[House Hearing, 108 Congress]
[From the U.S. Government Publishing Office]





                      THE NEW BASEL ACCORD: SOUND


                   REGULATION OR CRUSHING COMPLEXITY?

=======================================================================

                                HEARING

                               BEFORE THE

                            SUBCOMMITTEE ON
                       DOMESTIC AND INTERNATIONAL
                 MONETARY POLICY, TRADE AND TECHNOLOGY

                                 OF THE

                    COMMITTEE ON FINANCIAL SERVICES

                     U.S. HOUSE OF REPRESENTATIVES

                      ONE HUNDRED EIGHTH CONGRESS

                             FIRST SESSION

                               __________

                           FEBRUARY 27, 2003

                               __________

       Printed for the use of the Committee on Financial Services

                            Serial No. 108-5


86-852              U.S. GOVERNMENT PRINTING OFFICE
                            WASHINGTON : 2003
____________________________________________________________________________
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                 HOUSE COMMITTEE ON FINANCIAL SERVICES

                    MICHAEL G. OXLEY, Ohio, Chairman

JAMES A. LEACH, Iowa                 BARNEY FRANK, Massachusetts
DOUG BEREUTER, Nebraska              PAUL E. KANJORSKI, Pennsylvania
RICHARD H. BAKER, Louisiana          MAXINE WATERS, California
SPENCER BACHUS, Alabama              CAROLYN B. MALONEY, New York
MICHAEL N. CASTLE, Delaware          LUIS V. GUTIERREZ, Illinois
PETER T. KING, New York              NYDIA M. VELAZQUEZ, New York
EDWARD R. ROYCE, California          MELVIN L. WATT, North Carolina
FRANK D. LUCAS, Oklahoma             GARY L. ACKERMAN, New York
ROBERT W. NEY, Ohio                  DARLENE HOOLEY, Oregon
SUE W. KELLY, New York, Vice         JULIA CARSON, Indiana
    Chairman                         BRAD SHERMAN, California
RON PAUL, Texas                      GREGORY W. MEEKS, New York
PAUL E. GILLMOR, Ohio                BARBARA LEE, California
JIM RYUN, Kansas                     JAY INSLEE, Washington
STEVEN C. LaTOURETTE, Ohio           DENNIS MOORE, Kansas
DONALD A. MANZULLO, Illinois         CHARLES A. GONZALEZ, Texas
WALTER B. JONES, Jr., North          MICHAEL E. CAPUANO, Massachusetts
    Carolina                         HAROLD E. FORD, Jr., Tennessee
DOUG OSE, California                 RUBEN HINOJOSA, Texas
JUDY BIGGERT, Illinois               KEN LUCAS, Kentucky
MARK GREEN, Wisconsin                JOSEPH CROWLEY, New York
PATRICK J. TOOMEY, Pennsylvania      WM. LACY CLAY, Missouri
CHRISTOPHER SHAYS, Connecticut       STEVE ISRAEL, New York
JOHN B. SHADEGG, Arizona             MIKE ROSS, Arkansas
VITO FOSELLA, New York               CAROLYN McCARTHY, New York
GARY G. MILLER, California           JOE BACA, California
MELISSA A. HART, Pennsylvania        JIM MATHESON, Utah
SHELLEY MOORE CAPITO, West Virginia  STEPHEN F. LYNCH, Massachusetts
PATRICK J. TIBERI, Ohio              BRAD MILLER, North Carolina
MARK R. KENNEDY, Minnesota           RAHM EMANUEL, Illinois
TOM FEENEY, Florida                  DAVID SCOTT, Georgia
JEB HENSARLING, Texas                ARTUR DAVIS, Alabama
SCOTT GARRETT, New Jersey             
TIM MURPHY, Pennsylvania             BERNARD SANDERS, Vermont
GINNY BROWN-WAITE, Florida
J. GRESHAM Barrett, South Carolina
KATHERINE HARRIS, Florida
RICK RENZI, Arizona

                 Robert U. Foster, III, Staff Director

               Subcommittee on Domestic and International
                 Monetary Policy, Trade and Technology

                   PETER T. KING, New York, Chairman

JUDY BIGGERT, Illinois, Vice Chair   CAROLYN B. MALONEY, New York
JAMES A. LEACH, Iowa                 BERNARD SANDERS, Vermont
MICHAEL N. CASTLE, Delaware          MELVIN L. WATT, North Carolina
RON PAUL, Texas                      MAXINE WATERS, California
DONALD A. MANZULLO, Illinois         BARBARA LEE, California
DOUG OSE, California                 PAUL E. KANJORSKI, Pennsylvania
JOHN B. SHADEGG, Arizona             BRAD SHERMAN, California
MARK R. KENNEDY, Minnesota           DARLENE HOOLEY, Oregon
TOM FEENEY, Florida                  LUIS V. GUTIERREZ, Illinois
JEB HENSARLING, Texas                NYDIA M. VELAZQUEZ, New York
TIM MURPHY, Pennsylvania             JOE BACA, California
J. GRESHAM BARRETT, South Carolina   RAHM EMANUEL, Illinois
KATHERINE HARRIS, Florida
                            C O N T E N T S

                              ----------                              
                                                                   Page
Hearing held on:
    February 27, 2003............................................     1
Appendix
    February 27, 2003............................................    53

                               WITNESSES
                      Thursday, February 27, 2003

Ervin, D. Wilson, Managing Director and Head of Strategic Risk 
  Management, Credit Suisse First Boston.........................    42
Ferguson, Roger W. Jr., Vice Chairman, Board of Governors of the 
  Federal Reserve System.........................................     9
Hawke, Hon. John D. Jr., Comptroller, Office of the Comptroller 
  of the Currency................................................    11
Moore, Sarah, Chief Operating Officer, The Colonial Bank Group 
  Inc............................................................    44
Petrou, Karen Shaw, Executive Director, Federal Financial 
  Analytics, Inc.................................................    37
Powell, Hon. Donald, Chairman, Federal Deposit Insurance 
  Corporation....................................................    14
Spina, David, Chairman and Chief Executive Officer, State Street 
  Corporation....................................................    40

                                APPENDIX

Prepared statements:
    Oxley, Hon. Michael G........................................    54
    Emanuel, Hon. Rahm...........................................    56
    Ervin, D. Wilson.............................................    58
    Ferguson, Roger W. Jr........................................    74
    Hawke, Hon. John D. Jr.......................................    94
    Moore, Sarah.................................................   120
    Petrou, Karen Shaw...........................................   133
    Powell, Hon. Donald..........................................   145
    Spina, David.................................................   160

              Additional Material Submitted for the Record

Maloney, Hon. Carolyn B.:
    Letter to Hon. Alan Greenspan, Chairman, Federal Reserve 
      System Board of Governors, Hon. John D. Hawke, Comptroller 
      of the Currency, and Hon. Donald Powell, Chairman, Federal 
      Deposit Insurance Corporation, August 14, 2002.............   171
    Letter from Hon. John D. Hawke, Jr., Comptroller, Office of 
      the Comptroller of the Currency, September 6, 2002.........   173
Bond Market Association letter, February 27, 2003 (with 
  attachments)...................................................   176
Real Estate Roundtable, prepared statement, March 11, 2003.......   208

 
                      THE NEW BASEL ACCORD: SOUND

                   REGULATION OR CRUSHING COMPLEXITY?

                              ----------                              


                      Thursday, February 27, 2003

             U.S. House of Representatives,
         Subcommittee on Domestic and International
              Monetary Policy, Trade and Technology
                           Committee on Financial Services,
                                                   Washington, D.C.
    The subcommittee met, pursuant to call, at 10:05 a.m., in 
Room 2128, Rayburn House Office Building, Hon. Judy Biggert 
[chairwoman of the subcommittee] presiding.
    Present: Representatives Biggert, Kennedy, Feeney, Oxley, 
Hensarling, Murphy, Barrett, Harris, Maloney, Lee, Sherman, 
Frank, Baca, Emanuel, Capuano and Lynch.
    Chairwoman Biggert. [Presiding.] This hearing of the 
Subcommittee on Domestic and International Monetary Policy, 
Trade and Technology will come to order. Without objection, all 
members' opening statements will be made a part of the record. 
We would like to welcome everybody here today. I will start 
with my opening statement.
    Good morning. I would like to thank the witnesses for 
appearing this morning to outline the revisions of Basel 
Capital Accord, currently under discussion at the Bank of 
International Settlements. We have two very knowledgeable 
panels of experts before the subcommittee today, and I look 
forward to your testimony.
    The Basel Accord plays such a critical role in the 
operations of every bank that any changes to this accord must 
be closely monitored by the regulators and the Congress. The 
Federal Reserve and the other regulators have been hard at work 
seeking improvements in the Basel I structure. I want to thank 
you for all of your hard work on this complex issue. There is 
no question that there are flaws in the current system and 
change is needed. Many of the proposed changes to the Basel 
Accord are sound and will go a long way to reducing risk in the 
banking system and ensuring the efficiency of our national 
banks.
    I am, however, very concerned about the complexity of Basel 
II and the ability to effectively implement it. If we are going 
to go down the path of changing the primary tool used to 
protect against excessive risk, then we must make sure that it 
can be easily implemented and will not result in unforeseen 
costs. According to the regulators, Basel II will only apply to 
the largest U.S. financial institutions. However, many of us 
are concerned that the market could, in effect, force all U.S. 
institutions to comply with Basel II if they wish to remain 
competitive. The bottom line is that institutions that do not 
have the resources to turn the sophisticated models required by 
Basel II could be forced to consolidate their operations or to 
severely limit the types of products they offer.
    One of my primary concerns is the operational risk capital 
charge that will come under Pillar I of Basel II. This is a new 
capital charge which will be included with charges for credit 
risk and interest rate risk. Operational risk includes in its 
calculus possible losses from employee misconduct, fraud, 
system failure and litigation risk. These factors are very 
difficult to quantify for large banks, and nearly impossible to 
measure for smaller and medium-sized banks. So I question the 
logic of imposing a burdensome capital charge on institutions 
that is based mostly in theory, rather than on hard facts.
    Some have asserted that operational risk is simply the 
catch-all category of Basel II and has been included simply to 
define risks that are already accounted for in the capital 
accounts of most institutions. I would like to see if it would 
make more sense to include these risks under a more flexible 
Pillar II supervisory structure, instead of lumping them into a 
mandatory capital charge.
    I am also interested in the issue of home host regulators 
and how Basel II will ensure that foreign regulators will hold 
their financial institutions to the high standards that U.S. 
institutions are held. As we saw with the Basel I proposal, too 
many countries agreed to submit to the capital requirement in 
theory, but not in practice. I want to be sure that U.S. 
financial institutions of all sizes are not adversely impacted 
as a result of Basel II.
    There is no argument that Basel I should be updated to 
better reflect the marketplace in which financial institutions 
operate today. I want to thank again and applaud the authors of 
Basel II for their hard work. I am concerned, however, that 
this process is moving forward at the speed of light and 
without assurances that there will not be any unintended 
consequences for U.S. institutions and the U.S. economy as a 
whole.
    I very much look forward to hearing all your testimony, and 
would again like to thank you for appearing before this 
subcommittee. I might add that I am Congresswoman Judy Biggert 
from the state of Illinois and vice chair of this committee, 
and am sitting in for Peter King, the chairman, who had a 
conflict today. So in case you have a strange face sitting in 
this seat, that is why. So I appreciate that.
    Now, I turn to the ranking member, Mrs. Maloney of New 
York, for her opening statement.
    Mrs. Maloney of New York. I thank the acting chairwoman, 
and share many of the sentiments that she expressed in her 
opening remarks. I am very pleased to welcome Comptroller Hawke 
back to the committee, as well as Chairman Powell and Vice 
Chairman Ferguson. It is good to see all of you again, and I 
look forward to your testimony.
    This morning's hearing focuses on a critically important 
issue for our economy, and the safety and soundness of our 
financial system-the new Basel Capital Accord, Basel II. The 
first Basel Capital Accord established the minimum standard for 
the banks that operate internationally. Basel II is an attempt 
to build on this progress by allowing financial institutions to 
hold capital in amounts more reflective of risk and changing 
market conditions. Once implemented, the final Basel II Capital 
Accord will have profound consequences for the banking 
industry, our constituents, and the economy as a whole.
    Capital standards that are too high cut off credit, 
especially for borrowers with higher risk profiles. Capital 
standards that do not adequately protect against loss, risk the 
safety and soundness of the financial system. At this point in 
the evolution of Basel II, I believe that there is much to 
praise in the work of the committee, but serious areas of 
concern remain.
    The effort to align capital more closely with actual risk 
is a significant improvement over the current one-size-fits-all 
regime. At the same time, I share the concern expressed by some 
regulators and banks about the complexity and competitiveness 
issue raised by placing operational risk under Pillar I of the 
new Basel Accord. Operational risk is defined as the risk of 
direct or indirect loss resulting from inadequate or failed 
internal processes, people, and systems, or external events. 
These are extremely varied scenarios. They include potential 
natural disasters, terrorist attacks, actions of rogue traders 
and even litigation risk.
    It is my opinion that any final accord not require U.S. 
institutions to hold a higher amount of capital for operational 
risk than foreign competitors. Our supervisors are the world's 
most advanced and our institutions already have a contingency 
plan and practice risk mitigation for disasters. Even after 
September 11, when this attack in the heart of the world's 
financial center, the financial system recovered relatively 
well, given the scope of the disaster. I do not want to see 
investments and businesses' continuity planning, backup systems 
and insurance be reduced because institutions have to devote 
resources to capital changes and charges for operational risk.
    I am also troubled by the potential that U.S. institutions 
could have to hold additional capital because of litigation 
risk. In a sense, the U.S. would face the potential competitive 
disadvantage because our laws protect individuals against loan 
discrimination and allow them private rights of action.
    In addition to operational risk, there are several other 
issues that I hope will be addressed today. Basel II has yet to 
decide how host home country application of the accord will be 
implemented. If this is resolved incorrectly, there is the 
potential for competitive disadvantage for U.S. institutions if 
foreign banks are allowed to operate in the U.S. market under 
capital standards established by their domestic regulators. 
Additionally, some commentators are concerned that the accord 
could result in much lower capital requirements for large 
institutions, adding incentive for more consolidation in the 
industry. Finally, I look forward to a discussion of whether 
the final Basel Accord will increase the severity of business 
cycles by requiring additional capital during economic 
downturns and thereby contributing to credit crunches.
    I thank the regulators for the thousands of hours they and 
their staffs have contributed to this effort, and I look very 
much forward to the testimony.
    Thank you.
    Chairwoman Biggert. Thank you.
    We are very pleased to have the chairman of the committee 
here today, Mr. Oxley. Mr. Oxley is recognized for an opening 
statement.
    Mr. Oxley. Thank you, Chairlady. Let us first of all 
welcome our distinguished panel. It is good to have all of you 
back to the committee, Mr. Ferguson from the Fed, Mr. Hawke 
from the OCC, and of course FDIC Chairman Powell. Welcome back. 
We look forward to a spirited hearing this morning on the 
revisions of the Basel Capital Accord currently under 
discussion at the Bank of International Settlements. We have 
two very distinguished panels, and I look forward to both the 
panels' testimony.
    I want to first commend the Federal Reserve, the OCC, the 
FDIC and the New York Fed Chairman McDonough in particular for 
spearheading the reforms of the Basel Accord. The authors of 
Basel II have been working diligently for nearly five years to 
develop a workable regulatory capital regime. The primary goal 
of Basel II is to provide flexibility and risk sensitivity in 
the capital adequacy framework. This goal is laudable and will 
be a vast improvement over the one-size-fits-all approach of 
the Basel I Accord, and will certainly reduce risk arbitrage 
under the current system.
    This is a topic of critical importance to the banking 
sector and the economy. If we must sacrifice speed to achieve a 
workable and appropriate solution the first time, I see no 
problem in doing so. Basel II will impact not only the largest 
U.S. financial institutions, but financial institutions of 
every size and structure. The way banks calculate risk and 
compete with one another will be dramatically changed under 
Basel II. Specifically, I am concerned that as it is currently 
written, Basel II will force a medium-sized institution to 
either consolidate to compete with the largest banks, or simply 
cease to offer business lines that the largest banks can offer. 
According to the Federal Reserve, Basel II will only be 
mandatory for the 10 largest banks in the U.S., and will be 
voluntary for the next 10 largest banks. My concern is, what 
happens to the next 10 institutions and the 10 after those.
    I believe that the proposed operational risk charge could 
also result in unintended consequences, forcing banks to 
quantify the risk of such intangibles as litigation risk, 
employee fraud and system failure. Operational risk assessment 
seems to be much more art than science, and could force 
institutions to take large capital charges when there is little 
need for them. Such charges may disadvantage domestic financial 
institutions by requiring capital charges for factors that are 
difficult to quantify and are significantly less likely to 
occur in other countries.
    Basel II is extremely sophisticated. The cost and 
complexity of the proposed Basel II Accord could prove to be 
overly burdensome for both the institutions and the regulators 
charged with enforcing the new provisions. This proposal will 
completely change the way that banks are overseen. As such, the 
regulators are going to have to retrain and hire new staff and 
develop new methods for bank supervision. We need to ensure 
that all parties affected by these changes are prepared to 
ensure the smooth implementation of Basel II.
    In conclusion, I want to reiterate my support for the 
reform of Basel I. There is no question that change is needed. 
However, I strongly urge the Federal Reserve and the other 
regulators to give serious consideration to all the comments 
they hear today and the comments that will be made to the third 
consultative paper before moving forward with any rulemaking. I 
am troubled that a fast-track timeline for the completion of 
the Basel II accord has already been established. I understand 
that the authors of Basel II are seeking final rulemaking to be 
completed by the end of this calendar year. For a regulatory 
structure so complex and so far-reaching, we must take a 
measured approach in order to ensure that all voices have been 
heard, and that we mitigate or eliminate any unintended 
consequences of Basel II to the banking sector and the U.S. 
economy.
    I yield back.
    [The prepared statement of Hon. Michael G. Oxley can be 
found on page 54 in the appendix.]
    Chairwoman Biggert. Thank you, Mr. Chairman.
    We are also pleased to have the ranking member of the 
committee here today. Mr. Frank from Massachusetts is 
recognized for an opening statement.
    Mr. Frank. Thank you, Madam Chair. I want to express my 
appreciation to my fellow bookend, the chairman of the 
committee, for responding as he did when I and others brought 
this to his attention, and arranging to have this hearing. I 
think this is very important, and the chairman, I appreciate 
his responding in this way.
    I am going to take the opportunity of having Basel under 
consideration, particularly with the Fed here, just to say on 
an unrelated Basel topic, I was pleased to see the recent 
change with regard to the risk factor and the time of loans. We 
had a problem because I think there is a pretty good consensus 
that internationally short-term capital has been a 
destabilizing effect in some economies. To the extent that 
capital went in and out in East Asia, for instance, that was 
problematic.
    It was called to my attention that to some extent 
inadvertently Basel might have been contributing to that 
because in the risk factor, short-term capital was considered 
much less risky than long-term capital. That was a clear case 
of a perverse incentive. I understand that there has now been a 
modification so that short-term capital is considered, that it 
is given some kind of benefit from this, that it is only three 
months or less and that it is focused to a great extent on 
trade-related. I hope we can sharpen that, because obviously it 
would not make sense for us to be exaggerating an area of 
instability. So I appreciate that. This is an example of how we 
need always to fine-tune these things.
    As to this particular subject, I am concerned by several 
points that were raised to me by some of those who would be the 
subject of the regulation, and that is obviously often where we 
get our information. I am particularly concerned about the 
potential negative competitive effects, both within the United 
States and internationally. The function that is being 
regulated here is one that is performed both by banks and by 
institutions that are not banks. What has been raised to me is 
the differential impact on the banks, obviously, who would now 
be subject if it is a Pillar I approach to a capital charge, 
versus competitors who would not be. That is not just a matter 
of fairness, because we are not here to help one institution 
versus another. It becomes a matter of incentives. It becomes 
an incentive, to some extent, for institutions interested in 
this not to be banks, or to be setting up institutions that are 
not banks, so that we would wind up having set out to increase 
the regulation, potentially have more of this being done in 
entirely non-regulated areas. That is troubling.
    I am troubled by the potential adverse effect that has been 
raised by some and will be aired on American versus other 
institutions, depending on how this carried out 
internationally. I also am interested, and I particularly 
appreciate all three of the regulators coming here. I guess we 
have three out of the four. We do not have the thrift people, 
but on this one, I suppose they are not involved. I am 
interested in the legitimate differences of opinion among the 
regulators. Let me say I hope no one will think that it is 
somehow improper for various of the regulators to share with 
the Congress of the United States differences they may have. 
Once a regulation is promulgated by the appropriate processes, 
I would expect everybody to be diligent in carrying it out. But 
trying to paper over what might be legitimate differences in 
opinion, particularly when we are talking about some fairly 
technical matters, does not serve anybody well.
    So I encourage all to speak out. We know there have been 
some differences. We would expect that. There are institutional 
differences. These are not easy questions to answer, and I am 
appreciative.
    I want to join the chairman, too, in cautioning against 
excessive haste. I must say that when this was first brought to 
my attention, I spoke to people. I had a very good briefing, 
and I am very appreciative, that President Monahan of the 
Boston Federal Reserve arranged for me. One of the first things 
people told me was that this was nothing to be hasty about. I 
was told that this was not anything imminent. To some extent, I 
must say I am a little concerned when I was told that at the 
beginning, and now I am told, well, you have got to hurry up. I 
do not see any reason to hurry, and I hope that we will not be 
told that we are now confronting any fait accompli, that we are 
in plenty of time to do this.
    There does appear to be, let me say in closing, a consensus 
that we should have some regulation. Whether or not it should 
be with a formalized capital charge versus increased 
supervision is very relevant. Certainly while there are always 
risks in various things, this does seem to me to be 
qualitatively different from the risks that are involved when 
you were talking about quantifiable loans. I think the capital 
charge, a dollar reserve, a money reserve clearly has relevance 
there. Where we are talking about this area, I must say if I 
were coming at this myself ab initio would be more inclined to 
the non-charge regulatory approach, but obviously we will 
listen.
    So I thank the chairman for calling the hearing and I thank 
the three regulators for coming forward this way. I look 
forward to what they have to say.
    Chairwoman Biggert. Thank you.
    Members will be recognized for three minutes, if they wish 
to make an opening statement. Mr. Hensarling of Texas? Mr. 
Murphy of Pennsylvania? Mr. Barrett of South Carolina? Mr. 
Kennedy of Minnesota?
    Mr. Kennedy. Thank you.
    I would just echo the concerns that this does not create 
the international competitiveness that puts American financial 
institutions at a disadvantage. I am very interested in hearing 
your testimony. Thank you for coming.
    Chairwoman Biggert. Thank you.
    Mr. Emanuel of Illinois?
    Mr. Emanuel. Thank you. I obviously look forward to their 
testimony and obviously the Q&A afterwards. Thank you.
    [The prepared statement of Hon. Rahm Emanuel can be found 
on page 56 in the appendix.]
    Chairwoman Biggert. Okay. Ms. Lee of California?
    Ms. Lee. Thank you, Madam Chair.
    I just thank you for the hearing and look forward to the 
testimony. Specifically, I would like to listen closely to how 
Basel II really will affect smaller banks, as it relates to the 
new capital requirement systems. I look forward to also 
returning to my district to talk to our banks and 
representatives in the Bay Area about it. Thank you.
    Chairwoman Biggert. Thank you. Mr. Baca of California?
    To our other members that are here, Mr. Lynch, do you have 
an opening statement? Do you have a motion for unanimous 
consent to make an opening statement?
    Mr. Lynch. I do. I would ask unanimous consent that I be 
allowed to make a statement, Madam Chair.
    Chairwoman Biggert. Without objection.
    Mr. Lynch. Thank you very much.
    I do want to thank all of the witnesses here this morning 
who have come forward to help the committee with their work. I 
in particular want to thank David Spina and Maureen Bateman 
from State Street Corporation for coming here today. I am 
interested in hearing all of the testimony, but especially the 
testimony of those institutions that will have to eventually 
live under anything that is eventually adopted. I think that 
Mr. Spina will be uniquely situated to address that 
perspective.
    I expect that at some point, Madam Chair, we are going to 
be pulled out. There is a members only briefing with Tom Ridge 
on homeland security at 11 o'clock. I hope that at some point 
during the testimony here this morning and this afternoon, that 
we will hear from all of those, and especially Mr. Spina, on 
the specific issue of how will this regulation, especially 
Pillar I of Basel II, how will that affect institutions that 
have to work under that regulation going forward; how will that 
affect, as others have mentioned, the competitiveness of some 
of our institutions in this country. I want to echo the remarks 
and the concerns, or amplify the concerns of Mr. Frank about 
what this really would do in an international competitive 
situation with some of the banks from the European Union.
    I think there is much to be worked through in this. I hope, 
again, as Mr. Frank said, that this is not a fait accompli and 
that we really have an opportunity to look very hard at what we 
are about to do here, and that we protect the institutions that 
have protected our investors and our citizens so well in the 
past.
    Thank you, Madam Chair. I yield back my time.
    Chairwoman Biggert. Thank you.
    Mr. Capuano, would you have an opening statement?
    Mr. Capuano. Yes, Madam Chairman. Again, I would ask 
unanimous consent that I be able to make a statement.
    Chairwoman Biggert. Without objection.
    Mr. Capuano. Thank you, Madam Chair.
    Again, I will be very brief. First of all, I thank you all 
for coming here. I actually thank you very much for a lot of 
the information we have gotten. This is a relatively 
complicated area. Actually, it is a very complicated area, and 
we need all the information we can get. I thank you all for 
providing that.
    For me, when I see these types of things, I see new 
regulation. I have never been terribly opposed to regulation 
per se. It is not a swear-word for me, but the question is 
obviously reasonable, amounts of regulation is one thing. But 
more important than anything else, which is my big concern with 
the drafts that are here, is the concept of a level playing 
field. I know it is nobody's intention to not create a level 
playing field, but particularly with the new world that we have 
in financial services, level playing fields are not necessarily 
always made based upon the organizational structure of a 
particular entity engaged in a business line.
    Right now, I do not know what a bank is anymore. I know 
people have charters, but who is a bank? Realtors are banks 
sometimes. banks are sometimes realtors. Who is an insurance 
company? Who is not? No one knows anymore. So for me, I would 
simply encourage, and again, I am sure you have already 
considered it, but as you continue, to strongly encourage that 
you take the old concepts of organizational structure, knowing 
that they are in flux, knowing that they are changing daily, 
and to try to create that level playing field based on a 
business line, as opposed to an organizational structure both 
domestically and internationally. I know you are trying to do 
that, but to me that is the most important aspect here, and I 
look forward to helping you; or actually hopefully not having 
to help you to create that level playing field.
    Thank you.
    Chairwoman Biggert. Thank you.
    Let me just say before introduction of the witnesses that 
there is a briefing at 11 a.m., but I intend to continue on 
with the hearing. So I know that some of our members will be 
leaving, but hopefully they will return following that 
briefing, but we will continue with the hearing.
    Let me now introduce the members of the first panel. Dr. 
Roger W. Ferguson, Jr., was appointed to the Federal Reserve 
Board in 1997 and has been vice chairman of the Board of 
Governors since 1999. Dr. Ferguson was recently appointed 
chairman of the Committee on Global Financial Systems at the 
Bank of International Settlements in Basel, Switzerland. Before 
becoming a member of the board, Dr. Ferguson was a partner at 
McKinsey and Company, an international consulting firm. He 
received a B.A. in economics, a J.D. in law, and a Ph.D. in 
economics, all from Harvard University.
    Next on our panel is John D. Hawke, Jr., who has served as 
Comptroller of the Currency since 1998. Prior to his 
appointment as Comptroller, Mr. Hawke served for three and a 
half years as Undersecretary of Treasury for Domestic Finance, 
where he oversaw the development of policy and legislation in 
areas of financial institutions, debt management in capital 
markets, and served as chairman of the advance counterfeit 
deterrence steering committee and is a member of the Securities 
Investor Protection Corporation. Mr. Hawke has a B.A. in 
English from Yale University and a law degree from Columbia 
University.
    Donald E. Powell is the 18th chairman of the Federal 
Deposit Insurance Corporation. Prior to being named Cairman of 
the FDIC, Mr. Powell was president and CEO of the First 
National Bank of Amarillo. He received his bachelor of science 
degree in economics from West Texas State University, and is a 
graduate of the Southwestern Graduate School of Banking at 
Southern Methodist University.
    Thank you all, gentlemen. Without objection, your written 
statements will be made a part of the record. You will each be 
recognized for a five-minute summary of your testimony. After 
all of you have testified, then we will recognize members for 
five minutes each to ask questions of you. If that is agreeable 
with you, we will begin with Dr. Ferguson for your testimony.

 STATEMENT OF ROGER W. FERGUSON, JR., VICE CHAIRMAN, BOARD OF 
            GOVERNORS OF THE FEDERAL RESERVE SYSTEM

    Mr. Ferguson. Thank you very much, Acting Chairwoman 
Biggert. Representative Maloney, members of the subcommittee, 
and also Representative Oxley and Representative Frank.
    It is a pleasure to appear before you on behalf of the 
Board of Governors of the Federal Reserve System to discuss the 
evolving new capital accord, Basel II. I would also at this 
point like to thank my colleagues here at the table for their 
active participation over the last four or five years in 
developing Basel II, and to recognize the great work not only 
of the Federal Reserve Staff, but also the staffs of the FDIC 
and the OCC who have been active participants as well.
    Basel II is a complex proposal with many associated issues, 
but the format this morning requires that I be brief. As you 
have already indicated, the board has prepared a longer 
statement. I am pleased that this will be part of the record. 
This morning, I will limit myself to only a few highlights from 
that statement.
    There are several points that I believe should be 
emphasized at the outset before I address some of the questions 
you have raised. First, in the United States, as Representative 
Oxley has pointed out, Basel II will only be mandatory for a 
small number of large, complex banking organizations; about 
ten. Other entities may adopt it if they wish, although we do 
not think it will be cost effective for any but the larger 
organizations. All adopters, both mandatory and voluntary, will 
be required to construct the necessary infrastructure to 
produce and validate the key risk measurement inputs to the 
Basel II framework.
    Secondly, only those U.S. banks that adopt Basel II will be 
required to hold capital for operational risk. Third, beyond 
the required core group of ten or so, and what we expect at 
least initially may be another ten or so adopters by choice, 
all the other thousands of banks in this country will remain 
under the current capital structure known as Basel I.
    Finally, the process of developing the Basel II proposal 
has not been hasty. It has involved a truly unprecedented 
dialogue with banks on a wide range of risk management and 
capital issues. That dialogue continues, and in fact will never 
be over. The Basel Committee will soon be issuing a revised set 
of proposals that we intend to use as the basis for a U.S. 
domestic comment process during the spring and the summer. The 
Basel Committee intends to approve a revised proposal late this 
year, while we believe that the associated U.S. rulemaking 
procedures, which will be the usual ANPR and NPR procedures, 
will be completed some time next year. Again, I do not 
necessarily believe that to be a hasty timetable.
    Implementation could start as early as late 2006, but no 
U.S. bank will be permitted to adopt Basel II until its 
infrastructure for estimating the required inputs has been 
approved by its supervisor. It is important to emphasize that 
modifications to the Basel II proposals will be possible both 
before and after these critical milestone dates. As 
supervisors, we will be seeking continually to improve our 
understanding of the impact of the new rules and will be 
prepared to make necessary changes as appropriate.
    With these preliminary observations, let me quickly sketch 
out why we believe Basel II is necessary for the large, 
complex, internationally active U.S. banks. First, while Basel 
I is still quite effective for most banks, it is too simplistic 
effectively to capture the increasingly varied and complex 
operations of our largest banking organizations. Indeed, the 
Basel I capital ratios are too often misleading. Congress, you 
will recall, has required that these ratios be used as a 
mechanism for filtering the activities of banking organizations 
and guiding supervisory assessments of financial condition, 
including the need for supervisory intervention. Unfortunately, 
current trends will continue to erode the usefulness of the 
existing capital ratios for the largest banks unless 
significant steps are taken to address this concern.
    Second, risk measurement and risk management practices have 
improved dramatically since Basel I was created. Basel II is 
designed to capture those changes and to induce banks to carry 
them forward in their own internal risk management. Third, the 
necessity to induce banks to apply stronger and more 
comprehensive risk management techniques has been highlighted 
and heightened by the increased banking concentration both here 
and abroad. In this country, we now have a small number of very 
large banks and bank holding companies whose operations are 
tremendously complex and sophisticated. Weakness, let alone 
failure, at any one of them has the potential for severe 
adverse macroeconomic consequences. The regulatory entity for 
these entities must therefore encourage them to adopt the best 
possible risk measurement and risk management techniques.
    If we do not move in this direction, the risk of a problem 
at one or more of these entities will rise, providing us with 
only two unattractive options; on the one hand, increased risk 
of financial instability, or the adoption of much more 
intrusive supervision and regulation.
    Time does not permit me to describe the mechanics of the 
Basel II proposal, its risk inputs, regulatory formulas, use of 
internal estimates, et cetera. These are all in my longer 
statement, which again I urge you to read for your background. 
I would like instead to spend my remaining time addressing a 
small number of issues that some banks have raised with you and 
with us.
    A key feature of the Basel II framework is an explicit 
capital requirement for operational risk; the risk that losses 
can incur not from extending credit, but rather because 
processes, systems or people fail, or some events occur. This 
aspect of Basel II has generated aggressive criticism from 
those who feel that it would affect them adversely. But 
clearly, operational risk is real, and indeed often produces 
noteworthy losses; rogue traders, fraud and forgery, settlement 
failures, inappropriate sales practices, poor accounting and 
lapses of control, slippages in custodian and asset management, 
and large legal settlements for alleged losses caused by bank 
action or inaction.
    Indeed, I think my fellow supervisors would agree that our 
staffs have spent no little time dealing with operational risk 
issues in the last several years. Basel I bundled op risk with 
credit risk, which is to say it effectively ignored it. An 
early decision was made in the development of Basel II to 
unbundle other risks from credit risk, and to treat each 
explicitly. Most of the other risks are sufficiently modest so 
that they can be addressed by supervisory oversight, but the 
Basel Committee decided that operational risk is so important 
that it should be treated similarly to credit risk, with an 
explicit capital charge.
    The current Basel II proposals reflect this treatment, and 
thus the large U.S. banks required or opting to use the 
internal ratings-based Basel II capital requirement will also 
be required to hold capital.
    Chairwoman Biggert. Dr. Ferguson, if you could sum up. I 
think we will get to a lot of this in the questions also.
    Mr. Ferguson. Okay. I have a number of other points to 
make, but I am looking forward to responding to your questions 
in that regard.
    Let me also, if I could, speak to one other issue, and then 
conclude by saying that there is clearly strong agreement among 
the regulators that it is important to move past Basel I. I was 
pleased to hear the subcommittee in the opening comments 
address that. There are a number of technical issues which I am 
eager to address today, but at this stage I will sum up and 
allow others to speak.
    Thank you.
    [The prepared statement of Roger W. Ferguson, Jr. can be 
found on page 74 in the appendix.]
    Chairwoman Biggert. Thank you very much, Dr. Ferguson.
    Mr. Hawke?

STATEMENT OF HONORABLE JOHN D. HAWKE, JR., COMPTROLLER, OFFICE 
                 OF THE COMPTROLLER OF CURRENCY

    Mr. Hawke. Thank you, Madam Chairwoman, Congresswoman 
Maloney, Chairman Oxley, Ranking Member Frank, and members of 
the Subcommittee. I am pleased to have this opportunity to 
present the views of the OCC on the Basel Committee's proposed 
revisions to the 1988 Capital Accord. I think it is essential 
that Congress have the opportunity to express its views on any 
regulatory changes that could affect the operations and 
competitiveness of our banking system, and the Subcommittee is 
to be commended for its initiative in this regard.
    For the past few years, the Basel Committee, of which the 
OCC is a permanent member, has been working to develop a more 
risk-sensitive capital adequacy framework. The Committee has 
established a target date of December 2003 for the adoption of 
a revised Accord Basel II. Accordingly, the OCC and the other 
U.S. banking agencies have already begun the process of 
considering revisions to the current U.S. capital regulations 
through our domestic rulemaking process. This means publishing 
proposed revisions for public comment and carefully considering 
the comments that we receive.
    I want to assure the Subcommittee that the OCC, which has 
the sole statutory responsibility for promulgating capital 
regulations for national banks, will not sign off on a final 
Basel II framework until we determine through this notice and 
comment process that any changes to our domestic capital 
regulations are reasonable, practical and effective.
    Despite the enormous effort and great progress made by the 
Basel Committee, serious questions remain about some aspects of 
the Basel II framework. The first issue is complexity. One of 
the goals of Basel II is to encourage financial institutions to 
improve their own ability to assess and manage risk, and for 
supervisors to make use of bank self-assessments in setting 
regulatory capital. But before we can do that, banks have to 
demonstrate that their systems, and the capital determinations 
that flow from them, are reliable.
    Thus, Basel II sets detailed and exacting standards for 
rating systems, control mechanisms, audit processes, data 
systems and other internal bank procedures. This has led to a 
proposal of immense complexity--greater complexity, in my view, 
than is reasonably needed to implement sensible capital 
regulation. I believe we have to avoid the tendency to develop 
encyclopedic standards for banks, which minimize the role of 
judgment or discretion by banks applying the new rules or 
supervisors overseeing them.
    Moreover, Basel II has to be written in a manner that is 
understandable to the institutions that are expected to 
implement it, as well as to third parties. We have already seen 
problems in understanding the instructions for the qualitative 
impact study that has just been finished. It is imperative that 
the industry and other interested parties understand the 
proposed regulatory requirements.
    The second issue is competitive equality. We need to think 
carefully about the effects of Basel II on the competitive 
balance between domestic banks and foreign banks, between banks 
and non-banks, and between large internationally active banks 
in the United States and the thousands of other smaller 
domestic banks.
    In the United States, we have a sophisticated, hands-on 
system of bank supervision. The OCC has full-time teams of 
resident examiners on-site at our largest banks--as many as 30 
or 40 examiners at the very largest. In other countries, by 
contrast, supervisors may rely less on bank examiners and more 
on outside auditors to perform certain oversight functions. 
Given such disparities in the methods of supervision, it seems 
to us inevitable that an enormously complex set of rules will 
be applied much more robustly under our system than in many 
others. Thus, the complexity of the rules alone will tend to 
work toward competitive inequality.
    There is also a concern about the potential effect of Basel 
II on the competitive balance between large banks and small 
banks. As it is likely to be implemented in the U.S., Basel II 
would result in a bifurcated regulatory capital regime, with 
the largest banks subject to Basel II-based requirements and 
all others subject to the current capital regime.
    We expect that banks subject to Basel II will experience 
lower capital requirements in some lines of business than banks 
that remain under the 1988 Accord. That may put smaller ``non-
Basel'' banks at a competitive disadvantage when competing 
against the large banks in these same product lines. We should 
avoid adoption of a capital regime that might have the 
unintended consequence of disrupting our current banking 
structure of small, regional and large banks, and take steps to 
mitigate the adverse effects on the competitive balance between 
our largest and other banks.
    Finally, for many banks, the principal source of 
competition is not other insured depositories, but non-banks. 
This situation is especially common in businesses such as asset 
management and payments processing. While differences in 
regulatory requirements for banks and non-banks exist today, 
many institutions have voiced concern that implementation of 
Basel II may exacerbate those differences to the disadvantage 
of depository institutions.
    The third issue is operational risk, perhaps the most 
contentious aspect of the proposed revisions to the Basel 
Accord. The OCC supports the view that there should be an 
appropriate charge for operational risk. But I have also 
consistently argued before the Basel Committee that the 
determination of an appropriate charge for operational risk 
should be the responsibility of bank supervisors under Pillar 
II, rather than be calculated using a formulaic approach under 
Pillar I. I regret to say that I have not been able to persuade 
the Committee to adopt this approach.
    Basel's operational risk proposal has changed considerably 
since it was first introduced. The current proposal, especially 
the option of the Advanced Measurement Approach (AMA), which 
the OCC helped develop, is a significant improvement over 
earlier proposals. The AMA is a flexible approach that allows 
an individual institution to develop a risk management process 
best suited for its business, control environment and risk 
culture. Nevertheless, the OCC believes that more work needs to 
be done to develop guidelines for the appropriate treatment of 
operational risk.
    Finally, calibration. It has been a specific goal of the 
Basel Committee that the revised Accord be capital neutral. In 
other words, the aim is to maintain the overall capital of the 
banking industry at levels approximately equivalent to those 
that exist under the Basel Accord today. To ensure that overall 
capital in the banking system does not fall, the Committee has 
proposed the use of a minimum overall capital floor for the 
first two years following implementation of the new Accord.
    While the OCC supports a temporary capital floor, it does 
not believe that a reduction in minimum regulatory capital 
requirements for certain institutions is, in and of itself, an 
undesirable outcome. A drop in required capital is acceptable 
if the reduction is based on a regulatory capital regime that 
reflects the degree of risk in that bank's positions and 
activities. But, we are not yet at the point where we can 
really make a confident judgment about the impact of Basel II 
on capital levels. QIS-3, the latest qualitative impact study, 
was based on an incomplete proposal and was applied by the 
banks without any of the validation or control that would be 
present when the new regime is in full force. Thus, an effort 
to calibrate new capital requirements based on QIS-3 must 
confront great uncertainty. This uncertainty further 
illustrates the importance of moving cautiously before we 
incorporate Basel II into our domestic capital rules.
    In conclusion, as I indicated earlier, the OCC strongly 
supports the objectives of Basel II. This summer, the OCC and 
the other banking agencies expect to seek notice and comment 
from all interested parties on an advanced notice of proposed 
rulemaking that translates the current version of Basel II into 
a regulatory proposal. If we determine through our rulemaking 
process that changes to the Basel proposal are necessary, we 
will press the Basel Committee to make changes. We further 
reserve our right to assure that any final U.S. regulation 
applicable to national banks reflects any necessary 
modifications. Given the importance of this proposal, we need 
to take whatever time is necessary to develop and implement a 
revised risk-based capital regime that achieves the stated 
objectives of the Basel Committee, both in theory as well as in 
practice.
    Thank you very much.
    [The prepared statement of Hon. John D. Hawke, Jr., can be 
found on page 94 in the appendix.]
    Chairwoman Biggert. Thank you.
    Mr. Powell, you may proceed.

STATEMENT OF HONORABLE DONALD POWELL, CHAIRMAN, FEDERAL DEPOSIT 
                     INSURANCE CORPORATION

    Mr. Powell. Thank you, Madam Chair and members of the 
Subcommittee.
    Since 1999, the Basel Committee has worked hard to develop 
a new international capital framework referred to as ``Basel 
II.'' I entered this effort late in the game, having joined the 
FDIC eighteen months ago, and I am grateful to my fellow 
supervisors and their staff for the efforts to get us where we 
are today.
    Bank capital is critical to the health and well-being of 
the U.S. financial system. An adequate capital cushion enhances 
the banks' financial flexibility and their ability to weather 
periods of adversity. The conceptual changes being considered 
in Basel II are far-reaching. For the first time, we would 
create one set of capital rules for the largest banks and 
another set of rules for everyone else. Under the proposed new 
Accord, large banks will feed their internal risk estimates 
into regulator defined formulas to set minimum capital 
requirements. Under the new formulas, minimum capital 
requirements for credit risk would tend to be reduced, with 
additional capital being held under a flexible operational risk 
charge.
    Admittedly, the existing capital rules for the largest 
banking organizations have not kept pace with these 
institutions' complexity and ability to innovate. Basel II 
intends to align capital with the economic substance of the 
risks large banks take. That is a worthy goal. Nevertheless, 
before regulators and policymakers embrace Basel II, the FDIC 
has concluded that three critical issues need to be addressed.
    First, minimum capital requirements must not be unduly 
diminished. Lower capital requirements for credit risk, 
together with a set of more flexible capital charges imposed by 
supervisors, may work well in theory. Experience demonstrates, 
however, that it is difficult for supervisors to impose 
substantial capital buffers in the face of stiff bank 
resistance, especially during good economic times. Substantial 
reductions in minimum capital requirements for the largest U.S. 
banks would be of grave concern to the FDIC.
    Second, we must be satisfied that the regulators can 
validate the internal risk ratings. By allowing the use of 
banks' internal risk estimates, Basel II represents a 
significant shift in supervisory philosophy. This new 
philosophy demands that we have in place uniform and consistent 
interagency processes that are effective in assessing whether 
the banks' internal estimates are reasonable and conservative. 
These processes are being developed by the agencies, but the 
work here is not final.
    Third, we must understand and assess the competitive impact 
of Basel II. Basel II will most likely be mandatory only for a 
group of large, complex and internationally active U.S. banking 
organizations. This mandatory group of institutions does not 
include numerous large regional banking institutions, as well 
as thousands of smaller community-based banks and thrifts. If 
Basel II provides the largest U.S. institutions some material 
economic advantage as a result of lower capital requirements, 
the ``non-Basel'' institutions may find themselves at a 
competitive disadvantage in certain markets. This 
``bifurcated'' system raises the concerns of competitive 
inequity between these groups of banks.
    banks themselves are best equipped to evaluate these 
issues. We regulators, in turn, must provide them with 
straightforward dollars and cents information about the Accord 
and the capital they or their competitors may be required to 
hold.
    The FDIC will work with our fellow regulators to address 
these issues in the months ahead. Presuming these threshold 
issues are satisfactorily resolved, numerous Accord 
implementation issues still need to be decided. I will touch on 
two of them in my remaining time. To fully adopt the internal 
ratings-based approach proposal in Basel II, banks must make 
significant investments in staff expertise, internal controls, 
and make the necessary structural and culture changes. 
Qualifying for and living with Basel II will bring complexity 
and burden. Of course, a degree of regulatory complexity is 
unavoidable as banks seek to have capital tailored to their 
individual risk profiles. But these burden considerations, and 
the desirability of testing the waters with the new Accord, 
suggest that the universe of ``Basel II banks'' initially will, 
and should be, relatively small.
    The proposed capital charge for operational risk has 
attracted much discussion. Bank failures related to operational 
risk can be traced overwhelmingly to one common theme-fraud. 
This is certainly part of the reason banks hold capital. 
Whether the operational risk charge is called Pillar I or 
Pillar II is not of critical significance to the FDIC, provided 
the regulators implement this approach in a commonsense, 
flexible manner.
    Finally, in implementing the Accord, let us not overlook 
the importance of credit culture and the virtues of 
conservative banking. The Basel II internal risk estimates are 
likely to be only as robust as the credit culture in which they 
are produced. Rigorous corporate governance structures, 
effective internal controls and a culture of transparency and 
disclosure, all play an important role in ensuring the 
integrity of the banks' internal risk estimates. It will be 
important for supervisors not to place excessive reliance on 
quantitative methods and models. Models can be wrong and losses 
can depart from historical norms. That is why we need a margin 
for error. To repeat an earlier point, that is why we need 
capital.
    Thank you.
    [The prepared statement of Hon. Donald Powell can be found 
on page 145 in the appendix.]
    Chairwoman Biggert. Thank you very much. We will now have 
questions. I will yield five minutes to the chairman of the 
Financial Services Committee, Mr. Oxley.
    Mr. Oxley. Thank you, Madam Chairwoman. I appreciate that.
    Gentlemen, Mr. D. Wilson Ervin, representing Credit Suisse 
First Boston, will be testifying on the second panel. Always a 
problem with the second panel is that members are distracted 
and so forth, so I was looking over his testimony and he had 
some very pointed criticisms of Basel II and I thought maybe I 
would bring them up with you, and see how you respond. While 
giving some very good support and praise for the work of this 
project, he cites four macro issues that arise out of the 
proposed accord that he has some problem with. I would just 
like to ask each one of you to respond to those specific macro 
concerns.
    The first one is, as Mr. Ervin says, the current Basel 
proposal is too complex, too costly, and too inflexible to 
provide a robust, durable framework for bank supervision going 
forward. Implementing the proposed accord may have the effect 
of freezing the development of good risk management and locking 
it into an "early 2000" mindset. I am not quite sure what that 
means, but that is a good place to start.
    Dr. Ferguson?
    Mr. Ferguson. Certainly. I appreciate your giving me a 
chance to respond to this. First, on the question of 
complexity, the answer is Basel II is more complex than Basel 
I. There is no doubt about it. The question of why it is 
complex is the key issue here. It is complex because Basel I 
was a one-size-fits-all, very simplistic approach that did not 
reflect or does not currently reflect the way the largest banks 
manage their capital and manage their operations. As we went 
forward with Basel II, in consultation with the industry, as we 
came out with a variety of proposals, many in the industry 
asked for a slightly different approach, more flexibility, 
different options. What one ended up with was indeed a system 
that moved from one-size-fits-all to a system that is 
appropriately much more risk-sensitive, that reflects the range 
of activities that banks undertake, the range of risks that 
they take, and consequently is more complex.
    So the question is not that it is too complex, but I think 
it is complex because it reflects the complexity of the banking 
industry.
    Mr. Oxley. What about too costly?
    Mr. Ferguson. Second question, costly. I think of cost in 
terms of the cost-benefit analysis. There are two ways that I 
have thought about this cost problem over the last year or so 
when I have been actively involved in this hands-on way.
    First, many of the largest institutions are already going 
down this path. As I have gotten involved with this, as I have 
worked with the staff, I have discovered a large number of our 
large and complex institutions already approach risk management 
in a way that is quite similar to what Basel II is doing. They 
need some incentive. They need some encouragement. Some are 
laggard, which is one of the reasons why going in this 
direction is appropriate, but they have found it in their own 
business interest to start to manage in a way that is quite 
consistent with what Basel II has asked for.
    The second question with respect to cost is what is the 
benefit that one gets out of it, because it is more costly than 
simplistic approaches, but on the other hand there are clear 
business benefits, and I think national benefits to having 
banks that are managed in a way that focuses much more on the 
variety of risks that they face and the various portfolios, and 
recognize that there is more than a one-size-fits-all approach. 
So I look at this in terms of cost-benefit, not just being too 
costly.
    Mr. Oxley. Too inflexible?
    Mr. Ferguson. I think that is also a misunderstanding. As I 
tried to indicate in my opening remarks, one, I think Basel II 
and the interaction and development of Basel will allow for an 
ongoing improvement with respect to Basel. As my colleague Mr. 
Hawke indicated, the expectation would be that this would be 
implemented originally in the very first part of 2007, but 
there would be ongoing review through 2008 and 2009. So there 
is a chance to continue improvements. Obviously, through both 
Pillar I, Pillar II, and Pillar 2I, as new risk management 
techniques take hold, and there are new ways of estimating some 
of the important parameters, that the business community 
developed, the banking community develops, or that we develop, 
those can and will be reflected in the capital requirements. 
All we are asking banks to do is estimate some parameters, but 
the process by which they estimate them, as long as we as 
regulators can validate them, can and should evolve over time 
with the best risk-management technology and techniques that 
emerge as we go into the 21st century.
    Mr. Oxley. Thank you, Dr. Ferguson.
    Let me just go to Mr. Hawke. Complex, costly, inflexible?
    Mr. Hawke. Mr. Chairman, here on the table is the current 
version of Basel II. It is infinitely more complex than it 
needs to be. It is not complex simply because we are dealing 
with a complex subject. It is not only complex, it is virtually 
impenetrable. I defy ordinary people to get past page three or 
four of most of the parts of this document.
    Mr. Oxley. Ordinary people do not read that stuff.
    [Laughter]
    Mr. Hawke. Ordinary people called bank examiners have to 
apply it.
    Mr. Oxley. You are calling bank examiners ordinary people?
    [Laughter]
    Mr. Hawke. That is not a slur.
    [Laughter]
    It is complex because it reflects a mindset on the part of 
a controlling view in the Basel Committee that this needs to be 
a highly prescriptive document that addresses every nicety and 
every aspect of capital regulation. Every loophole is plugged. 
Every nuance is addressed. It reflects a pathological aversion 
to the exercise of supervisory discretion. That is why it is as 
complex as it is. It does not need to be this complex, and I 
have argued this point in the Committee for the past four 
years.
    Second, as to whether it is too costly or not, I think that 
depends on what the final impact is. If the capital of banks is 
really reduced to a point where it is better reflective of risk 
and that reflects a capital saving, then the cost may be 
entirely justified.
    And, quickly, as to the final point, whether it locks us 
into a year 2000 approach to risk measurement, I have thought 
for a long time that that was a danger. We have in a sense here 
a governmentally dictated approach to capital measurement. It 
is an approach that has an awful lot to say for it. But it is 
our approach, and banks are going to have to make an investment 
in implementing the approach that we put out there in final 
form. That does run the risk of inhibiting the development of 
new and better risk measurement systems, because banks will 
already have made the investment in the system that we have 
told them that they are going to have to follow. So I think 
that is a danger.
    Mr. Oxley. Thank you.
    Chairman Powell, could you give us a succinct Texas 
response to those three issues?
    Mr. Powell. First of all, I have never met a normal 
examiner.
    [Laughter]
    I am just kidding. Again, being a former banker, I have 
never seen a regulation that was not complex. They tend to be 
all complex. I think there is a need for a certain complexity 
in the regulations. Having said that, I think as it evolves 
over time, the complexity is diluted to some extent in real 
practice. I think regulators have a history of working with 
institutions to resolve complexities. So I am not as concerned 
as much about the complexity as some, and perhaps it should be 
complex. I am more concerned about making sure that Basel II 
maintains adequate capital ratios. I think it is necessary. I 
think it is important when we are addressing deficiencies 
within the system. We must and should have better risk models. 
Whether those models are more complex, again, depends upon the 
view. But my overriding concern is that those models do not 
produce watered-down capital requirements of these that are in 
existence today.
    Mr. Oxley. Thank you.
    Thank you, Madam Chairwoman.
    Chairwoman Biggert. Thank you.
    Mrs. Maloney, the ranking member, is recognized for five 
minutes.
    Mrs. Maloney of New York. I defer to the ranking member, 
Mr. Frank.
    Mr. Frank. I thank the gentlewoman. I want to say, as I 
read this, part of what I get is that when people have said 
this should have been Pillar II instead of Pillar I, the 
defense in part is yes, but it is a Pillar I that looks like 
Pillar II. Well, if it looks like Pillar II, why don't we make 
it Pillar II. Mr. Ferguson?
    Mr. Ferguson. Again, a good question. Let me explain what 
it does do and how it is different from Pillar II. The 
importance of Pillar I falls into three categories, Congressman 
Frank. One is transparency. Under Pillar I, you disclose the 
capital that you are holding for a particular purpose.
    Mr. Frank. Let's do these one at a time. Is there anything 
that would stop you from saying it is Pillar II, and as a 
transparency requirement, that as part of your administering it 
as a Pillar II, you would require that that amount of capital 
that you can show be made public?
    Mr. Ferguson. There is nothing that stops us from going 
that route.
    Mr. Frank. I just like to do things one at a time. It seems 
to me on transparency we have got a tie.
    Mr. Ferguson. Absolutely right. Let me go to Pillar II, the 
other elements of why Pillar I is important. Pillar I allows 
for more rigor in this process, and I frankly have to disagree 
with some of the tone I have heard from the subcommittee that 
this is very hard to quantify. There are a number of banks that 
already are doing risk management and risk measurement in the 
area of operational risk. Though not as quantifiable as credit 
risk, I would admit, it is more than just sort of a vague gut 
instinctive feel. Through the use of databases and a variety of 
statistical techniques, which I would admit are complex, it is 
possible to do a better job of quantification than perhaps some 
might think, and there are banks that are doing that.
    Now, the difference between Pillar I and Pillar II in that 
regard is that the enforcement of a rigorous, more easily 
quantifiable, more verifiable approach works much better under 
the authority of Pillar I than the give and take, back door, 
quiet negotiation that exists under Pillar II.
    Mr. Frank. I appreciate that. Let me ask you, then, about 
this one. The banks that have quantified this, do you think 
they have on the whole come up with adequate capital set asides 
to meet those risks under the current situation?
    Mr. Ferguson. The answer is I believe that is probably 
true. Let me elaborate. It is not just the banks that have 
quantified it in the way that we are thinking about.
    Mr. Frank. I understand. I appreciate it. You know, this is 
not the easiest stuff in the world, so you have got to be a 
little bit compassionate towards some of us who are learning 
this because this is our job. To be honest, I do not expect 
this to be coming up at a town meeting, even if I had one, and 
I do not have one. I need to go one at a time here. I am just 
talking now; you said that some people have said that it cannot 
be quantified, and you have said it can be with a reasonable 
approximation. We know you do not get precision.
    My question, then, is very specific. To the extent that you 
are familiar with those that have quantified, have they tended 
then; have they put up enough money? The second part of that 
question would be this, under the Pillar I approach, would the 
amount of capital a bank would be required to put up 
approximate what they are now doing--those that have 
quantified?
    Mr. Ferguson. You have led me to the point that I wanted to 
get to anyway, thank you very much.
    Mr. Frank. If I got to where you wanted to go, maybe it was 
not such a good way.
    [Laughter.]
    Mr. Ferguson. Two responses to your two questions. First, 
the answer, as I quickly check with staff here, yes, we would 
say that those that have been on the cutting edge in terms of 
using a more quantified approach to operational risk have ended 
up with a result that seems to us to be within the ballpark of 
reasonableness; point one.
    Point two, one of the major issues that one must understand 
in this discussion is that many of the banks that are most 
vociferous in opposition, and in fact the vast majority of U.S. 
banks, hold excess regulatory capital. The total amount of 
capital that we think would be required by quantifying op list 
would not go up. The difference would be in transparency and 
disclosure, because it would become clearer that they are 
holding some of that capital that they now describe as excess 
specifically for operational risk.
    Mr. Frank. But we have agreed that you could under a Pillar 
II approach deal with that by requiring that.
    Mr. Ferguson. Right, but I am responding to your question 
about whether the total amount of capital would have to go up, 
and the answer is no, the total amount would not.
    Mr. Frank. Let me ask you one last question, and then I 
want to turn to the others briefly. The people who make the 
decision to avail themselves of this capacity, the storage. We 
are talking here about people who decide they are going to have 
one of these banks be the place where they store stuff. My 
impression is we are not talking here about individual 
consumers, but entities that are themselves sophisticated 
institutions. Is that generally correct?
    Mr. Ferguson. Yes, generally speaking.
    Mr. Frank. Okay. Then here is my question, because I raised 
the question in some informal conversations, why we could not 
just do it with publicity, et cetera, and people said, well, 
why doesn't that work for deposit insurance, and does that mean 
you have to have deposit insurance. It was a reasonable 
question. I thought about it, and of course part of the problem 
is that many of the people who make a decision to put their 
accounts in a bank are unsophisticated consumers or they may be 
people who are sophisticated about some things, but the 
transactions costs of trying to figure out what was a safe bank 
and what was not would be impossible. I put myself in that 
category. I want to put my money in a bank. I do not want to 
have to check all these other things.
    But with regard to the people who avail themselves of this 
particular service, it would seem to me that if you went ahead 
and used the transparency authority you had and published how 
much capital they had, et cetera, made them publish it, and if 
in fact you thought it was inadequate and said so, that given 
the sophisticated nature of the consumer in this case, that 
that would be a pretty good protection. What is the matter with 
that?
    Mr. Ferguson. I think that it does not reflect two major 
points here. One is, as I have said, the negotiation and the 
discussion between the regulators and the institutions is one 
in which having the Pillar I capability allows us to get to 
reasonable answers.
    Mr. Frank. One point at a time. Wouldn't the fact that you 
might issue a statement saying you thought that the amount they 
set aside was inadequate; would not that be a pretty effective 
tool for you to use, given the again sophisticated nature of 
the consumer?
    Mr. Ferguson. That would be a dramatic change in the 
relationship. One of the things that happens in supervisory 
relationships is that by and large, unless an institution goes 
to the point that we need to have a public memorandum of 
understanding or a cease and desist order, we keep confidential 
the regulatory information. For example, we do not publish the 
so-called CAMEL rating. So to move into a position where in 
lieu of using Pillar I we are in a name-and-shame mode, a 
whistleblowing mode, changes the confidential relationship that 
we normally have with institutions. I would prefer not to do 
that for the sake of operational risk.
    I think this Pillar I approach allows the right kind of 
discussion and the right kind of transparency, without putting 
us in the awkward position of disclosing confidential 
information about how we consider banks in terms of, if you 
will, a rating. That is the implication of what you just said, 
and it is quite a change from the way that we normally deal 
with banks. I do not think you really want us to go down that 
path.
    Mr. Frank. No, my feeling is that the fact that you might 
do it would give you as much leverage as you needed.
    Mr. Ferguson. Yes, but what I have said is that the reality 
is that the banks know that historically we have not done that, 
and in fact we are by our own rules and regulations--
    Mr. Frank. You historically have not given them a charge 
for this kind of risk, either. The whole purpose of this is to 
change the history.
    Mr. Ferguson. Let me respond to your other question, which 
is whether or not sophisticated counter-parties would have a 
general sense. The answer is that even for sophisticated 
counter-parties, they may have a general sense of management, 
but in fact they really cannot look into these opaque 
institutions with the same clarity that the management itself 
has, and indeed in many cases the management itself uses. One 
of the things that you must understand is that Pillar I, or 
this entire approach, so-called advanced measurement approach, 
depends on the bank's management measurement tools with respect 
to operational risk. In some situations, we are leveraging 
their strengths and their internal view to develop capital, as 
opposed to only on externals.
    Mr. Frank. That is another question. If the bank does not 
have good internal management, then Pillar I is not going to 
work so well with them?
    Mr. Ferguson. No. The point of Pillar I, and using all 
three Pillars in this case, is to provide the banks with the 
right set of incentives to manage as we know the leading edge 
banks can do, and as we know many of the other large banks are 
starting to do already, which is not; while it is a relatively 
nascent science to compare their credit risk, this is not 
something which the people on panel two or any other leader of 
one of the major banks has a complete lack of experience or 
exposure. So we are trying to give them the incentive to keep 
going down a path that we, and I would think they, should be 
on.
    Mr. Frank. I appreciate it. I have taken too much time. I 
have some other questions, but I will submit them.
    Chairwoman Biggert. We will have another round.
    Let me ask the next question, and I will direct it to the 
other two gentlemen, although it really does apply to all three 
of you, but we can come back to that. I really do not want the 
answer; it is a question that is similar, but there are other 
things in here that I would like you to address, rather than 
what has just been talked about.
    It is my understanding that the operational risk will 
include a charge for the potential costs associated with U.S. 
tort liability, discrimination, suitability and similar laws, 
most of which do not apply in the European Union or in Japan. 
Would not such a capital charge have an adverse competitive 
impact on U.S. banks, and perhaps reduce compliance efforts? I 
wonder if you could give the subcommittee any examples of where 
the costs associated with compliance or litigation have 
resulted in a bank failure. If not, why impose a capital charge 
related to them? Would more effective supervision then enhance 
both the social policy goals of these rules and reduce the 
operational risk?
    Mr. Hawke?
    Mr. Hawke. I am frequently asked the question about whether 
operational risk events have resulted in bank failures. One has 
to scramble to try to find examples of that. There are probably 
one or two, but there is no question that operational risk 
events have resulted in significant loss. I do not think the 
test of failure is necessarily the right one.
    Differences between the United States and foreign 
countries, in things like tort liability may well exist, 
reflecting differences in risk between banks operating in those 
jurisdictions. If our banks are subjected to greater potential 
risk because we have a more refined system of tort liability, 
that is a real risk that they face. It may indeed result in 
some kind of competitive inequality.
    Chairwoman Biggert. Mr. Powell, do you have anything to 
add?
    Mr. Powell. I would not have anything to add except this. 
While Comptroller Hawke indicated that he is not sure that 
should be the test as it relates to operational risk, I would 
agree with him. We would be hard-pressed to find that 
institutions have failed on a regular basis because of 
operational risk. Some of these operational risks are 
insurable. One can purchase insurance for that risk.
    Having said that, clearly operational risk is very real in 
the marketplace, and capital should be allocated. We at the 
FDIC believe that there should be supervisory flexibility in 
addressing operational risk. As we indicated, we really have no 
preference whether it is in Pillar I or Pillar II.
    Chairwoman Biggert. Then saying that, is there any 
flexibility in Pillar I for operational risk?
    Mr. Hawke. Madam Chairwoman, I think the important thing to 
understand about operational risk is that there are at least 
three components that need to be addressed in assessing it. One 
is the nature of the risk; another is the quality of the 
controls that the bank has to address the potential risk. The 
third would be the quantification of that risk and the 
translation of that quantity into some kind of capital charge.
    All those things would have to be done whether this was 
nominally under Pillar II or Pillar I. I have argued in the 
Committee consistently that this should be a Pillar II exercise 
because so much of it is subjective in nature: the evaluation 
of internal controls, the evaluation of the nature of the risk. 
But ultimately, it comes down to a question of quantification 
and determining how much capital should be held against those 
risks.
    I think that the advanced measurement approach that we have 
developed, which is nominally a Pillar I approach, takes into 
account an appropriate degree of subjectivity. It is still a 
work in progress. We still have to make sure that it works 
right, that we are approaching the quantification issue, and 
the capital charge that results, in an appropriate way. But 
from my point of view, the good thing about the AMA approach is 
that it infuses a substantial amount of supervisory discretion 
into the process, the same kind of supervisory discretion we 
would have had if this had been under Pillar II.
    Chairwoman Biggert. Thank you. My time has expired. The 
gentlewoman from New York?
    Mrs. Maloney of New York. Thank you.
    Earlier I wrote Comptroller Hawke and others about my 
concern about the global competitive nature of the financial 
services industry, and the concern that American institutions 
not be placed at a disadvantage. He wrote back, and I would 
like to place both letters in the record, and expressed some of 
the testimony that he is giving today on the Pillar I versus 
Pillar II, for the charge or operational risk. He has testified 
that the advanced measurement approach appears to add more 
flexibility. I would like to put his letter in the record. I 
think it is very clarifying and important.
    Chairwoman Biggert. Without objection.
    [The following information can be found on page 171 through 
173 in the appendix.]
    Mrs. Maloney of New York. I would like to follow up on what 
you are saying on how in the world do you resolve the 
differences when you have a disagreement, as you have expressed 
today, between Pillar I and Pillar II, for the charge for 
operational risk? When we get to rulemaking, there will be 
differences of opinion, and the OCC has oversight for national 
banks, the Fed for holding companies; if you disagree, how do 
you resolve it? Who has the final trump card?
    Mr. Hawke. We spend a great deal of time trying to work out 
interagency differences. I think that effort has been 
enormously successful. We have common objectives and have 
worked very well together. I do not anticipate that that will 
change going forward.
    As I mentioned in my testimony, the OCC has the sole 
statutory responsibility for determining capital requirements 
for national banks. In the theoretical event that we do not 
come to closure with our colleagues at the Federal Reserve on 
an approach, national banks would be subject to whatever 
regulatory requirements we imposed on them. The Federal Reserve 
has authority to set the capital requirements for holding 
companies and non-bank subsidiaries of holding companies, but 
that ability to set holding company capital is not intended to 
supplant the judgment or authority of the primary supervisor 
with respect to the banks. Holding company capital is intended 
to protect the bank from the holding company, not to protect 
the holding company from the bank.
    I think our respective roles are pretty well spelled out by 
statute, but I do not anticipate that if this process works the 
way it should that we will end up having significant 
differences.
    Mrs. Maloney of New York. Comptroller Hawke, why is a 
capital charge being proposed for operational risk when there 
is no comparable one for interest rate risk? While significant 
problems remain quantifying and measuring operational risk, 
many of which you have pointed out today with your colleagues, 
interest rate risk is priced daily by well-understood 
methodologies. So why omit interest rate risk from Pillar I, 
when it has been the cause of bank failures, while subjecting 
operational risk to it? Why are we taking that away from Pillar 
I when we know there have been bank failures, and you testified 
you do not even know if there have been bank failures in 
operational risk.
    Mr. Hawke. That is a question that got raised and 
negotiated very early in the Basel discussions. There were a 
number of us in the U.S. delegation who felt that interest rate 
risk ought to be included in Pillar II. As I said, I felt that 
operational risk ought to be included there as well. In early 
negotiations in the Basel Committee, it was agreed that 
interest rate risk would be treated as a Pillar II item, with 
attention focused on outliers in the spectrum of interest rate 
risk.
    Mrs. Maloney of New York. Why shouldn't it be in Pillar I?
    Mr. Hawke. I think one can make an argument that it should 
be in Pillar I. It is probably easier to quantify.
    Mrs. Maloney of New York. Much easier to quantify than 
operational. So why is it not in Pillar I versus operational?
    Mr. Hawke. Interest rate risk is a lot easier to deal with. 
banks deal with it all the time. The concern with respect to 
interest rate risk was not the run-of-the-mill kind of risk, 
but the risk presented by outliers who have significant mis-
matches and different kinds of portfolios. It was thought that 
there was more room for supervisory discretion.
    Mrs. Maloney of New York. So the United States more or less 
wanted it in Pillar I, and the foreign countries did not; is 
that it?
    Mr. Hawke. No, the other way around. We wanted it in Pillar 
II.
    Mrs. Maloney of New York. You wanted it in Pillar II?
    Mr. Hawke. That was one that we won.
    Mrs. Maloney of New York. You won that one. Okay.
    One of the things that I am concerned about, and this is 
something that the ranking member mentioned and the chairman 
mentioned, and everybody on the panel both sides have mentioned 
our concern about how are we looking out for financial 
institutions, American banks, to make sure they are not placed 
at a competitive disadvantage? I would like to hear from all of 
you. What are you doing to make sure that we are not placed at 
competitive disadvantage? I can see a lot of things in this 
that could hinder the competitive ability of our banks. So I 
would want to know, do you have a formal procedure where you 
make sure that we are not in any way hindering American banks 
in the competitive market here or place unfair charges and 
burdens on them?
    Chairwoman Biggert. Briefly, please.
    Mr. Hawke. Let me say that the very purpose of Basel II was 
to try to improve competitive equality among internationally 
active banks since it was felt that Basel I left too much room 
for competitive inequalities to emerge. So in terms of 
competition and competitive equity among internationally active 
banks, that has been the name of the game. As I said, I think 
that some issues, like the very complexity of the process 
itself or the rule itself, work toward competitive inequity 
because of the differences in the nature of the supervisory 
systems between countries.
    Mr. Ferguson. If I may address that issue as well, a couple 
of things. One is, I believe that the strength of the U.S. 
banking system deals with the fact that we have very strong 
capital, among other things. If you compare the U.S. banking 
system to that in Europe and certainly in Japan, I see no 
competitive weakness at all in the U.S. by having strong 
capital. I think just the opposite.
    Second point, as my friend Jerry Hawke has pointed out, the 
name of the game here and the reason to have these three 
Pillars and to have transparency et cetera is to allow greater 
competitive comparisons across institutions. That is one of the 
reasons why we have entered into this, so as to reduce 
competitive inequity.
    The third is we clearly have in a number of places 
decisions that a bank from wherever they may be operating in 
the U.S. will be required to live by some of the elements of 
the accord that we are developing here as part of national 
discretion. So we have managed with this head-to-head 
competition in some of these various portfolios to confront the 
issue directly.
    I think we should not make the mistake of believing that 
having strong, well-capitalized banks with strong risk 
management weakens them in a competitive sense, because the 
recent history and long history indicates that the U.S. banking 
system is extraordinarily competitive vis-a-vis many others who 
have, frankly, exercised a lot more forbearance than we have. 
So I think the strength of our system comes from just the kind 
of regulation and the kinds of controls that we are discussing 
here today.
    Mrs. Maloney of New York. My time is up.
    Chairwoman Biggert. Mr. Kennedy, the gentleman from 
Minnesota.
    Mr. Kennedy. Thank you, and thank you, panel, for your 
testimony. I would just like to continue on that dialogue on 
competitiveness. I will grant you that we have the world's best 
banks and the world's best regulators, but when I look at that, 
how do I make sure, and does Basel II make us more likely to 
have uniformly applied regulations among the regulatory bodies 
in other countries? You talk about this, how it gives you more 
flexibility. Well, flexibility gives me concern if that means 
that the other regulators in other countries do not apply the 
same levels of standards that we do, that we put in that way 
American banks at a competitive disadvantage.
    Mr. Ferguson. I think there are three components to my 
answer to your question. First, it goes back to the differences 
between Pillar I and Pillar II, et cetera, where indeed Pillar 
II is by definition one that creates more of a negotiation. It 
is less transparent, and therefore there is more regulatory 
discretion. Consequently, the need to put things such as 
operational risk, I believe, in Pillar I where there is a more 
rigorous framework, yes, built around internal management and 
measurement approaches, but with a more rigorous framework and 
more rigorous outline, point one.
    Point two, is there are three Pillars here. One of them has 
to do with transparency. One of the best ways I believe to 
ensure the kind of international equality that you are 
discussing is to have the banks that are under Basel II or will 
be under Basel II required to disclose important parameters, 
not the ones that are of competitive sensitivity per se, but 
the ones that allow best comparisons across institutions in 
terms of the nature of their portfolios, the nature of their 
risk management capabilities so the counter-parties can look 
and understand a bit more about them.
    The third is that there is a structured process among the 
members of Basel II, of the Basel Committee. There is an accord 
implementation group that brings the regulators together to 
hold each other accountable for how this is being implemented. 
So that if we from the U.S. standpoint have a strong sense that 
some of our colleagues around the world appear not to be 
bringing the same focus, the same seriousness, we have this 
infrastructure, this communication technique through the so-
called AIG, the Accord Implementation Group, that allows us to 
pressure them and to encourage them to take the same approaches 
that we are.
    I think those three tools allow for a stronger sense of 
competitive equity, and a real sense of checks and balances in 
this process.
    Mr. Hawke. I would endorse the points that Roger made, and 
add one further point that continues to trouble me in the area 
of competitive equity: that is, the vast differences in the 
nature of supervision. As I said in my testimony, we have in 
our largest national banks 30 or 40 full-time on-site 
examiners. We are intimately involved with those banks. In 
banks in some other countries, an outside auditor may do a 
flyover once a year. There is a significant difference in the 
invasiveness, if you will, of supervision between the United 
States and other countries. Given that disparity, it is 
inevitable, no matter how good the mechanisms are that the vice 
chairman described, it is inevitable that there are going to be 
disparities in application. The complexity of the proposal adds 
to that potential.
    Mr. Powell. I would just add one comment. We have been 
talking a lot about the international anti-competitiveness. I 
think it is important for us also to pause and think about the 
domestic competitive inequities, if they are in fact are there. 
That is the reason I think some of the issues that we will be 
talking about as we go forward will come out in the public 
comments. I, too, am concerned about regional banks and smaller 
institutions that might be disadvantaged by Basel II.
    Chairwoman Biggert. Thank you.
    Mr. Kennedy. I would share that concern. I would just like 
to follow up. Your discussions of the regional concerns are 
shared with me when you have two different standards within the 
same country. But following up on the international side, in my 
years as chief financial officer, we would note significantly 
different responsiveness from a Japanese-style bank versus an 
American bank. One of my big concerns is the fact that the 
hangover from that period where we had excessive bad loans in 
the Asian countries that have not been written off; is this new 
accord going to help bring our Asian counterparts towards 
addressing those issues? Or do we have to look for other 
avenues to try to encourage that?
    Mr. Ferguson. I think that is again a serious question. One 
would hope that if this is indeed enforced, and if again the 
public disclosure part as well as the regulatory part forces 
banks around the world, including Japanese banks, to use these 
more sophisticated risk management techniques, that you will 
find less of this irrational pricing that you have talked 
about. One of the points that I have made often in discussions 
is that the international banks, particularly the U.S. banks, 
need not worry so much about strong regulation from the Fed or 
the OCC or the FDIC, as they need to worry about irrational 
pricing from competitors who do not have the same sophisticated 
approach to risk management capabilities as embedded in Basel 
II. So that hopefully would respond to some of your questions.
    If I could take one minute to respond to the question about 
domestic competitiveness, I think that is an issue that must be 
explored in the comment period. However, as I have said in my 
written testimony, there are a couple of reasons why I guess I 
have a little less concern than my colleague from the FDIC, Mr. 
Powell. The first is that smaller banks tend to have much more 
information about their local counter-parties than a large 
national bank that is not actively in that market. The large 
national banks tend to depend much more on models and the 
information that can run through models. We have not seen any 
sense in which small banks are at a competitive disadvantage 
today. They clearly have shown a great deal of strength because 
of their understanding of local market conditions.
    With respect to regional banks, the capital that matters is 
not the regulatory capital which we are talking about here, 
which is a minimum capital. It is economic capital. There is 
nothing in Basel that is going to change economic capital. It 
is going to make things more transparent, but not change the 
economic capital that is the factor that decides pricing. In 
places where economic capital, which by and large tends to be 
higher than regulatory, that will certainly be the case. In 
those few cases where economic capital is lower than regulatory 
capital, which is to say you have new techniques that have 
developed such as securitization, which clearly is an important 
part of the U.S. market, that already exists. Both larger banks 
and regional banks are both using these securitization 
mechanisms to maintain a relatively level playing field where 
regulatory capital was set too high and therefore there are new 
techniques.
    So I would argue even in the domestic situation, while it 
is important to ask the question, as we will when we get into 
the ANPR process, the proposed rulemaking process, I see 
nothing here that immediately leads me to believe that the 
competitive status quo is going to be changed domestically 
because of these capital changes. There are a number of other 
reasons that I have given in my written testimony to deal with 
the competitive issue as well.
    Chairwoman Biggert. The gentleman's time has expired. The 
gentleman from Illinois, Mr. Emanuel is recognized for five 
minutes.
    Mr. Emanuel. Thank you very much. Thank you for coming 
today.
    Obviously, since the decade and a half since the first 
Basel accord, it only makes sense to review, update and change 
given how much the marketplace has changed, and given that the 
first set of rules dealt with uniformity in the international 
market and tried to bring some safe and sound banking rules 
across borders and across markets. Although a lot of the 
questions have dealt with international competitiveness for 
American charter banks in the international market, I want to 
deal a little or ask some questions as it relates to how some 
of these rule changes have on a credit crunch. A lot of these 
discussions, as our ranking member made sense, you do not get 
questions like this about the Basel accord at town halls, which 
is true. You do get questions from a lot of folks about the 
notion that they cannot get access to capital at the very time 
they need capital. Some of the capital requirements here that 
have been discussed and recommended, my worry is they would 
actually have an adverse affect at the time in which you need 
capital, you cannot get it; at the time you do not need 
capital, you have access to it.
    So I would like to change just one; some of the rules and 
some of the suggestions here, the 20 percent operational risk 
capital charge, that also impact; it is also suggested that the 
flexible system that results in banks holding more capital in 
bad times and less capital in good times may adversely affect 
the economy by decreasing credit availability when it is needed 
most. I wanted to ask, as you go through the rulemaking 
process, what are some of the potential unintended consequences 
of new capital requirements as it relates to the flexibility 
that you are going to now ask for in the system, as it relates 
to the capital crunch in these times, whether the inverse 
effect?
    In any order, go ahead.
    Mr. Ferguson. I will respond first, and I am sure my 
colleagues will have other things to say as well.
    Obviously, we have been aware of the concern about cyclical 
implications with respect to Basel II. I have three or four 
components to my response. First is, I believe and I think we 
all collectively believe, that if you have a risk management 
system that is more risk sensitive, then what it will allow is 
for banks to make, and that sensitivity being measured over an 
entire cycle; I will not go through the technical reasons, but 
Basel II allows for that to be measured over an entire business 
cycle, not just in a short term-what you will find is that loan 
pricing is better. It reflects the risk. Therefore, what you 
will find is you have less of a tendency to make unreasonable 
loans during good times, and consequently are less surprised 
when loans fall off and profitability falls off in bad times. 
So there is a possibility that if you have much better risk 
management techniques and that plays through to better pricing, 
that you will get less of a cyclical swing, instead of more.
    The other point I would make is that we, being quite aware 
of some of these concerns, have also made a number of 
refinements and adjustments to allow for some of the 
measurements that the banks have to put in to again be less 
focused on a point in time in the cycle, and instead extend it 
out over a longer period of time. I will not try to go into all 
the technical details here, but we have been aware of that and 
have taken that on board.
    I would also say that one of the important changes under 
Basel II is that Basel I does not give banks credit for a 
number of things that matter and help to offset risk, that we 
plan to put into Basel II. For example, the current accord does 
not give any capital credit when collateral or other methods 
are taken to reduce risk and reduce the possibility of a loss 
given default. So that should also work to mitigate the 
possibility of having this be pro-cyclical. We will again 
continue to look at this as one goes into the comment period. I 
am aware of the comment, but I think the Basel Committee and 
the staff that support it, having heard the comment, have 
already undertaken two or three different efforts to reduce the 
risk of pro-cyclicality.
    The other point I would really have to make is indeed I 
would think when times get bad, it is important for banks to 
take that on board and to recognize, as they have during every 
slow period, that it is appropriate to tighten credit to some 
degree; not to create a credit crunch, but to tighten credit to 
some degree. Most of the times when we have seen credit 
crunches occur historically, it is because there is a sudden 
and unexpected loss in profitability that has the risk of 
eating into capital. If we have gotten this right, we will find 
that you have fewer of those incidents occurring going forward.
    So I am aware of the procyclicality argument, but I think 
there have been a number of efforts made here to refine this, 
to minimize that kind of risk, and indeed to make this, if you 
will, a tool that allows good bankers to be better bankers 
during both the good times and also the bad times.
    Mr. Hawke. Let me just answer briefly, unless you had 
another question. As a bank supervisor, not a central banker, I 
get a little bit nervous talking about procyclicality in the 
context of determining what the appropriate capital rules are 
for banks. I think that the best thing we can do to avoid a 
credit crunch is to make sure that our banks stay in 
sufficiently healthy condition to be able to make creditworthy 
loans when the opportunity arises, irrespective of what is 
happening in the economy. I think once we get into the business 
of trying to manipulate the capital rules to take account of 
changes in the macroeconomy, we run the risk of subverting the 
banking system to broader, perfectly legitimate concerns, but 
with the potential for effects that we see in some other 
countries where banking systems have been manipulated, where 
banking systems have become a disaster and have not been able 
to help in the recovery.
    So this is an area that I think we have to approach with 
great caution. As I say, my inclination as a bank supervisor is 
to look at capital rules without getting too concerned about 
procyclicality.
    Mr. Powell. I would tend to agree with Comptroller Hawke. I 
think the best defense against a credit crunch is a solid 
banking system. You build up capital in good times so that you 
can use it in bad times. I think there is a tendency for all 
bankers during nad times to impose additional requirements when 
we extend credit. But if in fact you have a healthy banking 
system, there is always going to be available credit.
    Chairwoman Biggert. The gentleman yields back. The 
gentlelady from California, Ms. Lee.
    Ms. Lee. Thank you, Madam Chair.
    Let me first thank the witnesses for your testimony and 
your presentations. I would like to ask all three of you just 
to give us some feedback with regard to Basel II as it relates 
to the real estate market. Some have said that it could 
negatively and adversely affect the U.S. real estate market. 
One, credit reallocations could adversely affect real estate 
development. Secondly, higher capital charges could result, 
well, would result in banks being forced to tighten their 
lending requirements, which of course then means that loans to 
anyone other than the highest rated would require banks to 
increase their capital services. So if banks were forced to 
retain more capital, it would be hard, I assume, to maintain 
some banks' current lending activities, with certain customers 
with lower credit ratings.
    Finally, I think one of the problems that many are raising 
with regard to the impact of Basel II on real estate 
development is that there would be fewer resources to purchase 
real estate loans from originators such as banks, leading to 
the tightening of credit in real estate markets. I would just 
like to get your feedback on those points, if in fact you see 
that as a problem or if in fact there are ways that it really 
is not a problem as you see it, with regard to Basel II.
    Mr. Hawke. Let me take a crack at that. I think the Basel 
Committee has been very sensitive to the potential for 
inadvertent credit allocation as a result of what we are doing. 
One of the problems with the existing Accord is that the risk 
weight buckets that are used are so inexact in their 
determinations of risk that they do create opportunities to 
arbitrage the capital rules and that does have an effect on how 
bank credit is allocated.
    On real estate specifically, we have an ongoing dialogue at 
present as to whether the approach to commercial real estate 
lending is the right one. Commercial real estate lending is not 
something that has been looked on in Washington with great 
favor because it lay at the heart of many of the bank failures 
in the late 1980s and early 1990s. The state of the art of 
commercial real estate lending has changed quite significantly 
since then. While there is an understandable skepticism and 
concern about the inherent safety of commercial real estate 
lending, we are inclined to think that we might not have to be 
as tough on that as the experience of a decade or more ago 
might suggest.
    Mr. Ferguson. If I may respond to this as well, I think 
that Jerry Hawke is absolutely right in suggesting that the way 
to maintain healthy bank relationships in the context of real 
estate lending is to create, again, a system in which they 
really evaluate their risks appropriately and lend the right 
amount at the right price. No country is benefited by having 
excessive lending to any one sector, for sure. If Basel II 
works well, or any new capital approach works well, then what 
you will find is that indeed you have got a much better 
allocation of capital and that is what we want.
    Ms. Lee. But with customers with lower credit ratings?
    Mr. Ferguson. That is the same issue. There is no different 
answer there. We have benefited in this country from the use of 
a number of new techniques that allow customers with lower 
credit ratings that have still good assets to get loans from 
banks. There is nothing that I see in Basel II that would put 
that at risk. I would think Basel II would encourage better 
pricing, for sure, which is again to everyone's benefit. There 
are other rules that obviously should deal with disclosure and 
transparency, et cetera. So I do not see any specific reason to 
worry about customers with the lower rating in some sense not 
getting the appropriate allocation at the appropriate price 
with respect to capital from Basel II.
    Mr. Frank. Will the gentlewoman yield?
    Ms. Lee. Yes.
    Mr. Frank. A brief question; one of the things that strikes 
me, we have the three different agencies. Is the Fed the 
controlling agency here regarding America's position, and is 
that automatic because it is through Basel. If not, who decided 
this? How did we get to the point where it is the impression it 
has been the Fed's opinion that has governed. Why is that the 
case and is that something that; how does that happen?
    Mr. Hawke. Congressman Frank, I have been sitting on the 
Basel Committee for four years, and I still do not understand 
how decisions are made. They appear to--
    Mr. Frank. Well, is it automatic because it is central 
bankers? Did the president at some point designate a lead 
agency? How does this happen?
    Mr. Hawke. There are four U.S. agencies that participate: 
the three of us and the Federal Reserve Bank of New York.
    Mr. Frank. The Federal Reserve of New York is for these 
purposes the equivalent of the national agencies?
    Mr. Hawke. Yes.
    Mr. Frank. That is kind of like giving the Ukraine two 
votes, and Byelorussia votes at the United Nations, in 1945.
    [Laughter]
    Mr. Ferguson. Perhaps I should respond to this.
    Mr. Hawke. I am not going to touch that one.
    Mr. Ferguson. Congressman Frank, the way this works is 
there are tough negotiations that occur among the three 
agencies. The people at this table get into negotiation. The 
people sitting behind us get into even more heated negotiations 
to try to develop a U.S. perspective. There is no lead agency 
here.
    Mr. Frank. Okay. Suppose there is a division, does the 
president ever decide?
    Mr. Ferguson. No.
    Mr. Frank. I have imposed on the committee's time, but this 
is one of the procedural things I think we ought to be 
straightening out. When we are talking about narrow technical 
things, it is one thing, but it does seem to me we probably 
ought to have some--
    Mr. Ferguson. But there is no difference in this area, I 
would argue, than in any other area of regulation. The OCC has 
pointed out clearly that they have lead responsibility.
    Mr. Frank. I differ with you, Mr. Ferguson, because each of 
you is supreme in his area of which bank, that you have certain 
basic things. But when we talk about an American negotiating 
position with other nations, it does seem to me we ought to 
have some more clarity as to who decides what that negotiating 
position is. Right now, apparently we do not.
    Mr. Ferguson. The Basel Committee has historically been a 
committee that has brought regulators together to try to 
determine what we think is the best approach to regulations.
    Mr. Frank. Right, but it does seem to me we ought to have 
somebody ready to make a decision.
    Mr. Ferguson. Well, that is in part one of the reasons that 
we negotiate, obviously, is to make sure that we can come to 
you and give you our best advice. Clearly, one of the reasons 
in a democracy is that you have a comment period when you do--
    Mr. Frank. Yes, but you also have somebody who finally--
    Mr. Ferguson. And we have this kind of discussions to do 
that.
    Mr. Frank. I think this is something the committee will 
have to look into.
    Chairwoman Biggert. The gentlelady's time has expired. Let 
us do one more round. We do have another panel, but if we can 
ask succinct questions and get succinct answers, we can do 
another quick round. So I will start with a question.
    There is the extensive comment period for this proposal and 
for any rules that are coupled with several years of data 
collection. Do you think that the time frame for implementation 
of Basel II is a little unrealistic? It seems to me that the 
time frame assumes that there will not be a need for a fourth 
consultative paper. Is this a foregone conclusion?
    Mr. Hawke. Not in my view, Madam Chairwoman. I think that 
the domestic rulemaking proceeding that we are going to be 
embarking on in the near future must be a fully credible and 
reasoned process that has integrity to it. That means that if 
we get comments back in that process from all sorts of 
potential commenters who have not yet had a chance to swing in 
on Basel, we have got to take them into account and evaluate 
them. That means that if our collective judgment is that there 
needs to be a fix, we have to either go back to Basel or let 
our colleagues on the Basel Committee know that there is going 
to be a U.S. exception on whatever the particular issue is.
    Chairwoman Biggert. Thank you. Mr. Powell?
    Mr. Powell. I agree with the Comptroller.
    Chairwoman Biggert. Thank you for your short answer.
    Mr. Ferguson. I agree as well.
    Chairwoman Biggert. Dr. Ferguson?
    Mr. Ferguson. I agree. You got two short answers in a row.
    Chairwoman Biggert. The Federal Reserve recently issued a 
white paper on infrastructure security in which it calls for 
U.S. domestic financial institutions to increase expenditures 
on infrastructure protection. This, coupled with the fact that 
the Basel II proposal calls for a mandatory operational risk 
charge troubles me. It seems like the Fed is requiring domestic 
financial institutions to pay twice; once for improvements in 
the infrastructure and once for a capital charge. Can you 
explain for me why these seemingly divergent policies are 
coming from the Fed?
    Mr. Ferguson. I do not think they are all divergent. I 
think they are actually quite consistent. Let me be pretty 
clear about two things. One is there have been failures due to 
operational risk. Secondly, the Fed as the lender of last 
resort has had the largest single discount window loan ever 
because of an operational failure. It was $20 billion. It 
happened many years ago, but on a daily basis we have 
institutions that because of operational failure borrow from us 
during the course of the day. It is called a daylight 
overdraft.
    Thirdly, obviously as you well know, one of the recent 
times I was here was post-September 11, in which we lent 
several hundred billion dollars or over $100 billion. So we 
take operational risk quite seriously.
    Fourthly, there is nothing inconsistent about the two 
activities that you just alluded to. The point of the white 
paper is to encourage institutions to build appropriate backup 
capability so they can be more resilient, and so the financial 
markets can be more resilient. The point of Basel II is to say 
because these things may occur even if you are resilient, it is 
important to have capital. The way Basel II will work is that 
if a bank has managed its operations so that it has reduced 
some of the kinds of risks that we are concerned about under 
Basel II and operational risk, then that will come into play 
because the amount of capital they will be expected to hold 
will be lower. There will be offsets, for example, for 
insurance as well. So the two things I would say in lieu of 
being contradictory are much more hand-in-glove. They are 
really quite complementary.
    Chairwoman Biggert. And you do not believe that there is a 
pay twice?
    Mr. Ferguson. No, I do not believe there is a pay twice.
    Chairwoman Biggert. Okay. Ms. Maloney, do you have another 
question?
    Mrs. Maloney of New York. Yes, I have a short question for 
Vice Chairman Ferguson. As you know, I have had a long interest 
in the Fed's role in the payment system. Federal law requires 
the Federal Reserve Board to calculate a private sector 
adjustment factor, a PSAF, to ensure that it is not competing 
at an undue advantage with private providers of payment 
services. How will the Fed adjust the PSAF for the operational 
risk capital charge banks will have to hold if the current 
version of Basel II is imposed?
    Mr. Ferguson. I cannot give you a specific answer. I can 
tell you in general how we think about this. We have in our 
system layers of backup that are similar to those that are 
expected in the private sector. In fact, I would argue that we 
have deeper backup than any private sector institution because 
obviously we have 12 institutions around the country and we 
work well together.
    One of the issues that is considered in the PSAF, as you 
know Congresswoman Maloney, is in fact questions of equity and 
what the equivalent equity in capital would be in the private 
sector. So obviously, we will consider that as we go forward. 
But let me reiterate the point I made earlier. I do not expect 
any bank to have an increase in the amount of capital being 
held because of this operational risk charge. There may be 
greater transparency. As Congressman Frank once said in another 
context, it is really moving capital from one drawer to 
another, from looking as though it is excess to being obviously 
associated with operational risk. That does not mean that the 
base of capital overall is going to go up, so I am not really 
sure that since there will be I do not believe brand new 
incremental capital in the banking system because of an 
explicit charge for operational risk, that we should have to 
change the PSAF. If that is the case, we will obviously adjust 
the PSAF so we stay in compliance with the Monetary Control 
Act.
    Mrs. Maloney of New York. I would like to follow up with 
Ranking Member Frank's question. Actually, I asked the same 
question earlier. How do you resolve differences? If you get 
back to us in writing. I have heard two descriptions of how you 
resolve it, and I am still not clear, so possibly if you could 
get back to us in writing.
    Very briefly, Vice Chairman Ferguson, I want to ask the 
same question actually I asked earlier. What is the necessity 
for a minimum capital charge or Pillar I treatment for 
operational risk, while you are not; why admit to interest rate 
risk from Pillar I when it has really been the cause of more 
bank failures, while subjecting operational risk to it. I do 
not understand why they are treated differently when interest 
rate risk is easier; there is a methodology that everyone 
understands and there are more bank failures from it. Why is 
that not getting Pillar I treatment?
    Mr. Ferguson. One of the things you have to understand is 
what the banks themselves do. banks themselves do operational 
risk as very large. We have taken a survey and we found that 
somewhere between 10 and as high as 15 percent of economic 
capital, which is not this minimum, but the economic capital 
that they hold, they often ascribe to operational risk. That is 
a significant sign that the banks themselves see operational 
risk as a real risk. We believe that implies and deserves 
treatment as this credit risk in Pillars I, II and III.
    The second point I would make is that banks actively manage 
interest rate risk on a daily basis. There are large committees 
called asset liability committees whose job it is to manage 
interest rate risk. What we have found over history is that 
they do a pretty good job of that. They are not perfect, and 
the reason that we, the U.S., have taken a consistent point of 
view that interest rate risk should be under Pillar II is that 
we have found that our discussions with them about how they 
manage interest rate risk under Pillar II has been quite 
sufficient in keeping that appropriately under control, and the 
banks understand that as well.
    So this is an area where in some sense things have worked 
reasonably well, and we believe that the status quo seems to be 
the best approach. That is sort of the whole goal of these 
various internal models, et cetera, that banks have. So I think 
you should think of these two things as being slightly 
different, and the approach to management being slightly 
different. Frankly, the incentives that are required are also 
slightly different, which is one of the ways I think op risk is 
very much like credit risk and deserves treatment across all 
three pillars.
    Mrs. Maloney of New York. I want to clarify my position, 
that I do not think that operational risk should be under 
Pillar I, but I appreciate your, or interest rate, for that 
matter. Would you like to; everyone has commented on it, would 
you like to comment on it too, Mr. Powell?
    Mr. Powell. The FDIC position is we are not concerned with 
whether it is in Pillar I or II. We have no preference there.
    Mrs. Maloney of New York. Okay. Thank you very much. My 
time is up.
    Chairwoman Biggert. Thank you. The gentleman from 
Massachusetts is recognized for five minutes.
    Mr. Frank. Mr. Powell, you just said that the FDIC has no 
position on whether it should be Pillar I or Pillar II?
    Mr. Powell. Right.
    Mr. Frank. Mr. Hawke, does the comptroller of the currency 
have a position on whether it should be Pillar I or Pillar II?
    Mr. Hawke. As I said, we have argued until we are blue in 
the face that it should be a Pillar II requirement.
    Mr. Frank. Well, I am back to governance. Okay, I 
appreciate that. Okay, we have got four; first of all, I have 
to tell you, Mr. Ferguson, this is a profound issue for me. You 
three are appointed by the President of the United States and 
confirmed by the United States Senate. The New York Fed, as 
capable a technical institution as it is, is, as are all the 
regional banks, a self-perpetuating institution with no 
democratic involvement in the appointment of the head.
    Now, what we have is this, the four members; one prefers 
Pillar II, one is indifferent, and we have a strong national 
position in favor of Pillar I. I think the governance here is 
awry. How did this happen?
    Mr. Hawke. I would not say that we have a strong national 
position in favor of Pillar I, Congressman Frank. The Basel 
Committee as a whole has taken that position.
    Mr. Frank. The Basel Committee of the United States?
    Mr. Hawke. No, the Basel Committee in Basel.
    Mr. Frank. Okay. But what about in the United States? I 
certainly got the impression that the United States position 
was strongly for Pillar I.
    Mr. Ferguson. I think where we are on this is that we 
believe, all of us, and I know Jerry will speak for himself, 
but I think what I have heard him say is he has argued many 
times for Pillar II. There was not a consensus. Pillar I with 
this AMA approach seems to be a reasonable place to end up.
    Mr. Frank. To whom?
    Mr. Ferguson. I think to us.
    Mr. Frank. Not to the FDIC, which is indifferent.
    Mr. Ferguson. As I said congressman, Jerry will speak for 
himself.
    Mr. Frank. He just did. He said he argued.
    Mr. Ferguson. Pillar I is a reasonable place to end up.
    Mr. Frank. Look, it is okay to have a position, but I do 
not think you are being totally straightforward about this. The 
FDIC did not have a position on Pillar I or Pillar II. The OCC 
was for Pillar II. And we wound up with Pillar I as a 
consensus. This is some consensus. I would like the power to 
impose such a consensus. I think clearly the Fed has become de 
facto the lead agency, maybe because we are dealing with 
international entities. I have to tell you, I think this 
requires some further thought on our process. To the extent 
that we are talking about fairly technical issues, that is one 
thing. For instance, one of the examples we are dealing with 
here; both my colleagues from California, Mr. Baca and Ms. Lee, 
raised small bank-big bank issues. To be honest, I think most 
people would rather have the FDIC and the OCC dealing with the 
small bank big bank issue than the New York Fed as an equal. I 
think these are legitimate governance issues that we have to 
raise.
    Nothing further for me. Mr. Ferguson, I will; oh yes, Mr. 
Powell.
    Mr. Powell. Congressman, I want to be sure that I am clear 
with you. While we do not have a preference whether this should 
be in Pillar I or Pillar II, we stress the need for supervisory 
flexibility in the implementation of it.
    Mr. Frank. I appreciate that, and I think that frankly goes 
more for where we are, not where we were.
    Mr. Powell. Right. I agree.
    Mr. Frank. Yes, Mr. Hawke.
    Mr. Hawke. I want to make clear that I support the AMA 
approach, even though I would strongly prefer Pillar II.
    Mr. Frank. I understand that. You are no longer blue in the 
face, but you used to be, and I do think that goes to how we 
got there.
    Mr. Ferguson, just so that people do not think I am being 
entirely anti-Fed, I will refrain from asking you what you 
think about the President's tax plan. And I have no further 
questions.
    [Laughter]
    Chairwoman Biggert. The gentleman yields back. This will 
conclude the first panel. Thank you, gentlemen, so much for 
coming, and your expertise.
    The chair notes that some members may have additional 
questions for this panel which they may wish to submit in 
writing. Without objection, the hearing record will remain open 
for 30 days for members to submit written questions to these 
witnesses, and to place their responses in the record.
    We will now proceed with the second panel. If they could 
come forward and take their seats as quickly as possible, 
please.
    I would like to welcome the second panel First we have 
Karen Shaw Petrou, the co-founder and managing partner of 
Federal Financial Analytics, a privately held company that 
specializes in information and consulting services for 
financial institutions. Ms. Petrou spent nine years at Bank of 
America as an officer in their San Francisco headquarters, and 
then in Washington as the representative of the bank on Capitol 
Hill, and before regulatory agencies prior to starting Federal 
Financial Analytics.
    Mr. Frank, did you want to introduce Mr. Spina?
    Mr. Frank. Yes, I am very pleased that we are joined by 
David Spina, who is the chairman and chief executive officer of 
the State Street Corporation, which is Boston-based, actually 
headquartered in the district of my colleague Mr. Lynch who has 
joined us. He has been at State Street since 1969 and has had 
obviously a variety of positions there. He became CEO in 2000 
and chairman in 2001. I am impressed when I read the 
information. I am impressed by two things, one that State 
Street was cited by Working Woman magazine as one of the top 25 
companies for executive women, but even more important that Mr. 
Spina chose to put this in his biography. Frankly, he is a man 
of many accomplishments, in a wide range of things. I would 
note that he manages to expand two cultures. His undergraduate 
is from Holy Cross and his M.B.A. from Harvard, so he has a 
certain cross-cultural aspect. I do want to commend State 
Street also for its ranking from Working Women magazine and for 
singling it out, and for calling our attention for what seems 
to me a very significant issue. Thank you, Madam Chair.
    Chairwoman Biggert. Thank you. Next we have D. Wilson 
Ervin, who is managing director of Credit Suisse First Boston 
and head of risk management. He is a member of CSFB's risk 
committee and the leadership and performance committee. He 
joined CSFB in 1982 and has been involved in fixed income and 
equity capital markets, the Australian investment banking team, 
and the mergers and acquisitions group. Mr. Ervin received his 
B.A. in economics from Princeton University.
    Finally, we have Ms. Sarah Moore, executive vice president 
and chief operations officer of the Colonial Bank Group. She is 
a certified public accountant and worked for Coopers and 
Lybrand for nine years prior to her career with Colonial. She 
is a graduate of Auburn University with a B.S. in accounting.
    Just so that Mr. Spina will not feel left out about his 
college credentials, he has a B.S. degree from the College of 
Holy Cross and an M.B.A. degree from Harvard University, and 
was an officer in the United States Navy and served a tour of 
duty in Vietnam.
    We are pleased to have this panel. As with the prior panel, 
if each of you could hold your comments to five minutes, and 
then we will have questions following that, and we usually get 
to any of the testimony that you did not get around to giving 
when you gave your testimony.
    Ms. Petrou, if you would proceed.

  STATEMENT OF KAREN SHAW PETROU, EXECUTIVE DIRECTOR, FEDERAL 
                      FINANCIAL ANALYTICS

    Ms. Petrou. Thank you very much, Madam Chairman, and 
members of the subcommittee. I appreciate very much the 
opportunity to present the perspective of Federal Financial 
Analytics on the capital rule.
    My firm advises financial services firms with an array of 
concerns on the Basel Accord. We also advise the Financial 
Guardian Group, which is an organization of those banks 
particularly concerned with the operational risk-based capital 
sections in the accord.
    I would like if I can to step back from the complexity of 
the accord because so much has been done and the hard work on 
this massive accord that Comptroller Hawke lately waved as 
evidence of its depth and breadth. Economists have been 
focusing very hard on how it will work and what its impact will 
be and how these models may or may not be appropriate. I think 
this is missing one fundamental lesson from decision theory, 
which is you should maximize, do the best you can, not optimize 
as it is put, letting in a sense the best drive out the good. 
This decade-long effort since Basel I was put in place in 1988, 
and was finally effective in 1992, we knew then that the rule 
had some significant flaws. Mr. Frank has pointed to one of 
those; the exemption from the capital framework of short-term 
lines of credit. That was a compromise that was known early on 
that that was in fact a very problematic one, because it 
created artificial incentives to structure loans and credit 
arrangements in a way to arbitrage the capital rules.
    You have heard a lot from many institutions complaining and 
asking questions about the Basel Accord, but I do not think 
many have questioned the fact that Basel II would fix this 
error, even though fixing it will cost them a good deal of 
money. That is one of the things I would argue needs to be done 
quickly. I think other things that are on the table on which 
all of the regulators who were here before you in the first 
panel agree can be done, should be done. Waiting for this 
complex accord to grind its way to consensus and conclusion on 
the 1,000 pages it has already hit and growing may delay 
urgently needed action that would protect financial systems 
here and abroad.
    It is essential, I think, that this action take place and 
take place quickly, because capital really does count. That 
message also gets lost in those 1,000 pages, but capital does 
count in the financial system in each of your districts. It is 
the fundamental driver of how profitability is measured. So a 
bank that has to hold more regulatory capital against a non-
bank is less profitable in that business on the whole as 
another institution.
    Economic capital is one of the ways the market says you 
look risky to me; you need to hold more capital; we want the 
shareholder putting up money before I as a debtholder or 
another counter-party bank take a risk. It is very important 
that regulatory and economic capital incentives align properly. 
In fact, that is the objective which Basel II was originally 
aimed at correcting; ending this regulatory arbitrage where 
regulatory capital and economic capital differs. To the degree 
that Basel II leaves these differences in place in areas like 
operational risk, for example, new forms of regulatory 
arbitrage will be created.
    Similarly, to the degree that concern about rapid action to 
address areas where capital should drop; mortgages, small 
business loans for example, low-risk credit on which I think 
most people have agreed on about at least what the right 
initial risk-based capital rule ought to look like. You will 
create different incentives for different lenders to be in 
those businesses, to the degree that finally Basel II 
recognizes the appropriate economic capital for low-risk assets 
and drops it, the big banks using Basel II will get an 
advantage over the smaller banks still left out of the system. 
That could drive credit availability in the regions, as well as 
the ability of local banks to structure products to meet local 
needs.
    This regulatory arbitrage issue is also apparent in some of 
the smaller details of the capital rules. The issue of 
commercial real estate has been mentioned. I would like to 
bring up another area which is the treatment of small and 
medium-size enterprises, SMEs in Basel talk. I like small 
businesses a lot. I own one, but small businesses can be very 
risky. The Basel rules define small and medium-size enterprises 
as companies with annual revenues of $50 million; not the mom 
and pop shops we are used to thinking about as small businesses 
in this country.
    The capital treatment for SMEs in the current version of 
Basel II is considerably lower than what most of analysts think 
is appropriate for economic risk. The reason is quite simple. 
Last year, Chancellor Schroeder threatened to take the Germans 
out of the Basel II negotiations unless the capital treatment 
for SMEs was fixed in accordance with German demands. That is a 
negotiating process. It is a legitimate one, but it is one 
where I think the Basel II rules remain potentially flawed. It 
is also an indication of the fact that this is a negotiation 
where the United States can, and when it is necessary to 
protect our interests, should intervene.
    The operational area is one where I think that should take 
place. We have had a very full discussion of that, and I know 
David Spina will touch on that in his testimony. It is an area 
where quick action on supervisory improvements is urgently 
needed. Everybody agrees that we learned a lot very much the 
hard way after the tragedy of September 11. On Tuesday, the 
Basel Committee put out, rule two for operational risk 
management. That now needs to be implemented, and implemented 
in a meaningful way, not just in the United States, but in 
Europe and Japan.
    We here have many tools to require appropriate supervision. 
I know Vice Chairman Ferguson cited some concerns that the U.S. 
regulators cannot enforce safety and soundness requirements. As 
a consultant in this field, I have never known them to be shy, 
nor should they be. Congress has given U.S. regulators many 
tools to enforce safety and soundness, and also to make the 
capital requirements count. One immediate step Basel II should 
look at is implementing comparable meaningful standards, 
including linking penalties to capital noncompliance. At the 
end of the day when the Basel II negotiations end, they will 
come back here. U.S. banks will be subject to unique sanctions 
if they fall below the sometimes arbitrary Pillar I thresholds. 
In the EU and Japan, nothing happens, we have seen that, and 
that is a central and immediate thing which Basel II needs to 
address.
    The small bank issue is one I have mentioned briefly. There 
are some potential and significant issues there that need to be 
addressed and there can be rapid action on the agreed parts and 
sections of Basel II. Finally, the non-bank issue is an 
extremely important one, especially in the area of operational 
risk, where the banks that will be particularly adversely 
affected by operational risk-based capital, an arbitrary Pillar 
I charge, compete head-on with non-banks in the asset 
management and payments processing area.
    Chairwoman Biggert. If you could wrap up, please.
    Ms. Petrou. Excess capital is not that when it is put into 
the regulatory framework where these penalties would apply. It 
is very important that those capital determinations be made by 
the market.
    Thank you.
    [The prepared statement of Karen Shaw Petrou can be found 
on page 133 in the appendix.]
    Chairwoman Biggert. Thank you very much.
    Mr. Spina?

STATEMENT OF DAVID SPINA, CHAIRMAN AND CHIEF EXECUTIVE OFFICER, 
                    STATE STREET CORPORATION

    Mr. Spina. Madam Chair, members of the subcommittee, thank 
you for this opportunity to testify today and, in absentia, I 
would like to thank Representative Frank for his introduction 
earlier. Let the record show that my mother could not have done 
a better job. It was very nice of him to be so gracious.
    I am chairman and CEO of State Street Corporation, a global 
financial services company chartered as a bank in 1792 in 
Boston Massachusetts. We provide services such as custody and 
safekeeping for investment securities, fund accounting for 
investment portfolios, and investment management for public and 
private institutions such as pension plans, mutual funds, 
endowments and the like.
    We believe the current Basel proposals will have 
significant negative competitive effects on U.S. banks, and if 
offered the option, we would choose not to opt into the new 
Basel operational risk capital framework. However, due to our 
significant position in our industry sector and the 
international nature of our business, we expect to be required 
by U.S. bank regulators to comply with Basel II.
    Before I summarize our objections, I would make clear that 
we agree with the Basel Committee that operational risk is a 
critical risk issue. We view the U.S. bank supervisory system 
as among the best in the world, which is an asset to U.S. 
banks. The strength of U.S. regulation, however, also creates 
challenges as we compete with institutions subject to less 
intensive regulatory supervision abroad. The U.S. supervisory 
approach to operational risk today is already working. It is 
treated as a Pillar II matter under Basel-speak today, and we 
believe that this provides a strong foundation for even better 
risk management practices going forward.
    The Basel Committee proposal would impose a new capital 
framework or requirements on banks based on statistical 
measures of operational risk. Using the Basel terminology, 
operational risk would fall under Pillar I, which establishes 
capital standards, as opposed to Pillar II, which addresses 
risks through supervision. The Basel definition of operational 
risk is a very, very broad definition, including nearly all 
risks inherent to conducting a business.
    Let me explain State Street's experience with operational 
risk. In the over 200-plus years that we have been in business, 
we have learned that relying on a capital cushion to absorb 
losses is a crutch, not a solution. Our focus is on rigorous 
risk management with a goal of reducing errors and avoiding 
losses. We minimize operational losses by making ongoing 
investments in systems, people and business continuity 
planning, and by ensuring our contractual arrangements clearly 
allocate risk between State Street and our clients. Our long-
documented history of very low operational losses tells us that 
this approach works.
    Operational risk, of course, is part of doing business for 
any company, but it is really an issue of earnings at risk, 
rather than capital at risk. In the very few highly publicized 
bank failures often attributed to catastrophic operational 
losses, no reasonable level of capital would have prevented 
bank failure. Adding a new regulatory capital requirement for 
operational risk will have a detrimental effect by creating 
disincentives for effective risk management and by creating an 
uneven competitive playing field for U.S. banks.
    Let me make four points very quickly. The Basel Committee's 
proposal creates a perverse incentive for banks to 
disproportionately focus financial and management resources 
towards meeting capital requirements, rather than on making 
essential investments in systems, people and business 
continuity planning. This is a little bit of the paying twice 
issue that Representative Maloney was referring to earlier.
    Second, the Basel Committee's proposal would disadvantage 
banks competing with non-banks. In the U.S., non-bank 
investment managers, fund accountants, payments processors and 
broker dealers are not subject to the current bank capital 
rules, nor will they be subject to the new capital requirements 
for operational risk. These non-banks include financial 
services firms that are well known; Firms like Fidelity 
Investments, our neighbor in Boston, SunGard, Merrill Lynch, 
and numerous others whose names you would recognize. The result 
under the Basel proposal is an unfair competitive disadvantage 
for banks competing with these non-bank financial firms.
    Third, the Basel Committee's operational risk proposal will 
hurt U.S. banks in the international marketplace. The 
proposal's untested quantification methods create a high 
probability of inaccurate capital assessments. Such errors 
disadvantage U.S. banks, which face far quicker regulatory 
response when we step over a regulatory line than we believe 
our competitors face in other countries. For example, U.S. 
banks are subject to the prompt corrective action required 
under FDICIA. It is prompt and it simply does not exist 
elsewhere in the world. In short, Basel creates a high risk of 
uneven application and enforcement, I think to the detriment of 
U.S. banks.
    Finally, the banks that are most negatively impacted by the 
Basel Committee's proposed treatment of operational risk are 
what people often call trust banks; banks that specialize 
primarily in holding individuals' and institutions' assets as a 
custodian, fiduciary or investment manager. Disproportionately 
penalizing such banks with a new capital requirement could 
discourage competition and participation in such business 
lines, to the ultimate detriment of all investors.
    In summing up, I urge the subcommittee and the U.S. 
regulators to consider the potential detrimental effects of the 
operational risk proposal on U.S. banks, and instead to insist 
on the adoption of a rigorous supervisory approach under Pillar 
II of the proposed Basel framework.
    Let me just simply say thank you and stop there. I look 
forward to your questions.
    [The prepared statement of David Spina can be found on page 
160 in the appendix.]
    Chairwoman Biggert. Thank you very much, Mr. Spina.
    Mr. Ervin?

  STATEMENT OF D. WILSON ERVIN, MANAGING DIRECTOR AND HEAD OF 
     STRATEGIC RISK MANAGEMENT, CREDIT SUISSE FIRST BOSTON

    Mr. Ervin. Thank you. Good afternoon, it is an honor to be 
here. My name is Wilson Ervin. I am presenting testimony today 
on behalf of Credit Suisse First Boston, and on behalf of our 
trade group, the Financial Services Roundtable.
    CSFB is a major participant in global capital markets, 
employing approximately 22,000 people. We are headquartered in 
New York and regulated as a U.S. broker dealer and a U.S. 
financial holding company. CSFB is also regulated as a Swiss 
bank and will be required to use Basel II. Our implementation 
will be governed primarily by the Swiss EBK, but also by other 
regulators including the Federal Reserve and the UK FSA.
    As head of CSFB's risk management functions, my job is to 
assess the risks of our bank and protect our capital. That is a 
goal similar to many of the goals of bank supervisors. We agree 
with the importance of bringing the current regime up to date 
and fully support the objectives of Basel II. I personally 
developed tremendous respect for the regulators who have worked 
on Basel II, many of whom have been in the room today. They 
have addressed a great many challenging issues with stamina and 
sophistication, and they have been tenacious in trying to get 
to a best practice solution in each one.
    Yet while there is much to admire in the new rules, there 
are also many elements that raise serious concerns. We hope 
this committee, in conjunction with regulators and banks, will 
use this opportunity to improve the current proposal so that 
Basel II can live up to its original and very worthy goals.
    Today, I would like to focus on four macro issues that 
Chairman Oxley mentioned earlier. They are, number one, cost, 
complexity and adaptability over time; number two, pro-
cyclicality or the risks that the new accord could actually 
deepen economic recessions; number three, operational risk; and 
number four, disclosure requirements.
    The first topic I would like to address is the high cost 
and complexity of the new rules and the effect this will have 
on whether the rules remain relevant over time. Most of this 
complexity can be found in Pillar I, which describes the recipe 
for calculating capital requirements. This is more than 400 
pages, as you saw earlier today, and more than 12 times the 
length of the original Basel Accord. It is a normal result from 
this kind of process. Once you start trying to boil down the 
complexity of the real world into a series of mathematical 
formulas, it is very hard to stop halfway. I am concerned that 
this very complexity will make the rules difficult to update 
over time, and potentially lock us into that ``early-2000'' 
mindset regardless of what the future looks like.
    An example of this complexity is the proposal for 
securitization, which is a common method for financing housing 
and credit cards. The draft proposal in this area alone runs to 
40 pages and contains daunting formulas, as you can see from 
the examples submitted in annex one of my written testimony.
    The cost of implementation will be high. We estimate that 
approximately $70 million to $100 million in startup costs for 
our firm will be spent, even though we already use fairly 
sophisticated techniques for measuring economic capital on an 
internal basis. When these costs are multiplied by the 
thousands of banks within the global banking system, this will 
amount to billions of dollars in additional costs. Some of 
these costs will be passed on to consumers and corporations, 
and some of these costs may force banks to exit certain 
activities and leave those markets to unregulated entities.
    Procyclicality: the new rules will change how banks 
calculate their capital and the amount of business they choose 
to do. We have analyzed the impact of applying the Basel II 
rules to loan portfolios over the last 20 years of credit 
cycles. Our calculations indicate the new rules require much 
more bank capital during economic recessions when compared to 
the current system. As an example, let's think about the last 
few years. This period has seen a large number of corporate 
downgrades in a sluggish economy. Unlike the current accord, 
the proposed system will require significantly more capital in 
that environment. Under those circumstances, banks will have to 
choose between raising more capital or cutting the amount of 
lending they do.
    My personal estimate is that our bank would have cut back 
our lending by perhaps 20 percent if the Basel II rules were in 
place last year. If all banks cut back on lending at the same 
time, as they will tend to do under a common global regulatory 
regime, the potential adverse impact on the real economy could 
act to lengthen and deepen economic recession. While it is 
difficult to estimate the size of this effect, I would submit 
that herd behavior can make small problems into big ones.
    In addition to credit risk reforms, Basel II also focuses 
on operational risk; the risk of breakdown in systems and 
people. While a more refined scientific approach to credit risk 
has considerable merit, the proposed quantification of 
operational risk is highly problematic, in my view. It would be 
great to quantify and control all risks with statistical 
methods, but there are fundamental reasons why this would be 
difficult to do with operational risk in practice. You have 
mentioned legal risks several times, and I think that is a 
particularly tough nut to crack.
    Can you really calculate the maximum loss a bank would 
suffer from that, or from potential fraud, an IT breakdown or a 
major disaster? How do you estimate how likely those events 
are? I have yet to see anything substantial that suggests that 
operational risk really is measurable in a way that is similar 
to market and credit risk. In fact, I think we may be creating 
a real danger, a false sense of security that we have measured 
operational risks and therefore controlled them.
    One of the strengths of the proposals is they go beyond 
capital calculations and also look to improve market 
transparency. While we support the concept behind the proposed 
rules here in Pillar 2I, the detailed proposals are cause for 
concern. We currently publish about 20 pages of detailed 
disclosure about risk in our annual report. We estimate that 
Pillar 2I would add another 20 to 30 pages of much more 
technical data to that total, but provide little of value to 
the reader. Indeed, few people in my experience are able to 
digest all of the information already presented on risk, and 
now this information would bury them in a deeper, more 
technical pile of data. While we support transparency, we 
believe the current proposals are more likely to confuse than 
to illuminate.
    In sum, we believe the Basel effort is a worthy goal, and 
we have a high regard for the efforts of the regulators who 
have worked very hard to build it. CSFB and the Financial 
Roundtable have also worked hard to contribute to that 
discussion in a constructive and open manner. Simplifying the 
complex rules currently found in Pillar I will require strong 
discipline in the next round of drafting, and return to some of 
the original philosophy of the project. I believe that much can 
be accomplished if we increase the emphasis on principles, 
rather than formulae in Pillar I, and if we increase the weight 
of Pillar II.
    Pillars II and III have real people on the other side--
regulators and the market. Real people can adapt to changes and 
new markets much more easily than a rule book can. This puts 
the burden back where it belongs, on the shoulders of bank 
management to demonstrate to the regulators, to you and to the 
public that we are doing a good job. That is in the spirit of 
the Sarbanes-Oxley reforms, and I think it is a smart and 
durable way to improve discipline.
    Thank you very much.
    [The prepared statement of D. Wilson Ervin can be found on 
page 58 in the appendix.]
    Chairwoman Biggert. Thank you very much, Mr. Ervin.
    Ms. Moore?

SARAH MOORE, CHIEF OPERATING OFFICER, THE COLONIAL BANK GROUP, 
                              INC.

    Ms. Moore. It is a pleasure, Madam Chair, to appear before 
the subcommittee to present our concerns on the revised Basel 
capital accord. I am Sarah Moore, executive vice president and 
chief operations officer of Colonial Banc Group, which owns 
Colonial Bank, a $16 billion bank operating in the southeast, 
Texas and Nevada.
    We anticipate the impact of the new accord will be far-
reaching, as it will affect not just the largest banks, but 
rather its effects will be felt by banks of all sizes. 
Moreover, it will have a measurable effect on the nation's 
economy. The revised Basel capital accord is an extremely 
complex document. We believe Basel II has the unintended 
consequence of giving the largest U.S. banks an unwarranted 
competitive advantage over smaller institutions that compete 
against them, and importantly, places all U.S. banks at a 
competitive disadvantage to non-banks and to foreign banks.
    We share the concerns about operations risk, but the most 
problematic issue in the accord for Colonial Bank and other 
regional banks is the proposed treatment of commercial real 
estate. We further believe that as drafted Basel II will lead 
to a loss of credit opportunities in the real estate sector 
since the accord treats lending to this area in an unreasonably 
disparate manner. Proponents of this new accord have argued 
that the accord will reduce the capital requirements for 
certain banks. However, with respect to real estate lending, no 
bank is able to utilize the tools under the accord for this 
purpose.
    While all other types of lending can utilize tools 
envisioned in the accord, real estate lending is set on a 
different shelf. Commercial real estate lending is identified 
in the accord as a more volatile high-risk type of lending than 
every other type of lending. banks that use risk assessment 
tools to measure performance of their real estate portfolios 
cannot, regardless of the performance of those portfolios, gain 
entitlement to lower capital standards, as the accord allows 
them to do with respect to every other type of lending.
    As a result of this arbitrary characterization of real 
estate lending and despite the hundreds of millions of dollars 
that will be spent in developing models and tools needed to 
comply with the accord, banks will be unable to adjust their 
capital levels to reflect the actual risk levels posed by real 
estate lending as determined by the tools themselves.
    Why did the Basel Committee use net charge-offs for all 
U.S. banks to develop risk-based capital allocations? I'll tell 
you. The numbers do not support the capital treatment provided 
under the new accord. This is made quite clear in the graph 
which we have attached to my written testimony. This graph 
illustrates net charge-offs by loan type for all commercial 
banks from 1985 through the third quarter of 2002. You can see 
from the data, since 1995, right in this area, that commercial 
real estate loans have had lower net charge-offs than consumer 
loans and C&I loans. Yet under the accord, banks must carry 
higher levels of capital for commercial real estate loans than 
all other types of loans.
    Let's walk through an example of how a commercial real 
estate loan is treated in the proposed accord, versus an 
unsecured loan to WorldCom. Assuming we have a $100,000 loan 
collateralized by a fully-leased office building, the borrower 
has performed as agreed, with a good repayment history, this 
loan would carry a capital charge of $8,000. By contrast, a 
$100,000 unsecured loan to WorldCom, which had a Moody's credit 
rating of A2 prior to WorldCom's announcement of accounting 
irregularities, would have carried a capital charge of only 
$1,600. Which one do you perceive as higher risk: a loan 
collateralized by real estate, which you can touch and re-sell, 
or a promise to pay from a telecommunications company? While 
the accord is intended to strengthen banks, in this instance it 
encourages making unsecured loans, rather than secured ones.
    The proposed accord also would create an uneven playing 
field as a result of the lending patterns of the largest banks 
in the country compared to regional and community banks. The 
level of commercial real estate loans, as a percent of total 
loans, is twice as high for banks under $15 billion as it is 
for banks over $200 billion. In the southeast, non-mammoth 
banks carry an even greater load. Thus, an automatic and harsh 
treatment of commercial real estate disadvantages smaller 
institutions far more than larger ones.
    The inherent flaws in the accord would benefit only a 
handful of the largest U.S. banks, while the majority of 
community and regional banks would be burdened by higher 
capital requirements and increased expenses. Moreover, the 
disparate treatment of commercial real estate lending will 
manifest itself through significant credit crunches and dismal 
economic performance.
    With that in mind, we urge the Congress to require that 
prior to any action on an international agreement on capital 
standards, the federal banking agencies, in consultation with 
the Secretary of Treasury, evaluate the impact of such a 
proposed agreement, take into account a number of factors such 
as the impact of the proposal on small and medium-size 
financial institutions, the real estate markets, and other 
factors, and then submit a report to Congress.
    I thank the subcommittee for allowing me to be heard today.
    [The prepared statement of Sarah Moore can be found on page 
120 in the appendix.]
    Chairwoman Biggert. Thank you very much. I appreciate your 
testimony. Once again, we will have a round of questions at 
five minutes each, so please keep your questions short and your 
answers, and we will have more times for questions.
    I will recognize myself for five minutes. Ms. Petrou, which 
countries win and which countries lose as a result of Basel II? 
Are France and Germany and the United Kingdom going to be 
treated equally with the United States under the proposed new 
accord? You mentioned in your testimony that Germany threatened 
to leave the negotiations if they did not obtain favorable 
treatment for small and medium-size enterprises? How common are 
these tactics?
    Ms. Petrou. This is a negotiation. The rules will apply 
equally to all parties in the Basel accord; the United States, 
UK, Germany, France, Japan and so forth. The real question is 
once each home country's regulator opens the rulebook, how will 
they interpret it and how will they enforce it.
    Chairwoman Biggert. Thank you. Mr. Ervin, your bank seems 
to be in a unique position of having regulation by both the 
United States and Switzerland?
    Mr. Ervin. As well as the UK and I believe approximately 
100 other regulators around the world.
    Chairwoman Biggert. So you have many host countries to be 
under regulation. Do you think that there is going to be; how 
will that work?
    Mr. Ervin. We are concerned. We have not seen how it will 
work yet. We already have tension, where occasionally one 
regulator will advise us to do one thing, and another regulator 
will request something different, and we need to comply with 
both. Sometimes that is very difficult in practice. That is a 
catch-22 situation. To date, that has been reasonably easy for 
us to manage, working cooperatively with regulators in the UK, 
Switzerland and here, which are our primary regulators. But the 
Basel accord is much more complex. It goes much deeper. I think 
you are going to have much more serious home-and-host problems 
going forward. The costs that we have talked about here will 
multiply very dramatically if we have to maintain multiple 
systems to satisfy the needs of multiple regulators.
    Chairwoman Biggert. Do you see that with this new complex 
structure as potentially having an adverse impact then on 
global trade in financial services? Will this drive further 
divisions in an already sensitive area?
    Mr. Ervin. I think you will see some significant changes in 
trade in financial services. I think this accord is enough of a 
``big bang'' so that we do not know all of them yet. I am not 
smart enough to predict exactly which changes will happen. I do 
think there will be some incentives that potentially increase 
consolidation in some areas, some places where it will affect 
banks differently in different countries, and also some areas 
where institutions have to become non-banks to compete 
effectively. I think you will see a lot of changes in trade, I 
am just not sure what they will be exactly.
    Chairwoman Biggert. Thank you. Ms. Moore, what interaction 
has Colonial Banc Group had with the Federal Reserve and the 
other regulators during the negotiations surrounding Basel II? 
Has your input been solicited by the Fed?
    Ms. Moore. It depends on which Fed you are talking with. 
The Federal Reserve Bank in Atlanta has solicited our comments, 
they met with us, they told us to get ready to begin to comply 
with the accord, which is contrary to what Vice Chairman 
Ferguson testified to this morning, that it will apply to only 
the 10 largest banks, and yet the Federal Reserve has told us 
that we need to get ready; that the expectation is that we 
should comply with the accord. We have had really no input into 
the process. I don't believe our voices were heard, it stopped 
at the Atlanta Fed.
    Chairwoman Biggert. I thought that as a regional bank that 
you would perhaps decide to be in it, or decide not to, but 
this sounds like it is more you might be told that you are in 
it.
    Ms. Moore. The Federal Reserve told us that they expect us 
to begin compliance with the accord. We also believe that the 
market forces will dictate that we comply. We are a publicly 
traded company. We have 124 million shares of stock 
outstanding. We feel like the market will force us to 
compliance, or we will be viewed as unsophisticated. Of course, 
we are very concerned because of the competitive disadvantages 
that we believe this will create on a regional bank our size.
    Chairwoman Biggert. If this were so, or even if you did 
decide, if that was changed, could you be prepared by January 
1, 2007?
    Ms. Moore. No.
    Chairwoman Biggert. Have any resources been directed to the 
effort?
    Ms. Moore. A whole industry has developed around providing 
banks resources to help them comply with Basel. We have 
consultants calling us each and every day; we can help you; we 
can help you; buy this software; we will help. We do not have 
the internal resources. We are busy trying to run a $16 billion 
bank every day. I am the chief operations officer. We have a 
lot of technology projects that are trying to keep us 
competitive. This will divert resources away from things that 
will make us more profitable and make us a stronger financial 
institution, no doubt about it.
    Chairwoman Biggert. Do you have any idea what this could 
cost your institution to implement Basel II?
    Ms. Moore. It will be tens of millions of dollars, not 
counting the internal man hours associated with Basel II.
    Chairwoman Biggert. Thank you very much.
    The gentlewoman from New York?
    Mrs. Maloney of New York. I defer to the ranking member.
    Mr. Frank. I thank the gentlewoman, because I am going to 
have to leave after this.
    I would ask particularly the two bank representatives, Mr. 
Ervin and Mr. Spina, I remember asking Mr. Ferguson why 
publicity was enough, because he acknowledged that transparency 
would be the same in either case. His answer to me was, better 
they should go with Pillar I with their ability to impose a 
capital requirement, than to engage in Pillar II because in 
that case they may have to say rude things about you, and that 
would undermine the cooperative relationship. My question then 
is, from your standpoint, would you think it would be better to 
have Pillar I, which would have this I think somewhat rigid 
requirement, would you trade that for Pillar II with the 
possibility that that might lead them occasionally to make 
public comments about you? It seemed to me that he had it 
reversed in what I would want if I were involved, and I 
wondered if you would both address. Mr. Spina, why don't we 
start with you?
    Mr. Spina. I think that in one sense we would all want 
simple rules, but what we are dealing here in capital 
allocation and capital adequacy for a bank is complex. If you 
imagine a dialogue with a regulator and the Federal Reserve is 
our principal regulator at the bank level, because we are a 
state-chartered bank--if they have a Pillar I rule, then they 
start with the high ground, the authoritarian position. They 
have the weight of everything behind them, so we do not have 
any wiggle room. I am not saying that we should, in some cases.
    Pillar II, does allow for more dialogue Back and forth, but 
at the end of the day it is still the Federal Reserve, that is 
the decision-maker and they can still pull the rug on us and 
issue a cease and desist order or something like that. The 
question is whether they start the dialogue with all the 
authority behind them, or whether they finish it. I would much 
rather have it under Pillar II.
    Mr. Frank. Mr. Ervin?
    Mr. Ervin. I would agree with that. Like State Street, we 
pay attention when the Fed talks. That is regardless of whether 
it is Pillar I or Pillar II. Either one would be public. If 
your Pillar I calculations fall below a level, that is as 
public as if you were in a ``name-and-shame'' situation under 
Pillar II. Our point has mostly been that the mathematics and 
the modeling capability fits in Pillar I, and to my mind 
operational risk modeling really does not seem to be built on 
solid foundations.
    Mr. Frank. I appreciate that. It did seem to me, as Mr. 
Ferguson explained, he said basically they wanted to stick with 
Pillar I rather than Pillar II because if they did it under 
Pillar II, they might reach the point where it almost sounded 
like it was Pillar I, so they start out with Pillar I. That is, 
they got to that point and I was not persuaded by that.
    Let me also ask, again this is new to us, but in some ways 
it seems to me the capital charge may be almost irrelevant to 
the evils they say they are trying to ward off; we have got 
ING, baring and some of the other, the Allied Irish Bank; would 
the level of capital charge we are talking about have been of 
any use, Ms. Petrou, in the situation of those, if there had 
been a capital charge, would that have helped greatly?
    Mr. Spina. I do not believe that it would have been 
sufficient to cover the losses in those cases.
    Mr. Frank. Ms. Petrou?
    Ms. Petrou. No, I would certainly concur with that. I noted 
in Chairman Powell's testimony he talked about operational risk 
as the cause of many recent bank failures, and then he points 
out correctly that those operational risks were internal fraud, 
for example in Keystone. This committee had many hearings on 
the failure of Keystone National Bank, and you will recall that 
that internal fraud was in part inside chief executive officers 
burying piles of paper on assets they had said they had sold, 
they did not sell them, and they buried all the paper in their 
own backyard.
    I do not know what an operational risk-based capital charge 
would have done. To expect that on the one hand the risk 
managers would be calculating some form of measurement charge 
with the possibility upstairs, and then--
    Mr. Frank. I appreciate that, but again there is obviously 
the analogy here to the capital that you need for lending risk, 
but it does seem to me with lending risk you are much more in a 
more or less situation that you may miscalculate. Whereas with 
this kind of risk, it seems to me more likely to be an either-
or than a more-or-less, and it does seem to me that the capital 
charge and the level of a capital charge is more suited to the 
former. Is that a reasonable view, Mr. Ervin?
    Mr. Ervin. I think that is a very reasonable view. It goes 
to the fundamental difference between the two. In market and 
credit risk, you take those risks specifically for the prospect 
of gain. It is part of your business. It's different with 
operational risk, nobody wants more fraud risk or more legal 
risk. You try and stamp that out as soon as you can find it. So 
that makes it a fundamentally different animal. I think that is 
one of the core reasons why it is hard to put under Pillar I.
    Mr. Frank. Yes, it does seem to me that more-or-less and 
either-or are different conceptual frameworks, and that we 
ought to do that. I assume we would agree that there ought to 
be very serious supervision here about management risk.
    Chairwoman Biggert. The gentleman's time has expired. The 
gentlewoman from New York?
    Mrs. Maloney of New York. Clearly, I think we need more 
hearings on this, and I am glad that the ranking member had 
called for this initial hearing, and I hope that he calls for 
more, because I think some very serious issues have been raised 
when three executives from American business and international 
business point out the flaws in this and the ways that they 
perceive it will really hurt their ability to provide services 
to our constituents, to consumers.
    I would really like Ms. Petrou to respond to the rather 
startling example that Ms. Moore gave, where the credit risk of 
buying WorldCom under the Basel accord, according to her 
example, would have been perceived a higher capital standard 
for the real estate than for WorldCom. Isn't the whole point of 
Basel to make the capital risk relationship more true to 
reality? The example she gave was exactly the reverse. So I 
would like to hear your comment on it.
    I feel that one of our roles in government is oversight. I 
am very concerned about any competitive disadvantage. If the 
bankers could just in your closing remarks go over what you 
think. We certainly do not in this country want to do anything 
that makes it harder for the American business, American 
financial banks to operate, because then that has a negative 
impact on people, on our consumers, on our constituents. I 
would like you to comment on the real life, real world 
consequences that this will have on your profitability, your 
products, and the impact on your constituents. But Ms. Petrou, 
could you please comment on the; I found her example 
startling--could you comment on that please?
    Ms. Petrou. Yes, ma'am. It is. It is an example of the many 
problems I think that are buried in those thousand pages. When 
people sit down and start to run them, there are startling 
results. This is in part because the treatment of credit risk 
mitigation is still very incomplete. I would argue it is one of 
the things that Basel ought to be doing quickly; collateral, 
certain forms of loan insurance. There are numerous ways we 
have learned over the years to put somebody in the middle 
between a lender and loss. There is a lot that could be done to 
fix that, but I am not convinced the current version does.
    Mrs. Maloney of New York. I want to thank Mr. Oxley for 
calling for these hearings, and of course my colleague, Ms. 
Biggert, with whom we work on so many issues. Could you comment 
on the competitive disadvantage that all of you have testified, 
and also whether or not the Fed or the OCC has responded to 
your concerns when you have raised them.
    Mr. Spina. From State Street's perspective, we compete in 
much of our products and services with non-banks. Accounting 
firms and data processing firms can offer similar services. We 
do offer bank-related services, which is why we keep our bank 
charter as well. But clearly, if we had a capital charge, that 
would impose a cost on the company. We would have to earn a 
return on that capital and our competitors would not be 
burdened with that cost. So I think it would be a material 
event in the sense that it would force us to reexamine our 
business model entirely and see how we provide those services.
    In terms of dialogue, we are uniquely focused in this kind 
of business, and we have benefited from a lot of dialogue and 
access to the Federal Reserve. I give them very high marks on 
that. The Boston Federal Reserve, the New York Federal Reserve 
and the Board of Governors have sponsored meetings both at 
State Street and in Washington and in New York. We have made 
our points, but we do not seem to come to closure, which is 
really why we are here. They hold their position that they 
think operational risk needs to be Pillar I, notwithstanding 
the arguments.
    I have seen them bend in other related situations on 
different aspects of the credit risk proposal, after dialogue, 
and the proposals have gotten better, and this whole advanced 
management approach is a lot better than where we started a 
couple of years ago. However, we still cannot get them all the 
way to Pillar II, which is where we are focused.
    Chairwoman Biggert. I hate to break in here, but we have 
just a few minutes because of the timing of the room. So Mr. 
Ervin, if you could just in a couple of sentences, and Ms. 
Moore, we will have to complete our hearing.
    Mr. Ervin. I would support Mr. Spina's comments. I think 
that some of the biggest differentials are going to be between 
banks and non-banks. We compete very heavily with non-banks in 
many of our lines of business. I am worried that we will become 
less competitive and potentially will have to cede some of 
those lines of business to non-banks going forward.
    With respect to national implementation, as I said before, 
we see a lot of differences in different countries. I would 
tell you that you do not need to worry about Switzerland. They 
are one of the toughest regulators out there. They are very 
proud of their banking tradition, and are very strict. But I 
think there is a risk that the stricter regimes, such as 
Switzerland or the U.S. regime or the UK regime, could be 
disadvantaged versus other countries.
    Ms. Moore. I like the idea of more hearings. It is an 
excellent idea. I feel like the industry, especially banks of 
our size, are just now getting up to speed on the impact of 
Basel. When the regulators are telling you, and making public 
statements, that only Basel will apply to the top 10 banks; 
banks are thinking, great, I don't have to worry about that 
600-page complex document, when in reality they should be 
worried about it. I believe these hearings will raise the 
awareness of the banking industry and get more people like 
Colonial Bank involved in the process. Thank you.
    Chairwoman Biggert. Thank you. The chair notes that some 
members may have additional questions for this panel which they 
may wish to submit in writing. Without objection, the hearing 
record will remain open for 30 days for members to submit 
written questions to these witnesses and to place their 
responses in the record.
    Thank you all very much. You have been an excellent panel, 
and thank you for sitting and waiting through the other panel. 
We really appreciate it. I wish we had more time, but maybe you 
will be back. Thank you very much.
    The hearing is adjourned.
    [Whereupon, at 12:57 p.m., the subcommittee was adjourned.]
                            A P P E N D I X


 
                           February 27, 2003
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