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Testimony of Vice Chairman Roger W. Ferguson, Jr.
Basel II
Before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate
June 18, 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 risk-sensitivity, that is the hallmark of Basel II. The modified definition of riskweighted 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 riskweighted 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 riskmeasurement 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 A-IRB 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 self-selecting 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 lower-quality, 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 risksensitive 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, risksensitive 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 riskmitigation 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 risk-reducing 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
Basel II framework, portfolio by portfolio if necessary. Basel II would not lock risk
management into any particular structure; rather Basel II could evolve as best practice
evolves and, as it were, be evergreen.
The Schedule and Transparency
I would like to say a few words about the schedule. In a few weeks, the agencies will be
publishing their joint ANPR for a ninety-day comment period, and will also issue early
drafts of related supervisory guidance so that banks can have a fuller understanding of
supervisory expectations and more carefully begin their planning process. The comments on
the domestic rulemaking as well as on CP3 will be critical in developing the negotiating
position of the U.S. agencies, and highlighting the need for any potential modifications in
the proposal. The U.S. agencies are committed to careful and considered review of the
comments received.
When the comments on CP3 and the ANPR have been received, the agencies will review
them and meet to discuss whether changes are required in the Basel II proposal. In
November, we are scheduled to meet in Basel to negotiate our remaining differences. I fear
this part of the schedule may be too tight because it may not provide U.S. negotiators with
sufficient time to digest the comments on the ANPR and develop a national position to
present to our negotiating partners. There may well be some slippage from the November
target, but this slippage in the schedule is unlikely to be very great.
In any event, implementation in this country of the final agreement on Basel II would
require a Notice of Proposed Rulemaking (NPR) in 2004 and a review of comments
followed by a final rule before the end of 2004. On a parallel track, core banks and potential
opt-in banks in the United States will be having preliminary discussions with their relevant
supervisors in 2003 and 2004 to develop a work plan and schedule. As I noted, we intend to
conduct more Quantitative Impact Studies, starting in 2004, so we can be more certain of the
impact of the proposed changes on individual banks and the banking system. As it stands
now, core and opt-in banks will be asked by the fall of 2004 to develop an action plan
leading up to final implementation. Implementation by the end of 2006 would be desirable,
but each bank's plan will be based on a joint assessment by the individual bank and its
relevant supervisors of a realistic schedule; for some banks the adoption date may be beyond
the end of 2006 because of the complexity of the required changes in systems. It is our
preference to have an institution "do it right" rather than "do it quickly". We do not plan to
force any bank into a regime for which it is not ready, but supervisors do expect a formal
plan and a reasonable implementation date. At any time during that period, we can slow
down the schedule or revise the rules if there is a good reason to do so.
The development of Basel II has been highly transparent from the beginning and will remain
so. All of the consultative papers over the past five years have been supported by a large
number of public papers and documents to provide background on the concepts, framework,
and options. After each previous consultative paper, extensive public comment has been
followed by significant refinement and improvement of the proposal.
During the past five years, a number of meetings with bankers have been held in Basel and
in other nations, including the United States. Over the past eighteen months, I have chaired a
series of meetings with bankers, often jointly with Comptroller Hawke. More than 20 U.S.
banks late last year joined 365 others around the world in the third Quantitative Impact
Survey (QIS3), which was intended to estimate the effects of Basel II on their operations.
The banking agencies last month held three regional meetings with the bankers that would
not be required to adopt Basel II but might have an interest in choosing to adopt the A-IRB
approach and the AMA. Our purpose was to ensure that these banks understand the proposal
and the options it provides them.2 As I noted, in about one month the banking agencies in
this country hope to release an ANPR that will outline and seek comment on specific
proposals for the application of Basel II in this country. In the past week or so we have also
released two White Papers to help commenters frame their views on commercial real estate
and the capital implications of recognizing certain guarantees. These, too, are available at
our web site.
This dialogue with bankers has had a substantive impact on the Basel II proposal. I have
attached to my statement a comparison of some of the major provisions of Basel II as
proposed in each of the three consultative documents published by the Basel Committee on
Bank Supervision (appendix 2). As you can see, commenters have significantly influenced
the shape and detail of the proposal. For example, comments about the earlier proposed
crude formulas for addressing operational risk led to a change in the way capital for
operational risk may be calculated; banks' may now use their own methods for assessing this
form of risk, as long as these methods are sufficiently comprehensive and systematic and
meet a set of principles-based qualifying criteria. That is the AMA. The mechanism for
establishing capital for credit risk has also evolved significantly since the first consultative
paper on the basis of industry comments and suggestions; as a result, a large number of
exposure types are now treated separately. Similarly, disclosure rules have been simplified
and streamlined in response to industry concerns.
At this stage of the proposal, comments that are based on evidence and analysis are most
likely to be effective. Perhaps an example of the importance of supporting evidence in
causing a change in positions might be useful. As some members of this committee may
know, the Federal Reserve had concluded earlier, on the basis of both supervisory judgment
and the available evidence, that the risk associated with commercial real estate loans on
certain existing or completed property required a capital charge higher than the capital
charge on other commercial real estate and on commercial and industrial loans. In recent
weeks, however, our analysis of additional data suggested that the evidence was
contradictory. With such inconsistent empirical evidence, we concluded that, despite our
supervisory judgment on the potential risk of these exposures, we could not support
requiring a higher minimum capital charge on commercial real estate loans on any existing
or completed property, and we will not do so.
In the same vein, we also remain open minded about proposals that simplify the proposal
but attain its objective. Both the modifications of the proposals in CP3 and the changes in
U.S. supervisory views, as evidenced by the commercial real estate proposal, testify to the
willingness of the agencies, even at this late stage of the process, to entertain new ideas and
to change previous views when warranted.
Summary
The existing capital regime must be replaced for the large, internationally active banks
whose operations have outgrown the simple paradigm of Basel I and whose scale requires
improved risk-management and supervisory techniques to minimize the risk of disruptions
to world financial markets. Fortunately, the state of the art of risk measurement and risk
management has improved dramatically since the first capital accord was adopted, and the
new techniques are the basis for the proposed new accord. In my judgment, we have no
alternative but to adopt, as soon as practical, these approaches for the supervision of our
larger banks.
The Basel II framework is the product of extensive multiyear dialogues with the banking
industry regarding evolving best practice risk-management techniques in every significant
area of banking activity. Accordingly, by aligning supervision and regulation with these
techniques, it provides a great step forward in protecting our financial system and that of
other nations to the benefit of our citizens. Basel II will provide strong incentives for banks
to continue improving their internal risk-management capabilities as well as the tools for
supervisors to focus on emerging problems and issues more rapidly than ever before.
I am pleased to appear before you today to report on this effort as it nears completion. Open
discussion of complex issues has been at the heart of the Basel II development process from
the outset and will continue to characterize it as Basel II evolves further.
Appendix 1 (14 KB PDF): Large Losses from Operational Risk, 1992-2002 Return to text
Appendix 2 (40 KB PDF): Evolution of Basel II Proposals Return to text
Footnotes
1. Papers from that conference are available at
http://www.newyorkfed.org/pihome/news/speeches/2003/con052903.html Return to text
2. The documents used in these presentations are available at the Board's web site,
http://www.federalreserve.gov/banknreg.htm ("Documents Relating to US Implementation
of Basel II"). Return to text
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2003 Testimony
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APPENDIX 1
Large Losses from Operational Risk
1992-2002
10 Large Operational Losses Affecting Banks and Bank Affiliates
Loss #
1
Amount
($M) Firm
1,110 Daiwa Bank Ltd.
2
1,330 Barings PLC
Year Description
1995 Between 1983 and 1995, Daiwa Bank incurred $1.1 billion
in losses due to unauthorized trading.
1995 A $1.3 billion loss due to unauthorized trading triggered
the bank's collapse.
3
900 J.P. Morgan Chase
2002 J.P. Morgan Chase established a $900 million reserve for
Enron-related litigation and regulatory matters.
4
770 First National Bank
Of Keystone
2001 The bank failed due to embezzlement and loan fraud
perpetrated by senior managers.
5
691 Allied Irish Banks
2002 Allied Irish Bank incurred losses of $691 million due to
unauthorized trading that had occurred over the previous
five years.
6
636 Morgan Grenfell
Asset Management
(Deutsche Bank)
1997 A fund manager violated regulations limiting investments
in unlisted securities for three large mutual funds.
Deutsche Bank had to inject GBP 180 million to keep the
funds liquid, with total costs in the matter exceeding GBP
400 million.
7
611 Republic New York
Corp.
2001 Republic Bank paid $611M in restitution and fines
stemming from its role as custodian of securities sold by
Princeton Economics International, which had issued false
account statements and commingled client money.
8
490 Bank of America
2002 Bank of America agreed to settle class action lawsuits filed
in the wake of its merger with NationsBank. The suits
alleged omissions relating to its relationship with D.E.
Shaw & Co.
9
440 Standard Chartered
Bank PLC
1992 Standard Chartered Bank lost $440M in connection with
the Bombay stock market scandal. A government panel
charged that the banks involved broke Indian banking laws
and guidelines while trading in government bonds,
investing money for corporate clients, and giving money to
brokers to invest in the Bombay stock market.
10
440 Superior Bank FSB
2001 The bank failed due to improper accounting related to
retained interests in securitized subprime loans.
Note: Loss Amounts are obtained from public sources and are gross loss amounts prior to possible recoveries.
1
APPENDIX 2
Evolution of Basel II Proposals
The following table provides a summary of modifications made by the Basel
Committee on Banking Supervision (Committee) to its proposal for a New Basel Capital
Accord (New Accord). Since release of its first consultative paper in June 1999, the
Committee has been engaged in extensive dialogue with banking organizations and other
interested parties regarding the new capital adequacy framework. These consultations
have resulted in the release of three consultative papers and the completion of several
quantitative impact studies in which banks were asked to assess the impact of the
Committee’s proposal on their current portfolios.
In many instances, the additional information obtained from market participants
was instrumental to additional analyses conducted by the Committee. The table captures
changes made to the approaches to be implemented in the United States: the Advanced
Internal Ratings Based (A-IRB) approach to credit risk and the Advanced Measurement
Approach (AMA) to operational risk. Modifications to the Standardized approach to
credit risk, as well as the Basic Indicator and Standardized approach to operational risk
are not featured.
2
Proposals contained in the
Committee’s first consultative paper
(CP1) issued June 1999
Modifications captured in the
Committee’s second consultative
paper (CP2) issued January 2001
Modifications captured in the
Committee’s third consultative
paper (CP3) issued April 2003
Minimum Capital Requirements (Pillar 1 of the proposed New Accord)
Advanced Internal
Ratings-based (IRB)
Approach to Credit Risk:
General Comments
The Committee’s first consultative
paper (CP1) introduced the possibility
of an IRB approach for calculating
minimum capital requirements for
credit risk. The concept of an IRB
approach was meant to allow banks’
own estimates of key risk drivers to
serve as primary inputs to the capital
calculation, subject to minimum
standards.
CP1 made reference to further work of
the Committee (in consultation with the
industry) on key issues related to the
IRB approach. The remainder of that
section of CP1 highlighted some of the
issues the Committee expected to
consider.
The Committee’s second consultative paper
(CP2) described the IRB framework in detail.
Among other elements, CP2 defined the
various portfolios and outlined the mechanics
of how to calculate the IRB capital charges.
Another critical element was presentation of
the minimum qualifying criteria that banks
would have to satisfy to be able to use the
IRB approach to credit risk.
CP2 also outlined expectations regarding
adoption of the advanced IRB approach
across all material exposure types of a
banking organization. A floor on t he
minimum capital requirement was specified.
After consideration of the feedback
provided by industry participants,
particularly that gathered through
quantitative impact studies, the Committee
made adjustments to the level of capital
required by the IRB approaches.
Among other elements (as described
below), the IRB approach was refined to
allow for greater differentiation of risk. For
example, the Committee approved a new,
more appropriate treatment of loans made to
small- and medium-enterprises (SMEs).
The retail portfolio was divided into three
subcategories. CP3 also outlined a treatment
for specialized lending.
The qualifying criteria for the IRB approach
have been streamlined. The criteria are now
described in a principles -based manner.
CP3 also simplified the floor capital
requirement such that there will be one floor
that applies to banks adopting the IRB
approach to credit risk and advanced
measurements approaches (AMA) to
operational risk for the first two years
following implementation of the proposed
Accord.
3
Not specified in CP1.
Exposure Type:
1. Wholesale (corporate,
sovereign and bank)
Wholesale exposures were defined to
include corporate, sovereign and bank
exposures. Banks are expected to assess
the risk of each individual wholesale
exposure.
CP2 described the mechanism for
assessing the risk of each wholesale
exposure. The quantitative inputs
(probability of default (PD), loss given
default (LGD), exposure at default
(EAD) and effective remaining maturity
(M)) by exposure type were specified.
Additionally, CP2 relates the
quantitative inputs to the risk weight
formula applicable for all three
wholesale exposures. Further, minimum
qualifying standards for use of the IRB
approach were described in detail.
An adjustment was introduced for
reflecting in regulatory capital any
concentrations a bank may have to a
single borrower within its wholesale
portfolio.
Based on findings from the impact studies
conducted by the Basel Committee, and in
response to industry concerns about the
potential for cyclical capital requirements
and the treatment of SMEs, the slope of the
wholesale risk weight function has been
flattened. This has the effect of producing
capital requirements that differ by a smaller
amount as the estimated PD of an exposure
increases.
CP3 confirmed that banks making use of the
advanced IRB approach would need to take
account of a loan’s effective remaining
maturity (M) when determining regulatory
capital, but that supervisors may exempt
smaller domestic borrowers from that
requirement.
As part of the treatment of corporate
exposures, another adjustment to the risk
weight formula has been made that results in
a lower amount of required capital for credit
extended to SMEs versus that extended to
larger firms.
In response to industry feedback, the
proposed adjustment for single borrower
concentrations has been eliminated given the
additional complexity it would introduce into
the IRB framework. That said, banks would
be expected to evaluate concentrations of
credit risk under Pillar 2 of the proposed
Accord.
4
Not specified in CP1.
2. Retail
Retail was identified as a single
exposure type. The risk weight formula,
the inputs to be provided by banks and
minimum qualifying criteria also were
specified. In contrast to the individual
evaluation required for wholesale
exposures, it is proposed that banks
assess retail exposures on a pool basis.
Retail has been sub -divided into three
separate exposure types (residential
mortgages, qualifying revolving exposures
(e.g. credit cards), and other retail
exposures). Each of the three exposure types
has its own risk weight formula in
recognition of differences in their risk
characteristics.
Qualifying criteria pertaining to retail
exposures have b een further defined.
3. Specialized Lending
Not specified in CP1.
The second consultative paper provided
a definition of project finance. An IRB
risk weight formula for this exposure
type was not specified.
Specialized lending (SL) has been defined to
include various financing arrangements
(project, object and commodities).
Additionally, this exposure category has
been defined to include income producing
real estate and the financing of commercial
real estate that exhibits higher loss rate
volatility.
For all but one SL category, qualifying banks
may use the corporate risk weight formula to
determine the risk of each exposure. When
this is not possible, an additional option only
requires banks to classify SL exposures into
five distinct quality grades with specific
capital requirements associated with each.
A Federal Reserve white paper explores
issues surrounding the valuation of
commercial real estate to be consistent with
reference to the white paper on double
default.
5
4. Equity
Not specified in CP1.
A definition of equity exposures was
provided in CP2. Reference was made
to treating such holdings in a manner
similar to that required of banks’
investments in securities firms or
insurance companies.
The definition of equity exposures has been
expanded. CP3 outlines two specific
approaches to determining capital for equity
exposures. One builds on the IRB treatment
of corporate exposures. The second provides
banks with opportunity to model the
potential decrease in the market value of
their holdings. CP3 also described the
qualifying criteria for such exposures.
5. Purchased Receivables
Not specified in CP1.
Not specified in CP2.
CP3 describes a capital treatment for
purchased receivables (retail and corporate).
Subject to certain qualifying criteria, banks
will be permitted to assess capital on a pool
basis for corporate receivables as they are
permitted to do for retail exposures and
purchased retail receivables.
Qualifying Criteria for Use of
the Advanced IRB Approach
Qualifying criteria were not specified in
CP1. However, a sound practice paper on
the management of credit risk was issued
shortly after CP1.
Qualifying criteria were developed to
ensure an appropriate degree of
consistency in banks ’ use of their own
estimates of key risk drivers in
calculating regulatory capital. The
qualifying criteria for corporate
exposures were provided in detail with
less discussion of those pertaining to
retail, sovereign and bank exposures.
The qualifying criteria have been
streamlined. In response to industry
feedback, the criteria are now described in a
principles-based manner for all IRB exposure
types. The intent is to allow for consistent
application of the requirements, as well as
for innovation and appropriate differences in
the way in which banking organizations
operate.
Other Elements of the IRB
Framework
Not specified in CP1.
Not specified in CP2.
The IRB capital requirement includes
components to cover both expected and
unexpected losses. CP3 specified methods
for recognizing loan loss reserves as an offset
to the expected loss component of risk
weighted assets by exposure type. CP3 also
specified a definition of default and factors to
be considered for use in the IRB approach.
6
Credit Risk Mitigation
(e.g. collateral, guarantees, and
credit derivatives)
An IRB treatment for recognizing credit
risk mitigants was not specified in CP1.
A credit risk mitigation (CRM)
framework was introduced in CP2. It
allowed banks to recognize collateral in
their own estimates of default.
Guarantees and credit derivatives remain
subject to a treatment where the risk
weight of the guarantor is substituted for
that of the borrower.
Securitization
An IRB treatment of securitization was not
specified in CP1.
CP2 outlined an IRB treatment of
securitization. Initial thoughts about
how to address exposures held by banks
(qualifying for the IRB treatment) that
originate securitizations and those that
invest in transactions put together by
other parties were discussed in general
terms. It was indicated that the
Committee would continue its work to
refine the IRB treatment of securitization
during the comment period for CP2.
The qualifying criteria concerning
recognition of CRM techniques have been
further clarified. Banks are provided with
greater flexibility to recognize guarantees
and credit derivatives in the IRB risk inputs
(e.g. PD and LGD). However, banks are not
permitted to recognize “double default”
effects when determinin g the impact of CRM
techniques on their capital requirements. A
Federal Reserve white paper attempts to
analyze the issues surrounding default of a
borrower and a guarantor (“double default”)
for losses to be incurred on a hedged credit
exposure.
An IRB treatment of securitisation is
discussed in detail. Banks may (subject to
certain qualifying criteria) base the capital
requirement on the external rating of a
securitization exposure or the IRB capital
requirement for the pool of assets underlying
a given securitization. Capital treatments for
liquidity facilities and securitizations
containing early amortization provisions also
have been specified.
7
Advanced Measurement
Approaches (AMA) to
Operational Risk
An explicit charge for operational risk was
discussed in the context of capital
requirements for other risks that the
Committee believed to be sufficiently
important for banks to devote the
necessary resources to quantify and to
incorporate into their capital adequacy
determinations. Reference was made to a
range of possible approaches for assessing
capital against this risk.
The internal measurement approach
(IMA) was introduced in CP2 for
determining capital for operational risk.
Subject to meeting a set of qualifying
criteria, banks were expected to
categorize their operational risk
activities into business lines. Based on a
number of inputs (some to be supplied
by the supervisor and others to be
estimated by banks themselves), a
capital charge would be determined by
business line. A floor was established
for banks using the IMA below which
minimum capital for operational risk
could not fall.
The Committee confirmed that operational
risk would be treated under Pillar 1 of the
proposed New Accord. After extensive
consultation with the industry, the advanced
measurement approaches (AMA) for
operational risk has been developed.
The AMA builds on banks’ rapidly
developing internal assessment systems.
Banks may use their own method for
assessing their exposure to operational risk,
so long as it is sufficiently comprehensive
and systematic, subject to satisfying a set of
principles-based qualifying criteria.
Banks using the AMA may recognize
insurance as an operational risk mitigant
when calculating regulatory capital. The
separate floor on the capital charges for
operational risk introduced in CP2 has been
abandoned, as noted in the general discussion
of the Advanced IRB approach.
Supervisory Review (Pillar 2 of
the proposed New Accord)
Four principles of supervisory review were
established. In sum, the principles discuss
the need for (i) banks to conduct their own
assessments of capital adequacy relative to
risk; (ii) supervisors to evaluate such
assessments and to take appropriate action
when necessary; (iii) supervisors to expect
banks to operate above the minimum
regulatory capital ratios; and (iv)
supervisors to intervene at an early stage to
prevent capital from falling below prudent
levels.
The four principles of supervisory
review were further refined in CP2.
Reference was made to existing
guidance developed by the Committee
relating to the management of banking
risks.
Supervisory expectations regarding the
treatment of interest rate risk in the
banking book were outlined in this
section of CP2.
To help address potential concerns about the
cyclicality of the IRB approach, the
Committee agreed that a meaningfully
conservative credit risk stress testing by
banks using the IRB approach would be
required to ensure that they are holding a
sufficient capital buffer.
Additionally, the section on supervisory
review (Pillar 2) discusses the need for banks
to consider the definition of default, residual
risks, credit risk concentration and the risk
associated with securitization exposures.
8
Market Discipline
(Pillar 3 of the proposed
New Accord)
Some of the Committee’s early
expectations regarding bank
disclosures were outlined. Reference
was made to future work aimed at
producing more detailed guidance on
disclosures of key information
regarding banks’ capital structures,
risk exposures and capital adequacy
levels.
A comprehensive framework
regarding banks’ disclosures was
provided. Qualitative and
quantitative disclosures by exposure
type were outlined. Distinctions
were drawn between core and
supplementary disclosure
recommendations, and those
considered requirements.
In response to industry feedback, the
Committee completed efforts to clarify
and simplify the market discipline
component of the proposed New Accord.
The aim was to provide third parties with
enough information to understand a
bank’s risk profile without imposing an
undue burden on any institution. The
disclosure elements have been
streamlined to accomplish this objective,
and are now regarded as requirements.
@FedFRASER