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Testimony of Vice Chairman Roger W. Ferguson, Jr.
Basel II and H.R. 2043
Before the Subcommittee on Financial Institutions and Consumer Credit, Committee
on Financial Services, U.S. House of Representatives
June 19, 2003
Chairman Bachus, Congressman Sanders, members of the Subcommittee on Financial
Institutions and Consumer Credit, thank you for inviting me here this morning to testify on
behalf of the Board of Governors of the Federal Reserve System on Basel II and H.R. 2043.
Basel II, of course, is shorthand for the proposal being negotiated in Basel, Switzerland,
among the major countries of the world to develop a new agreement on capital standards for
internationally active banking organizations. This new accord would replace the existing
accord, Basel I, developed fifteen years ago.
Basel I and the Changing Marketplace
Basel I has served the United States well, by facilitating an international capital standard
that contributes to competitive equity between our banks and foreign banks in markets here
and abroad. It has, unfortunately, outlived its usefulness for our larger banking
organizations, which have become increasingly complex and driven by new technologies
that permit financial transactions unimagined when Basel I was initiated as the international
standard.
From the perspective of banks, supervisors, counterparties, and stakeholders, capital is a
cushion to ensure banks' safety and soundness and to provide a benchmark by which their
financial condition can be measured. The nature of how the large banks of the world do
business has changed so much that, for them, Basel I now provides neither an appropriate
cushion nor an accurate risk benchmark. For these large banks, Basel I has to be replaced,
particularly in a world whose financial markets are so interrelated that significant difficulties
at any one of the largest banks would place the world financial system at risk.
Basel I versus Basel II
We are fortunate that changes in technology in the last decade have permitted modern
principles of finance to be applied in banking, especially at the larger banks. The new
methodologies have already begun to revolutionize risk measurement and management in
ways that promise greater safety, soundness, and stability in our banking and financial
system, particularly if the new methods are harnessed to the supervisory process. Basel II
holds out that promise and builds on the best practices in risk management in banking over
the past decade.
The Federal Reserve believes it is imperative that both banks and their supervisors act now
to improve risk measurement and management; to link, to the extent that we can, the amount
of required capital to the amount of risk taken; to attempt to further focus the supervisorbank dialogue on the measurement and management of risk and the risk-capital nexus; and
to make all of this transparent to the counterparties and uninsured depositors that ultimately
fund--and hence share--these risk positions. That is what Basel II seeks to do while at the
same time also seeking a level regulatory playing field for banks that compete across
borders.
How does Basel II differ from Basel I? As under Basel I, a bank's risk-based capital ratio
would have a numerator representing the capital available to the bank and a denominator
that is 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,
the greater risk-sensitivity, that is the hallmark of Basel II. The modified definition of riskweighted assets will also include an explicit, rather than implicit, treatment of "operational
risk."
Developing Basel II
The development of Basel II has been highly transparent and over the past five years has
been supported by a large number of public papers and documents on the concepts,
framework, and options. The Basel consultative paper (CP3) published in late April was the
third in the series. After each previous consultative paper, extensive public comment has
been followed by significant refinement and improvement of the proposal. CP3 itself is out
for public comment until July 31.
During the past five years, a number of meetings with bankers have been held in Basel and
elsewhere, including in the United States. Over the past eighteen months, I have chaired a
series of meetings with bankers, often jointly with Comptroller Hawke. More than twenty
U.S. banks late last year joined 365 others around the world in the third Quantitative Impact
Study (QIS3) intended to estimate the impacts of Basel II on their operations. The banking
agencies last month held three regional meetings with banks that would not, under the U.S.
proposal, be required to adopt Basel II, but may have an interest in choosing to do so. Our
purpose was to ensure that these banks understand the proposal and the options it provides
them.1 In about one month the banking agencies in this country hope to release an Advance
Notice of Proposed Rule Making (ANPR) that will outline and seek comment on specific
proposals for the application of Basel II in this country. In the last 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 Supervisor's
Committee (appendix 1). As you can see, commenters have had a significant effect on the
shape and detail of the proposal. For example, comments about the proposed crude formulas
for addressing operational risk led to a change in the way capital for operational risk may be
calculated; the change allows banks to 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. Industry comments and suggestions have also led to a
significant evolution since the first consultative paper in the mechanism for establishing
capital for credit risk; 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. Most important, the Basel Committee, and certainly all the U.S.
representatives, still have an open mind on all the provisions in CP3 and will try once again
to evaluate commenters' views and suggestions as we try to complete negotiations by the
end of this year.
Perhaps an example of the importance of supporting evidence in causing a change in
positions might be useful. As some members of this committee 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 that 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 these loans,
and we will not do so.
In the same vein, we remain open minded about new suggestions, backed by evidence and
analysis, and approaches that simplify the proposal but still attain its objectives. 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 negotiating process, to entertain new ideas and to change
previous views when warranted.
It should be underlined that response to public comments has eliminated complexity in some
parts of the proposal but added complexity in others. Banking organizations have different
procedures and processes; one-size-fits-all rules would force many organizations to spend
large sums and reduce their operating efficiencies to change their approaches. Permitting
banks to use their own methodologies requires regulatory options that, in turn, impose rules
that are more complex. Indeed, recent suggestions from bankers have led us to add questions
to our ANPR with the goal of obtaining information that may lead to additional options, and
hence complexities, in Basel II in our final round of negotiations.
Scope of Application in the United States
We are interested in comments from all sections of the banking industry, even though nearly
all the banking organizations in this country will remain under the current capital regime. I
began my statement today with the observation that Basel I, the basis for the current capital
rules, has 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 do not yet need the full panoply of sophisticated riskmanagement techniques required under the advanced versions of Basel II. In addition, for
various reasons, most of our banks now hold considerable capital in excess of regulatory
minimums: More than 93 percent have risk-weighted capital ratios in excess of 10 percent-an attained ratio that is 25 percent above the current regulatory minimum.
Moreover, U.S. banks have long been subject to a comprehensive and thorough supervisory
process that is much less common in most other countries planning to implement Basel II.
Indeed, U.S. supervisors will continue to be interested in reviewing and understanding the
risk measurement and management process of all banks, those that remain on Basel I and
those that adopt Basel II. Our banks also disclose considerable information through
regulatory reports and under accounting and Securities and Exchange Commission rules so
that our banks are already providing significant disclosures--consistent with another aspect
of Basel II.
Thus, when we balanced the costs that would be faced by thousands of our banks under a
new capital regime 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 to be 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 be of benefit to 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 the promotion of competitive
consistency of capital requirements for banks that compete directly in global markets. The
focus on global markets is one of the reasons that we did not believe it was necessary to
impose Basel II on most U.S. banks because they operate virtually entirely in domestic
markets.
Another important objective in developing the negotiating positions for U.S. supervisors has
been encouraging the largest banking organizations of the world to continue to incorporate
into their operations the most sophisticated risk measurement and management techniques.
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, as I noted, difficulty at one of the largest banking organizations could have
drastic impacts on global financial markets. In our view, prudential supervisors and central
bankers would be remiss if they did not address the evolving complexity of our largest
banks and ensure that modern techniques were being used to manage the risks being taken.
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 to
establish the size of that charge known as the Advanced Management Approach (AMA).
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 would provide an important incentive for the bank to take
actions to limit their potential losses from operational problems.
To promote a more level global playing field, the banking agencies in the United States will
be proposing in the forthcoming ANPR that those U.S. banking organizations with foreign
exposure above a specified amount would be in a "core" set of banks--those that would be
required to adopt Basel II. To improve risk management for those organizations whose
disruption would have the largest effect on the global economy, we would also require
banks whose scale exceeds a specified amount to be in the core set of banks, although the
amount of overlap with the banks already included under the foreign asset standard is quite
large. To further ensure that we meet our responsibilities regarding stability, the agencies
will propose, as I noted, that all banks adopting Basel II in the United States would be
required to adopt the most sophisticated versions of the new accord--the A-IRB for credit
risk and the AMA for operational risk. We are proposing that U.S. implementation of Basel
II exclude from use for credit risk the less sophisticated, Foundation Internal Ratings Based
(F-IRB) approach and the least sophisticated, Standardized approach, and that it exclude
from use for operational risk the Basic Indicator approach and the Standardized approach.
Ten U.S. banks meet the proposed criteria to be among the core group of banks and thus
would be required, under our proposal, to adopt A-IRB and AMA. 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--the ability to
quantify and develop the necessary risk parameters on credit exposures and develop
measurement systems for operational risk exposures--voluntarily to choose Basel II using
the A-IRB and AMA. We estimate that ten large banks now outside the core group would
make this decision before the initial implementation date after they make the necessary costbenefit calculations. These banks would no doubt consider both the capital impact of Basel
II as well as the message they want to send their counterparties about their risk-management
techniques.
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 will 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 they are more focused on the disclosure aspects of Basel II, rather than on the scope
of application. To be clear, supervisors have no intentions of pressuring any of the nonmandatory banks to adopt Basel II.
If, indeed, ten core banks and about ten other banks adopt Basel II before the initial
implementation date, they would today account for 99 percent of the foreign assets and twothirds of all the assets of domestic U.S. banking organizations, a coverage indicative of the
importance of these entities to the global banking and financial system. These data are also
indicative of our intention to meet our responsibilities for international competitive equity
and best-practice policies at the organizations critical to our financial stability while
minimizing cost and disruption for the purely domestic, less complicated organizations.
Competitive Equity
The proposed application of Basel II has raised some concerns about competitive equity for
U.S. banks. 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 about 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 holds mainly lower-quality, and therefore riskier,
commercial loans just because the former would have lower required capital charges. The
capital requirements should be a function of risk taken, and, under Basel II, if the two banks
have very similar loans, they both should have very similar capital charges. For this reason,
competitive equity among Basel II banks in this country should not be a genuine issue, since
capital should reflect the risks 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,
imposing Basel II, via A-IRB and AMA, for a small number of large banks, and the current
capital rules for all other U.S. banks. The stated concern of some observers is that the banks
that remain under the current capital rules, with capital charges that are not as risk sensitive,
would be at a competitive disadvantage against Basel II banks that would have lower capital
charges on less-risky assets. Of course, Basel II banks would have higher capital charges on
higher-risk assets and would bear the cost of adopting a new infrastructure, neither of which
Basel I banks will have. And any bank that might feel threatened could adopt Basel II if they
made 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 will be an unintended consequence of disadvantaging those banks that
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, we see reasons to believe that banks remaining under the
current capital regime, as outlined by the agencies' proposed scope of application and the
resultant bifurcated regulatory capital system, would experience little, if any, competitive
disadvantage.
The basic question is the role of regulatory capital minimums 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 the 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 rivals' regulatory
capital minimums generally would not have any 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 in
which banks are now engaging in capital arbitrage transactions that produce an effective
reduction in their current regulatory capital charges. The more risk-sensitive A-IRB
imposes, in effect, risk-sensitive capital charges that for lower-risk assets are similar to what
the larger banks have been successful for years in obtaining through capital arbitrage
transactions. In short, competitive realities may not change in many markets where capital
charges would become more explicitly risk sensitive.
Concerns have also been raised about the effect of Basel II on the competitive relationships
between depository institutions and their non-depository rivals. Of course, the same
argument that economic capital is the driving force in pricing applies. It is only reinforced
by the fact that the cost of capital and funding is less at insured depositories than at their
non-depository rivals because of the safety net. Insured deposits and access to the Federal
Reserve discount window (and Federal Home Loan Bank advances) lets insured depositories
operate with far less capital or collateralization than the market would otherwise require and
does require of non-depository rivals. Again, Basel II is not going to 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
This discussion has centered on addressing credit risk--the risk that the lender will suffer a
loss because of the inability of a borrower to repay obligations on schedule. A few words on
operational risk are now in order. 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
Basel II. 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 risks have been implicitly covered in one risk
measure and capital charge. But Basel II, by designing a risk-based system for credit 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 2 to this statement lists some of these recent events here and abroad. 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.
Imposing a capital charge to cover operational risk would no more eliminate operational risk
than does a charge for credit risk eliminate credit risk. For both risks, capital is a measure of
a bank's ability to absorb losses and survive. The AMA for determining capital charges on
operational risk is a principles-based approach that obligates 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, for example, insurance. This approach parallels that
for credit risk, in which capital charges can be reduced by shifting to less-risky exposures or
by adopting risk-mitigation techniques such as collateral or guarantees.
Some banks for which operational risk is the dominant one oppose our proposal for 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 capital
charge under Pillar 1. The Federal Reserve believes that would be a mistake, greatly
reducing the transparency of risk and capital that is such an important part of Basel II, and
making it difficult to treat risks comparably across banks because Pillar 2 is judgmentally
based.
The Federal Reserve takes comfort from the fact that most of the banks to which Basel II
will apply in the United States are well along in developing their AMA-based operational
risk capital charge and believe that the process has already induced them to adopt riskreducing innovations. Late last month, at a conference held at the Federal Reserve Bank of
New York, presentations on operational risk illustrated the significant advances in
operational risk quantification being made by most internationally active banks. The
presentations were from representatives of major banks in Europe, Asia, and North America.
Many of the presenters provided detailed descriptions of techniques their own institutions
are incorporating for operational risk management.2 Many banks also acknowledged the
important role the Basel process played in encouraging them to develop improved
operational risk measurement and management processes.
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 believed 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.
Maintaining the current level of average capital in the banking industry can be accomplished
either by requiring each bank to maintain its Basel I capital level or by recognizing that
there will be divergent levels among banks dictated by different risk profiles. To go through
the process of devising a more risk-sensitive capital framework just to end with the Basel I
result seems pointless. In the Board's view, banks with lower risk profiles should have, as a
matter of sound public policy, 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. Of course, capital ratios are not the sole consideration. The
improved risk measurement and management, and their integration into the supervisory
system under Basel II, are also critical to ensuring the safety and soundness of the banking
system. When coupled with special U.S. features that are not changed by Basel II, 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 if it is consistent with improved risk management.
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 functions that convert those parameters to
capital requirements. When they do, these changes can be substituted directly into the Basel
II framework, portfolio by portfolio if necessary. Basel II will not lock risk management
into any particular structure; rather Basel II will evolve as best practice evolves and, as it
were, be evergreen.
The Schedule
A few words now about the Basel II 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 will 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.
H.R. 2043
This subcommittee has asked the Federal Reserve for its views on H.R. 2043. We agree with
a key motivation of that bill: to ensure that the agencies work together and that any position
taken in negotiation by U.S. representatives is reached with full understanding of its effect
on the banking industry and the public more generally. We believe that the current process
does just that, and that the bill may not help in the achievement of those goals and could be
counterproductive. The agencies have long demonstrated that on various matters, including
Basel II, they have been able to reach agreement and come to a common position.
Sometimes the process is smooth and other times less so, but it always ends in a position
that we believe reflects the best interests of the United States. The agencies also have
demonstrated their open mindedness and willingness to look at facts, to evaluate alternative
views and judgments, and to change their minds on the basis of both public comment and
interagency discussions; my statement gives some examples of this. The agencies need to
continue to have the room to disagree and work out their differences on the basis of their
experience and expertise. A formal structure to force consensus on Basel issues is not
needed.
Indeed, the Board is concerned that, if adopted, H.R. 2043 would reduce our ability to
negotiate with other countries' representatives on matters of importance to American banks
and our financial system. Our counterparties would know that we could not bargain or make
commitments until we received congressional guidance, a process likely to slow
negotiations or bring them to a halt. Meanwhile, Basel I, an outdated and ineffective
regulatory structure for our largest banks, would continue in effect.
Finally, we believe that the bill, if enacted, would set an unfortunate precedent of
congressional involvement in technical supervisory and regulatory issues. We both expect
and welcome congressional oversight, but H.R. 2043 is, in our judgment, unnecessary.
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 in order to minimize the risk of
disruptions to world financial markets. Fortunately, the state of the art of risk measurement
and 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 bank 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.
Unfortunately, no change in bank regulatory policy can be made without inevitably
confronting a number of dissatisfied banks, regardless of the potential benefits of the
proposed change for the banking system, the economy, and the public as a whole. We now
face three choices. We can reject Basel II. We can sidetrack it by delay. Or we can continue
the domestic and international process, using the public comment and implementation
process to make whatever changes are necessary to make Basel II work more effectively and
efficiently. The first two options require staying with Basel I, which is simply not viable for
our largest banks. The third option recognizes that an international capital framework is in
the self-interest of the United States, since our institutions are the major beneficiary of a
sound international financial system. The Board strongly supports the third option.
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 (40 KB PDF): Modifications to the New Basel Capital Accord Return to text
Appendix 2 (16 KB PDF): Large Losses from Operational Risk, 1992-2002 Return to text
Footnotes
1. The documents used in these presentations are available at the Board's web site,
http://www.federalreserve.gov/banknreg.htm ("Documents Relating to U.S. Implementation
of Basel II"). Return to text
2. These presentations are publicly available on the Federal Reserve Bank of New York web
site, http://www.newyorkfed.org/pihome/news/speeches/2003/con052903.html. Return to
text
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-1APPENDIX 1
Modifications to the New Basel Capital Accord
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 included release of three consultative papers as well as 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 cons ultative 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 frame work 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 the
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 s uch 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.
-3Not 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.
-42. Retail
Not specified in CP1.
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 been 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 arrangeme nts
(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 forthcoming Federal Reserve white paper
will explore issues surrounding the valuation
of commercial real estate.
-54. 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
bas is 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 t he 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.
-6Credit 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 tre atment 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 determining 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 securitization 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 amort ization 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 o f 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.
APPENDIX 2
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 corp orate 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.
@FedFRASER