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Remarks by Governor Laurence H. Meyer

At the Bank Administration Institute's Conference on Treasury, Investment, ALM,
and Risk Management, New York, New York
October 15, 2001

Basel II: Moving from Concept toward Implementation
Thank you for giving me the opportunity to discuss the bank capital reform process that
continues to be developed under the auspices of the Bank for International Settlements in
Basel. It is a particular pleasure to review developments with this audience of bank treasury,
investment, and risk-management practitioners that has been assembled by the Bank
Administration Institute to analyze the implications of Basel II.
Perhaps I should begin by noting that this has been, and continues to be, a long and difficult
process. Many important parts of the proposal have not yet been announced or are in the
process of modification. I hope today to clarify the reasons the process is taking longer than
we had expected it would. I hope that by reviewing our objectives and the challenges we all
face--virtually all of which reflect the sheer complexity of modern commercial banks--we
might gain a better understanding of the future schedule and more support for the process.
We need your support. And I believe that the U.S. banking system will be even stronger if
we can develop an effective process for improving internal-ratings-based systems at our
banks and then key our capital and supervisory processes and procedures to such systems.
That is what the Basel proposal is all about.
I. The Vision
It is, I think, too easy, as we contemplate the complexities and the resultant apparent
slowness of the process, to lose sight of the point I've just made and to forget what we're
trying to do. Let me underline that our ultimate objective is a safer and sounder banking
system through better risk management at banking organizations. The tools are risk-based
capital (pillar I), risk-based supervision (pillar II), and disclosure of risks to enhance market
discipline (pillar III). The approach is to incorporate within the regulatory and supervisory
processes some of the quantitative risk-management tools that large complex banking
organizations (LCBOs) now use, or will be using by the time the enhanced Accord is
implemented, to evaluate and manage their own risk positions. This requires--and it is
essential to our vision--that both supervisors and banks focus on the same positions,
controls, and objectives. In the process, not only would other LCBOs be required to improve
their risk management, but, in addition, a system would be established that can evolve
naturally as risk-management practices themselves evolve.
For the most part, these new quantitative techniques are designed to address risk at LCBOs.
They involve highly detailed and comprehensive management information systems. Such
systems are cost effective for LCBOs, but they simply do not apply to the vast majority of
banks in this country or, for that matter, to smaller and regional banks any place in the
world. For this reason we do not intend that the hallmark of Basel II--the harnessing of

internal-ratings-based systems for use in the supervisory process--be applied in this country
to any but the largest and most complex banking organizations. Indeed, the internal-ratingsbased, or IRB, approaches explicitly assume within their risk-weight formulas a high degree
of portfolio diversification that very few banks can achieve.
As you know, there are two versions of the IRB approach: Foundation and Advanced. The
Foundation version has a high degree of built-in conservatism, under which rigid
supervisory rules would establish many of the credit-risk parameters that would determine
bank capital requirements. That is because the Foundation approach is designed to address
either banks in the early stages of developing their risk-management systems or those
operating in a supervisory environment that is not yet prepared to validate and enforce the
sound-practice standards applicable to banks under the Advanced IRB approach. In this
country, the Foundation version may be useful as a transition for banks that have not yet
developed the ability to estimate all of the necessary credit parameters or have not
convinced their supervisors that they can both do so and use those parameters in making
credit decisions. The Foundation version may also be useful for large organizations that
have relatively limited business lines.
But we would expect--and we believe the market would as well--that the LCBOs will switch
quite rapidly to the Advanced version of IRB. These entities, by their very nature, will be
expected to have implemented the risk-management systems required by the Advanced
version. If they do not, supervisory pressures and market realities will bring very strong
inducements indeed upon such organizations to change their procedures.
The Standardized approach to Basel II is extremely close to the current Basel I and should
ultimately involve quite modest changes on the part of most non-LCBO U.S. banks. Indeed,
it may not even be cost effective to apply the Standardized approach in this country, with
only modest revisions to the current Basel I suggested for most, certainly all smaller, banks.
It is, of course, not an option for LCBOs in the United States, given our risk-management
objectives.
We expect significantly different impacts across the small number of large U.S. entities that
will use the Advanced IRB approach. That is because the intention is not to develop a
cookie-cutter, one-size-fits-all set of requirements. Rather, each bank is to develop
meaningful, empirically based risk classifications across its credit portfolios and subportfolios. For each sub-portfolio of loans, each bank will estimate the probability of
default, the expected loss given default, exposure at default, and the associated capital to
meet selected solvency standards. The supervisors will evaluate the risk-classification and
risk-estimation processes at each bank using the Advanced IRB approach of Basel II, and if
the processes are found to be acceptable, those classifications and associated capital needs
will be the basis for the minimum regulatory capital requirements. To ensure the credibility
of this process, we will expect those same risk classifications and quantifications of default
probabilities and loss severities to be used for pricing, reserving, internal capital allocation,
and other management purposes. Not doing so would raise doubts about using these data at
that bank for establishing capital requirements. We want our supervisory standards to be
based as closely as possible on the information managers use to run the bank.
We expect a wide distribution of minimum regulatory requirements across the individual
LCBOs, reflecting the differences in their portfolios and risk preferences. We anticipate,
however, that the average minimum regulatory requirement will decline under the Advanced

IRB capital structure. It is less clear that the amount of capital held will adjust quite as
much, for several reasons. Pillar II of the proposed new Accord, enhanced supervision,
might call for additional capital at individual institutions, depending on the supervisors'
evaluation of controls, management, individual risk structures, and so forth. These variables
are difficult to capture in pillar I through formal capital regulations. Pillar II will also
address those risk areas--such as interest rate risk--for which it is not optimal to develop a
single pillar I rule applicable to all banks. Pillar III, as you know, calls for enhanced
disclosure of risk exposures to the public. And we expect that market and supervisory
discipline will ensure that banking organizations maintain sufficient capital above the
regulatory minimums as a prudent sound-banking practice. That has certainly been the case
under the current capital regime.
Pillars II and III have not, I think, received the attention they deserve by the industry.
Perhaps it is because of the challenge of developing a new regulatory regime. Perhaps, also,
banks in the United States believe that they are already subject to supervisory oversight
(pillar II) and already engage in sufficient disclosure (pillar III). But both pillars are critical
modifications for several important reasons. As I noted, pillar II is designed to avoid the
need to design rules for everything and to give supervisors the flexibility to adjust to fit
individual cases. Pillar III, by harnessing market discipline as another form of oversight, is
also critical to avoiding an increase in regulation that would otherwise come as
organizations become more complex. More disclosure--especially on risk exposures--is
going to be necessary.
Pillars II and III are also extremely important for ensuring that banks here and abroad are
treated consistently. In the United States and in other countries, pillar II supervision is
essential to ensuring, on an ongoing basis, that banks are implementing pillar I in a
disciplined way. The pillar III disclosures are equally important in ensuring a level playing
field among internationally active banks. Those banks in this country that argue that
disclosure will create an uneven playing field vis-à-vis domestic non-banks should consider
whether they might not be better served by disclosure rules for their foreign bank
competitors.
The combination of pillars I, II, and III is necessary to build a structure consistent with the
increasingly important process of internal capital allocation at banks and to achieve what
economists call incentive-compatible regulation. By that we mean a regime in which the
regulatory rules and processes induce behavior that is consistent with the banks' own
systems, objectives, and processes. Such a structure forces supervisors to view the internal
capital-allocation process consistently with bank managers. It may well be that the
supervisors' role in the oversight of economic capital determination and the markets' review
of banks' risk exposure and management may be more important than the establishment of
regulatory capital minimums.
II. The Process
As any manager knows, the process of converting a vision to reality is difficult for reasons
varying from unacceptable costs to conflicting visions. We have been working to revise the
Basel Accord--trying to give birth to Basel II--for half a decade. And I think it important to
underline that we have made tremendous progress. Many things have been decided to
enhance the risk sensitivity of the revised Accord and many of the proposals that needed
modification have been revised. Perhaps most important, the Basel discussions have clearly
begun to move the regulators and the banking industry to focus more on risk management

and its relationship to capital, to analyze the issues, and to collect the data needed for better
quantification.
Nonetheless, it is important to understand why the process of converting vision to reality has
necessarily been a long one. There are three reasons. One is the need to develop consensus
among nations with different banking systems, different supervisory structures, and different
supervisory philosophies. That takes time, and cutting corners would inevitably lead to
undesirable imbalances and competitive inequities. It would be a mistake to underestimate
the importance of this difficulty. Compromises have been made, and more will be necessary
on all sides.
Candor requires that I say that another reason for the slow progress is that the banking
industry was less far along developing its risk-management tools and processes than we had
anticipated. As a result, regulators working closely with the industry, have had to do more of
the original research and data development than we had thought would be necessary. And
while in some areas, industry practices are clearly converging, in other areas a wide
diversity of market practices still prevails. This has forced supervisors to devise a regulatory
approach that accommodates innovation while providing an adequate degree of consistency.
Beyond the difficulty of reaching an agreement and the challenge of identifying emerging
sound practices, the most important reason for delay is the sheer complexity of moving from
concept to application. The state of practice is dynamic--indeed, the efforts to develop a
Basel II, as I said, have themselves accelerated advances in risk-management practices. But
all of us are facing issues that either we had erroneously thought were relatively simple or
we had not at first considered. It has taken time to work through these issues. Moreover, we
should not lose sight of the fact that large, complex banking organizations--for whom the
real innovations at Basel are designed--are themselves, well, complex. Capital regulations
cannot be extremely simple and at the same time appropriately sensitive to the multifaceted
operations and risks of the LCBOs. We could try to apply simple rules to complex
organizations, but the result could be easily predicted: We would not solve the problems of
capital arbitrage and risk sensitivity, and the rules would treat some operations at some
banks unfairly. As in medicine, the first principle should be, "Do no harm." And that means
that the rules will be complex in order both to be fair and to avoid unintended consequences.
One of the complexities of unbundling risk-related capital charges is, in the view of many
Basel Committee members, the need for an explicit capital charge for operational risk.
Devising such a charge has proved extremely difficult because of a lack of both an agreedupon methodology and credible industry data. This has required the adoption of a strategy to
permit banks to use their own internal measurement approaches--subject to quantitative and
qualitative criteria and, on a transitional basis, to a minimum or floor capital charge. Soundpractice guidelines are also being developed for the pillar II supervisory review process. The
interval before final implementation in 2005 provides time for both the industry and
supervisors to develop the database and to develop explicit operational risk charges better
linked to the real risk at each bank.
The Federal Reserve, and I believe the other U.S. agencies, have been, and will continue to
be, committed to developing and applying a truly risk-based capital framework and
supervisory process for both operational and credit risks. As with any such massive effort,
timetables are required in order to motivate and to coordinate broad organizational efforts.
But we have a prior commitment, one that discussions with the industry suggest that you

share. That commitment is: To get it right. If we imposed a flawed structure on the industry,
we would be doing a disservice to the banking industry and shirking our public
responsibilities. Thus, we will continue to try to get it right, even if it means more delay and
modification to time schedules than either group wants. Of course, we also understand that
the capital framework will continue to evolve as market practices change and supervisors
learn more about the strengths and weaknesses of what we develop. Getting Basel II right
does not mean that it can or will be perfect, even on the day the initial rule becomes final.
Critical to getting it right is a genuine interaction of the regulators and the banking system.
We simply cannot develop Basel II correctly without your help. That does not mean
dropping every feature that some entity believes is too costly or too burdensome or would
put a crimp in a particular activity. But it does mean that, given our objective of creating a
risk-based capital system to promote better risk management and a safer banking system, we
need your operational skills and counsel. The industry's initial assistance and subsequent
comments on this year's January consultative document were, by and large, exactly in that
vein. They were extensive and exceptionally thoughtful, and most were genuinely designed
to produce a better system to address both private and public needs. We have taken them
seriously, and responding to them has been time consuming. You will, I think, see the result
in the next consultative document which I hope will be published early in 2002. But we need
continued assistance from an even broader range of institutions.
I trust that when the 2002 consultative document is published early next year, the banking
industry will provide us with thoughtful feedback, and especially information, to help us
gauge the overall quantitative effect of the proposals on your respective institutions. This
must be an iterative process involving supervisors and the banking industry, and there must
be mutual trust if it is going to work effectively. It is not necessarily our intention to avoid
rules that an individual bank may find costly or inconvenient, but rather to avoid unintended
consequences that raise costs beyond their benefits. Moreover, we hope that your comments
will be preceded by an understanding that our wider objective is to develop a safer and
sounder banking system by strengthening risk management at banking organizations.
I would like to underline that as extensive as our database is, as large as the data collection
burden is for you, we simply do not have the individual bank information to estimate
accurately the effect of alternative proposals on your capital requirements; it is up to you to
tell us. We are, as I have said, trying to get it right.
The comment process will continue to be extensive. I already mentioned the BIS third
consultative document, which is expected early next year. At some stage, as the proposal
becomes more definitive, the U.S. agencies will have to go through the U.S. rule-making
process, with an additional request for comment. And any final rule would have a delayed
effective date to allow both the industry and the regulators sufficient time to implement
what will, by necessity, be a complicated rule. But between now and the effective date of the
new rules, as our mutual needs and mutual capabilities change, we cannot remain idle. Large
banks need to continue to enhance their internal risk classification systems, develop
empirically based techniques for risk classification of pass loans, and strengthen the process
for calculating their internal economic capital requirements. For our part, we have begun to
train our examination staffs to evaluate banks' internal systems. Since we will also be living
with the current Accord for some years before Basel II can be implemented, we are also
shoring up the present capital rules, such as the treatment of recourse and other retained
interests in securitization transactions.

The effort to improve capital rules and develop better risk management is thus multifaceted.
I would not, however, like to lose sight of the fact that the establishment of pillar I is, at
least for the next few months, the Prince in this production of Hamlet, or the centerpiece of
Basel II for the non-English majors in the audience. Thus, much depends on both pillar I's
level and how it's interpreted. That raises the issue of calibration.
III. Problems of Calibration
The single biggest problem in developing a final proposal for Basel II is the calibration of
the absolute level of the minimum required regulatory capital. You might think of the
calibration process as establishing the average amount of capital to be minimally required in
the banking system, understanding that in a risk-sensitive system, the required level can be
expected to vary across individual banks. The January 2001 proposal was criticized for
setting the absolute level of capital too high, and it may well have been too high. But we-and the banking industry--are struggling with three related challenges in determining the
right level. These challenges are, first, reaching agreement about the right number in a stable
world; second, making whatever adjustments are needed because we live in a world with
crises and business cycles; and third, making sure the different approaches offered in the
new Accord fit together properly.
Let's begin with establishing the right level of minimum regulatory capital in a stable world,
or as Sherlock Holmes might pose the question, "Is 8 percent the right solution?"
Many risk managers might respond to the search for the "right" average capital requirement
by arguing that one should develop and implement portfolio risk models and use the
answers, allowing appropriate margins for model error. At the beginning of the Accord
revision process, many risk managers assured regulators that the art of credit-risk modeling
was advanced and that there was broad consensus. However, upon further investigation,
regulators--and I believe many practitioners themselves--have discovered that there is less
rigor and less consensus than had appeared to be the case initially. Such diverse views and
practices reflect the ugly fact that the devil is in the details of model parameter values. This
lack of agreement, together with the associated uncertainty, is not just a problem for the
regulators. To the extent that banks and market participants rely on such models for internal
pricing, capital allocations, and other decisionmaking purposes, this is a problem for us all.
The fact is that we--both supervisors and bankers--do not yet know the right answers with
high confidence. In these circumstances, the Basel II process could lose momentum unless
we can agree to go forward with something that seems reasonable and with the
understanding that reasonable people may differ and that changes may be needed as we gain
experience.
The problem becomes even more complex when we recognize that market economies are
cyclical and have crises. In a risk-sensitive system, we expect that the risk measures in the
capital formula will have worse values at the trough than at the peak, so capital requirements
will move somewhat as macroeconomic conditions change. This is often called the problem
of procyclicality of capital requirements. If the minimum capital requirements rise as the
economy weakens, it can be argued that a system of risk-sensitive capital requirements may
lessen credit availability at just the wrong time. The jury is still out on just how procyclical
the Basel II framework ultimately will be, or whether it may, in fact, be less procyclical than
the current system in which the lack of rigor in credit evaluations itself creates a procyclical
pattern of reserving and charge-offs. We have already taken some steps to address
procylicality concerns since issuance of the January 2001 consultative package. For

example, we've improved the proposal's treatment of expected losses--and other measures
are in train.
Finally, there is the problem of making the pieces of the new Accord fit together. The Basel
Committee has said it wants modest capital relief incentives for large, international banks to
move from the Standardized to the Foundation version of the IRB approach and similar,
perhaps larger, additional incentives to move from the Foundation to the Advanced version.
But as I noted, these approaches and versions were designed for banks of very different
levels of complexity and sophistication and for different regulatory regimes. The basic riskweight functions are the same across the Foundation and Advanced versions of the IRB
approach. Because of the conservatism built into the Foundation version, capital
requirements for a given bank under the Advanced version, at least in this country, could be
considerably less than under the Foundation version. If the revised Standardized approach is
calibrated to yield capital similar to that of the current Accord and Advanced requirements
are far below Standardized requirements, in the United States there may well be a very large
reduction in capital requirements relative to today's levels for the banking system as a
whole. This is because we expect virtually all LCBOs to choose--or to be induced to choose-the Advanced approach.
I must tell you frankly that regulators here and abroad would be quite uncomfortable if
Basel II resulted in a substantial shedding of capital by the world's megabanks. At least until
we have more experience, I think you should expect that we will have transition rules
designed to limit the amount of actual reduction in capital that will be permitted, at least
until we have time to evaluate the actual experience under Basel II. That is part of the
necessary requirement to be sure we've got it right before errors become irreversible.
I suppose that too little capital is more of a challenge for regulators than for banks. But this
problem arises from features of the real world that none of us can ignore. Supervisory
philosophies and resources differ quite a bit across countries, and we must have a regulatory
capital regime that can accommodate such differences. At the same time, we all believe that
there must be competitive equity, and that banking systems must be well-enough capitalized
to be stable. As I noted earlier, perhaps pillars II and III and market realities will blunt the
problem of excessively low capital. But you will understand, and I hope respect, our need
for caution.
IV. Summing Up
I am sure of one thing: The next Accord will be imperfect no matter how hard we all try.
The challenges are daunting, and I doubt we can meet them all at the outset. But I believe
we will develop a set of rules and policies that will be a substantial improvement over the
current framework and--most important--that the new groundwork will spur important
further progress in risk management and in banking supervision. Indeed, if the effort does
nothing but improve risk management at banks and improve the risk focus of supervisors, it
will be worth the time and resources we have all expended. But if you will help us with your
comments and suggestions, I think we can come closer than that to the vision I described.
To do so is in the interest of us all.
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