengthen their portfolio risk management as CRE concentrations
grow. Institutions are expected to conduct their own analyses of CRE concentration risk and establish
their own concentration limits. Institutions, after all, are in the best position to identify and understand
their concentration risk.
Another significant concern expressed in the comment letters by bankers is that the proposed
guidance will be implemented in an inconsistent manner, creating an uneven playing field with some
banks facing higher supervisory expectations. Issuing the guidance on an interagency basis should
encourage a consistent supervisory approach. Further, the agencies are also developing interagency
training materials about the new guidance for their examiners to support more effective and consistent
implementation.
Another concern expressed by bankers is that examiners will take a "one-size-fits-all" supervisory
approach and will not consider a bank's specific portfolio characteristics and risk-management
practices when applying the guidance. The supervisory evaluation of institutions' CRE concentration
risk would always be conducted on a case-by-case basis, taking into consideration the institution's
own analysis of its CRE concentration risk. The diversity of an institution's CRE portfolio, the
effectiveness of an institution's risk-management practices, and the presence of any other factors that
mitigate its risks would be key considerations in the supervisory evaluation of the level of an
institution's CRE concentration risk.
Bankers in their comments also have expressed concern about how examiners will evaluate capital
adequacy for banks with a CRE concentration. The proposed guidance addresses capital adequacy in
a principles-based manner, noting that institutions should hold capital commensurate with the level
and nature of all their risk, including their concentration risk. This message is entirely consistent with
the agencies' existing capital adequacy guidelines. In evaluating capital adequacy, the agencies will
consider, for example, the level and nature of inherent risk in an institution's CRE portfolio as well as
management expertise, historical performance, underwriting standards, risk-management practices,
market conditions, and any loan loss reserves allocated for CRE concentration risk. Moreover, the
quality of institutions' risk-management practices will be a significant consideration in the evaluation of
capital adequacy. Our concerns about capital adequacy will be reduced if an institution has strong
riskmanagement practices. On the other hand, if an institution has inadequate risk management and no
prospects for near-term improvement, there could be a concern that the institution may not have
sufficient capital to serve as a buffer against unexpected losses from CRE concentrations.
Finally, bankers' comments have expressed concerns about how the issuance of the proposed
guidance might affect the availability of CRE credit. The proposed CRE concentration guidance is not
intended to limit or discourage institutions' CRE lending. We recognize that such lending is an
important business activity for banks. We also believe that CRE concentration risk can be safely
managed. In that regard, the proposed guidance is simply intended to reinforce and build upon
existing guidance on risk-management practices for addressing the risks arising from concentrations in
CRE lending.
In conclusion, although it is sometimes an unpopular strategy when loan performance is good, we
believe that it is far more prudent, and indeed our responsibility, to work proactively to address small
but emerging issues to help prevent their evolution into larger problems for the banking industry and
the economy as a whole. That is why we feel it is important to issue this guidance at this time.
Thank you very much for your attention. I welcome any comments you may have and will be happy to
answer any questions.