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




 
                    THE NEW BASEL ACCORD: IN SEARCH
                       OF A UNIFIED U.S. POSITION

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

                                HEARING

                               BEFORE THE

                            SUBCOMMITTEE ON
               FINANCIAL INSTITUTIONS AND CONSUMER CREDIT

                                 OF THE

                    COMMITTEE ON FINANCIAL SERVICES

                     U.S. HOUSE OF REPRESENTATIVES

                      ONE HUNDRED EIGHTH CONGRESS

                             FIRST SESSION

                               __________

                             JUNE 19, 2003

                               __________

       Printed for the use of the Committee on Financial Services

                           Serial No. 108-40



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                            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 Chair   JULIA CARSON, Indiana
RON PAUL, Texas                      BRAD SHERMAN, California
PAUL E. GILLMOR, Ohio                GREGORY W. MEEKS, New York
JIM RYUN, Kansas                     BARBARA LEE, California
STEVEN C. LaTOURETTE, Ohio           JAY INSLEE, Washington
DONALD A. MANZULLO, Illinois         DENNIS MOORE, Kansas
WALTER B. JONES, Jr., North          CHARLES A. GONZALEZ, Texas
    Carolina                         MICHAEL E. CAPUANO, Massachusetts
DOUG OSE, California                 HAROLD E. FORD, Jr., Tennessee
JUDY BIGGERT, Illinois               RUBEN HINOJOSA, Texas
MARK GREEN, Wisconsin                KEN LUCAS, Kentucky
PATRICK J. TOOMEY, Pennsylvania      JOSEPH CROWLEY, New York
CHRISTOPHER SHAYS, Connecticut       WM. LACY CLAY, Missouri
JOHN B. SHADEGG, Arizona             STEVE ISRAEL, New York
VITO FOSSELLA, New York              MIKE ROSS, Arkansas
GARY G. MILLER, California           CAROLYN McCARTHY, New York
MELISSA A. HART, Pennsylvania        JOE BACA, California
SHELLEY MOORE CAPITO, West Virginia  JIM MATHESON, Utah
PATRICK J. TIBERI, Ohio              STEPHEN F. LYNCH, Massachusetts
MARK R. KENNEDY, Minnesota           ARTUR DAVIS, Alabama
TOM FEENEY, Florida                  RAHM EMANUEL, Illinois
JEB HENSARLING, Texas                BRAD MILLER, North Carolina
SCOTT GARRETT, New Jersey            DAVID SCOTT, Georgia
TIM MURPHY, Pennsylvania              
GINNY BROWN-WAITE, Florida           BERNARD SANDERS, Vermont
J. GRESHAM BARRETT, South Carolina
KATHERINE HARRIS, Florida
RICK RENZI, Arizona

                 Robert U. Foster, III, Staff Director

       Subcommittee on Financial Institutions and Consumer Credit

                   SPENCER BACHUS, Alabama, Chairman

STEVEN C. LaTOURETTE, Ohio, Vice     BERNARD SANDERS, Vermont
    Chairman                         CAROLYN B. MALONEY, New York
DOUG BEREUTER, Nebraska              MELVIN L. WATT, North Carolina
RICHARD H. BAKER, Louisiana          GARY L. ACKERMAN, New York
MICHAEL N. CASTLE, Delaware          BRAD SHERMAN, California
EDWARD R. ROYCE, California          GREGORY W. MEEKS, New York
FRANK D. LUCAS, Oklahoma             LUIS V. GUTIERREZ, Illinois
SUE W. KELLY, New York               DENNIS MOORE, Kansas
PAUL E. GILLMOR, Ohio                CHARLES A. GONZALEZ, Texas
JIM RYUN, Kansas                     PAUL E. KANJORSKI, Pennsylvania
WALTER B. JONES, Jr, North Carolina  MAXINE WATERS, California
JUDY BIGGERT, Illinois               DARLENE HOOLEY, Oregon
PATRICK J. TOOMEY, Pennsylvania      JULIA CARSON, Indiana
VITO FOSSELLA, New York              HAROLD E. FORD, Jr., Tennessee
MELISSA A. HART, Pennsylvania        RUBEN HINOJOSA, Texas
SHELLEY MOORE CAPITO, West Virginia  KEN LUCAS, Kentucky
PATRICK J. TIBERI, Ohio              JOSEPH CROWLEY, New York
MARK R. KENNEDY, Minnesota           STEVE ISRAEL, New York
TOM FEENEY, Florida                  MIKE ROSS, Arkansas
JEB HENSARLING, Texas                CAROLYN McCARTHY, New York
SCOTT GARRETT, New Jersey            ARTUR DAVIS, Alabama
TIM MURPHY, Pennsylvania
GINNY BROWN-WAITE, Florida
J. GRESHAM BARRETT, South Carolina
RICK RENZI, Arizona


                            C O N T E N T S

                              ----------                              
                                                                   Page
Hearing held on:
    June 19, 2003................................................     1
Appendix:
    June 19, 2003................................................    59

                               WITNESSES
                        Thursday, June 19, 2003

Elliott, Steven G., Senior Vice Chairman, Mellon Financial 
  Corporation....................................................    44
Ferguson, Hon. Roger W. Jr., Vice Chairman, Board of Governors of 
  the Federal Reserve System.....................................     7
Gilleran, Hon. James E., Director, Office of Thrift Supervision..    17
Green, Micah S., President, The Bond Market Association..........    48
Gup, Benton E., Chair of Banking, University of Alabama..........    46
Hawke, Hon. John D. Jr., Comptroller, Office of the Comptroller 
  of the Currency................................................    11
Powell, Hon. Donald, Chairman, Federal Deposit Insurance 
  Corporation....................................................    15
Thomas, Karen M., Director of Regulatory Affairs and Senior 
  Regulatory Counsel, Independent Community Bankers of America...    50

                                APPENDIX

Prepared statements:
    Oxley, Hon. Michael G........................................    60
    Bachus, Hon. Spencer.........................................    62
    Gillmor, Hon. Paul E.........................................    65
    Elliott, Steven G............................................    66
    Ferguson, Hon. Roger W. Jr...................................    82
    Gilleran, Hon. James E.......................................   114
    Green, Micah S...............................................   122
    Gup, Benton E................................................   128
    Hawke, Hon. John D. Jr.......................................   141
    Powell, Hon. Donald..........................................   167
    Thomas, Karen M..............................................   182

              Additional Material Submitted for the Record

Davis, Hon. Artur:
    Letter to Federal Reserve Chairman Alan Greenspan with 
      response, May 2, 2003......................................   189
Maloney, Hon. Carolyn B.:
    Federal Banking Agencies letter, June 25, 2003...............   195
KeyCorp, prepared statement......................................   197


                    THE NEW BASEL ACCORD: IN SEARCH
                       OF A UNIFIED U.S. POSITION

                              ----------                              


                        Thursday, June 19, 2003

             U.S. House of Representatives,
         Subcommittee on Financial Institutions and
                                    Consumer Credit
                           Committee on Financial Services,
                                                   Washington, D.C.
    The Subcommittee met, pursuant to call, at 10:06 a.m., in 
Room 2128, Rayburn House Office Building, Hon. Spencer Bachus 
[Chairman of the Subcommittee] presiding.
    Present: Representatives Bachus, Kelly, Toomey, Hart, 
Capito, Tiberi, Hensarling, Murphy, Brown-Waite, Oxley (ex 
officio), Sanders, Maloney, Watt, Sherman, Velazquez, Davis and 
Frank (ex officio).
    Chairman Bachus. [Presiding.] Good morning. The 
Subcommittee on Financial Institutions and Consumer Credit is 
convened. The Subcommittee meets to examine the proposed Basel 
II Capital Accord and its potential effects on the domestic and 
international banking systems.
    The goal of Basel II is to develop a more flexible and 
forward-looking capital adequate framework that better reflects 
the risks facing banks and encourages them to make ongoing 
improvements to their risk assessment capabilities. The 
Subcommittee on Domestic and International Monetary Policy, 
Trade and Technology held a hearing in February to examine the 
proposal, where we heard from a distinguished panel of 
regulators, including Federal Reserve Vice Chairman Ferguson, 
Comptroller Hawke, Chairman Powell and a panel of private 
sector witnesses.
    This hearing revealed that the federal regulators did not 
have a unified position on the scope and merits of Basel II. 
Following this hearing, I along with Congresswoman Maloney, 
Chairman Oxley, Ranking Member Frank, introduced H.R. 2043, the 
United States Financial Policy Committee for Fair Capital 
Standards Act.
    H.R. 2043 requires the federal banking regulators to 
develop a unified position on issues under consideration and 
the Basel Committee on Banking Supervision. Today, we will hear 
from the Federal Reserve, OCC and FDIC, along with OTS Director 
James Gilleran.
    Our second panel of private sector witnesses includes 
representatives of a large bank, a financial services trade 
association and university professor. I look forward to hearing 
from today's witnesses and thank them for taking time from 
their busy schedules to join us.
    I applaud the intent and the objectives of Basel II 
agreement: to ensure solvency of our banking institutions and 
protect against substantial losses; to create international 
standards to better manage risk; and align regulatory capital 
to economic risk.
    The distinguished witnesses on our first panel are to be 
commended for the work they have already accomplished on this 
agreement. Nonetheless, I have concerns regarding Basel II on 
several grounds.
    First, I believe it is unnecessarily complex and costly, 
with inflexible formulas replacing current rules and 
supervisory examinations. In addition, I believe that the 
current draft would create an uneven playing field, one that 
unfairly penalizes many banks in this country, particularly our 
regional banks.
    But my main concern is about the transparency of the Basel 
process as a whole and specifically, how the U.S. position at 
the Basel Committee is determined. I know that there has been 
an extensive comment period. And representatives of the Federal 
Reserve Board assure me that the banks that would be subject to 
Basel II approve of it.
    Nonetheless, some of the banks have indicated to me, 
through their representatives, that they are in fact 
tremendously concerned about Basel. I understand that banks 
that have reservations about the U.S. position are hesitant to 
object openly to a regulatory agency that exercises power over 
them.
    This concern seems reasonable to me. I believe we must 
arrange for a full airing of the views of all interested 
parties, without institutional constraint.
    In addition, it has become clear to me that the bank 
regulators are not in agreement on the desirability of the 
accord as currently drafted. I am hesitant about this Congress 
supporting fundamental changes to our banking system in the 
face of a lack of consensus among thoughtful regulators.
    And I note at this time that the Senate testimony yesterday 
by banking representatives did describe Basel II as a 
fundamental change in banking supervision and regulation. H.R. 
2043 would require the regulators to reach agreement by 
establishing a procedural framework for further deliberations 
on Basel.
    Our bill would create an interagency Committee, chaired by 
the Treasury Department, and include federal banking 
regulators. If the members cannot reach consensus on a 
position, the position of the Treasury would prevail.
    It is important that the secretary, as part of the elected 
administration, set U.S. policy. Yesterday, I announced at the 
Exchequer Club, that the Subcommittee plans to mark up this 
legislation in July.
    In closing, I want to thank Chairman Oxley, Ranking Member 
Frank and Mrs. Maloney for working with me to develop this 
legislation. I look forward to working with them and other 
members of this Subcommittee on this important issue. I also 
look forward to the testimony of our regulators this morning 
because, as I have said on two or three occasions, we are 
concerned that there are different opinions on Basel II and its 
effect on the banking institutions and our financial system as 
a whole.
    I now am pleased to recognize Mrs. Maloney for an opening 
statement. Or Mr. Frank--I am sorry. Mr. Frank has come in.
    [The prepared statement of Hon. Spencer Bachus can be found 
on page 62 in the appendix.]
    Mrs. Maloney. I defer to the ranking member of the 
Committee and appreciate so much his intelligent concern on 
this issue and so many others. Thank you, Barney.
    Chairman Bachus. I just simply did not see that you had 
come in. So I apologize.
    Mr. Frank. I try to be as unobtrusive as possible, Mr. 
Chairman.
    [Laughter.]
    I appreciate your acknowledging that. I want to comment--
and I appreciate your diligence in giving us a chance to be 
involved in this. I must say, I do get the feeling from the 
Federal Reserve that our interest is not entirely welcome. But 
that is one of the things that concerns me.
    I have procedural concerns here as much as substantive. And 
I was pleased to hear that you plan to move on this legislation 
because I think we have a very big problem in the way in which 
we formulate policy here.
    Globalization is a fact. It is probably as important in the 
financial markets, given the nature of money and its 
fungability in finance. Globalization is as powerful a force 
there as anywhere else.
    So formulating American policy to deal with these global 
issues is very important. And I think we do not have a coherent 
process in place for formulating these.
    And we began these conversations. And some financial 
institutions had substantive concerns, called them to my 
attention and the attention of some others.
    We began these discussions based on those. But my concern 
broadened to include the procedures because we were initially 
told that there was a Committee of U.S. regulators that had 
come up with this common position.
    But it now is clear that two of the three federal agencies 
disagree with the position to some extent. And frankly, we were 
told, to some extent, by the Federal Reserve it seemed to me, 
that everybody was in agreement.
    And then we heard from the Comptroller of the Currency and 
the head of the FDIC that there was not agreement. And to adapt 
the line from Chico Marx when he was caught at something he had 
denied, the question became, ``Who are we going to believe, 
them or our own ears?''
    And I am going with my ears. And I think what we need to do 
is to create a structure here.
    I also continue to believe that while I, along with 
everybody else, have not just respect but gratitude for the 
great work that the New York Federal Reserve Bank does in 
helping us manage our financial institutions, it ought never to 
be considered to be on a par with those institutions of the 
federal government which have a Presidential appointee at the 
head who was confirmed by the Senate.
    So when we are told that there is a four-member Committee 
and it is the Federal Reserve Board, the New York Fed and the 
Comptroller of the Currency and the FDIC, I think that is not 
an appropriate structure. I should add that I have been 
concerned about some of the substance. And I will ask some 
questions specifically about that.
    But I also believe that, given the lack of coherence in the 
procedures and given the disagreements that evidently exist--
and they are legitimate disagreements. These are not easy 
questions to answer.
    There is nothing wrong at all with there being legitimate 
differences of opinion among regulators. To some extent, they 
have different regulatory functions. But they also have 
inarturial perspectives. And these are the things that we ought 
to have discussed.
    But given the obvious differences that continue to exist 
among the responsible regulators, it seems to me an error for 
us to go forward with what purports to be an American 
government position, which does not represent not just some of 
the important regulators, but frankly does not seem to have a 
lot of support in Congress.
    And as much as I respect the work that the Federal Reserve 
does, it is not, I think, empowered to speak for the U.S. 
government by itself to the extent that it seems to me to be 
doing in this situation. I do think that there needs to be some 
better working together.
    Now I would assume the Fed would have a major role here, a 
lead role in some ways. But I think that we have gotten ahead 
of ourselves in purporting to have a unified position from 
which there is significant dissent among the relevant 
regulators and within the Congress and the relevant Committees.
    So I appreciate this further chance to address that. And I 
thank you very much, Mr. Chairman, for your very diligent work 
in this regard.
    Chairman Bachus. Thank you. Are there other members wishing 
to make--Chairman Oxley? Would you like to make an opening 
statement?
    Mr. Oxley. Thank you, Mr. Chairman. And thank you for 
calling this hearing.
    I think the presence of the Chairman and the ranking member 
of the full Committee indicate how concerned we are about the 
whole process and that this rarely occurs. And I do think it 
does point out some concerns that we have, particularly because 
it does appear that the regulators have different opinions on 
this.
    Certainly, the last hearing reflected that. And subsequent 
events have also indicated a fissure within the regulating 
community here. And obviously, there are some concerns on this 
side of the dais as well.
    I am going to ask unanimous consent that my formal 
statement be made a part of the record, Mr. Chairman.
    Chairman Bachus. Without objection.
    Mr. Oxley. But only to say that I echo some of the concerns 
that the gentleman from Massachusetts brought up in regard to 
the substance, as well as the process going forward. This is a 
big deal. And the decisions ultimately will reflect and affect 
the financial system in this country for a long, long time.
    And it is critical that we get it right, not just from the 
banking perspective, but a number of non-banking perspectives 
as well. I notice we have, on the second panel, some testimony 
from the Bond Market Association, which would indicate that 
there are some folks that have, perhaps, some opinions as well 
that are not technically in the banking community.
    So this has a broad reach and a long effect, a long-term 
effect on our markets and our banking system. And that is why I 
applaud the Chairman for his diligence in this.
    We thank him for scheduling a markup on the Oxley-Frank 
legislation. And I think it does reflect some of the very 
sincere concerns that many of us have.
    We have a great deal of respect for Mr. Ferguson and for 
the Fed and for their distinguished leadership. It does appear 
that there is a difference of opinion on this issue. And we 
need to make certain that, at the end of the day, we have a 
unified position from this side before going forward.
    And with that, I yield back the balance of my time.
    [The prepared statement of Hon. Michael G. Oxley can be 
found on page 60 in the appendix.]
    Chairman Bachus. Thank you.
    Mrs. Maloney?
    Mrs. Maloney. I thank the Chairman for holding this second 
hearing on the Basel II Capital Accord. For more than a year 
now, I have been closely following the progress of Basel II.
    I participated in the earlier hearing. And I have met with 
regulators and bankers. After all this discussion, I still 
believe there are significant issues appropriate for 
congressional review. As early as last August 14, I wrote the 
regulators about this issue. And I believe that many of my 
concerns expressed then are still relevant. I remain concerned 
about the inclusion of operational risk in Pillar 1. And most 
importantly, I want to know more about what the ultimate impact 
of the accord will be on U.S. competitiveness.
    As a New Yorker, I am very aware of the contingency 
planning effort that financial institutions are taking for 
physical attacks. I want to be reassured that investments and 
business continuity planning, backup systems and insurance will 
not be reduced because institutions have to devote resources to 
capital charges for operational risk.
    From an international competitiveness standpoint, the U.S. 
is fortunate that we have the opportunity today to receive 
testimony from probably the most sophisticated and most 
professional group of financial service regulators in the 
world. In each country where Basel II is applied, the domestic 
regulators will ultimately be responsible for the compliance of 
the in-country institutions.
    Not every country has as distinguished a group of 
regulators as the U.S. And I fear that differing levels of 
application by various international regulators of such an 
enormously complex proposal could affect the competitiveness of 
our industry and have an impact on all of our constituents and 
our economy.
    For these reasons, I am pleased to have joined Chairman 
Bachus, Chairman Oxley and Ranking Member Frank in introducing 
H.R. 2043, the United States Financial Policy Committee for 
Fair Capital Standards Act. This legislation takes a balanced 
approach to ensuring a unified U.S. position at Basel and a 
full study of the effects of the accord on our domestic 
industry.
    I look forward to the markup in July. And I look forward to 
working with the Chairman on this proposal. And I thank him 
again for making it a priority of this Subcommittee.
    And as I said, I am highly, highly concerned about the 
impact of Basel on the competitiveness of our financial 
institutions, our financial system. We should not do anything 
that would place the United States at a disadvantage by having 
a higher capital standard for U.S. institutions.
    I yield back.
    Chairman Bachus. Gentleman from Pennsylvania is recognized.
    Mr. Toomey. Thank you, Mr. Chairman. I just want to briefly 
second the comments generally that the gentlelady from New York 
just made. One of my concerns is that we have the most robust, 
in some ways most aggressive and most effective regulatory 
framework for financial institutions arguably in the entire 
world.
    We also have some of the most competitive and most 
successful financial institutions in the world. And I am a 
little bit concerned about one specific aspect of the proposed 
capital requirements.
    And that would be that we would use a Pillar 1 approach for 
operational risk, which strikes me in many ways more 
appropriately dealt with under the Pillar 2 approach. And I am 
concerned that if we go with the Pillar 1 specific capital 
requirement, we would in fact be placing our financial 
institutions, extremely well regulated, extremely successful in 
a variety of ways, at a competitive disadvantage to other 
financial institutions.
    So I hope we get a chance to explore that issue at this 
hearing today. And I thank you for conducting this hearing, Mr. 
Chairman.
    Chairman Bachus. Mr. Davis, do you have an opening 
statement? All right. Thank you.
    Ms. Kelly or Mr. Hensarling? All right.
    If there are no further opening statements, at this time I 
want to welcome our first panel of distinguished witnesses. 
From my left to right, they are: the Honorable Roger W. 
Ferguson, Jr., Vice Chairman, Board of Governors of the Federal 
Reserve System; the Honorable John D. Hawke, Jr., Comptroller, 
Office of Comptroller of the Currency; the Honorable Donald 
Powell, Chairman of the Federal Deposit Insurance Corporation; 
and the Honorable James E. Gilleran, Director, Office of Thrift 
Supervision.
    I would like to commend you gentlemen on your work to date 
on the Basel Agreement, Basel II, and for the attention you 
have paid to this issue. I think there have already been 
positive changes in the U.S. position. We applaud those.
    I note from your testimony today, Vice Chairman, that you 
indicated further movement on the real estate issue, and I 
commend you for that.
    At this time, we will start with Vice Chairman Ferguson. We 
welcome your testimony. You will not be limited by the 5-minute 
rule. And I am sorry that some of you may not have received 
that message earlier. I apologize for that.

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

    Mr. Ferguson. Chairman Bachus, members of the Subcommittee 
on Financial Institutions and Consumer Credit, Chairman Oxley, 
Ranking Member Frank, thank you for inviting me to testify on 
behalf of the Federal Reserve Board on Basel II and H.R. 2043.
    I will be brief. But I ask that my entire statement be 
included in the record.
    The development of Basel II over the past 5 years has been 
transparent and has been supported by a large number of public 
papers and documents on the concepts, framework and options, as 
well as by a large number of meetings with bankers. Over the 
past 18 months, I have chaired a series of meetings with 
bankers, often jointly with Comptroller Hawke.
    The banking agencies last month held three regional 
meetings with banks that would not, under the U.S. proposal, be 
required to adopt Basel II, but may have an interest in 
choosing to do so. The comment period for the third Basel 
consultative paper, sometimes called CP-3, is now in progress.
    And in about a month, the banking agencies in this country 
hope to release an advance notice of proposed rulemaking, so-
called ANPR, that will outline and seek comment on specific 
proposals for the application of Basel II in this country. We 
continue to be open-minded about new suggestions, backed by 
evidence and analysis, and approaches that simplify the 
proposal, but still attain its objectives.
    When the comments on CP-3 and ANPR have been received, the 
agencies will review them and meet to discuss whether change 
are required in the Basel II proposal. In November, we have 
scheduled to meet in Basel to negotiate our remaining 
differences.
    Realistically, this part of the schedule may be too tight 
because it may not provide U.S. negotiators with sufficient 
time to digest the comments on the ANPR and develop a national 
position to present to our negotiating partners. Some slippage 
in the schedule will no doubt occur.
    Implementation in this country of any final agreement on 
Basel II would require a notice of proposed rulemaking, an NPR, 
in this country in 2004 and, of course, a review of comments 
from that notice of proposed rulemaking. Additional 
quantitative impact studies starting in 2004, and probably 
conducted for the next 2 years, will also be necessary so we 
can be more certain of the impact of the proposed changes on 
individual banks and the banking system.
    As it stands now, by the fall of 2004, core and opt-in 
banks will be asked to develop an action plan leading up to 
final implementation. Whenever a final rule is developed, in 
2004 or in 2005, there would be at least a 2-year lag before 
implementation.
    Within that implementation interval, the large banks to 
which Basel II will be applied in this country will be 
developing their individual bank implementation work plans in 
conjunction with their supervisor. As you know, most of the 
banks in this country will remain under the current capital 
rules. No bank that will be required or chooses to adopt the 
new capital accord would be forced into a regime for which it 
is not ready.
    To be sure, supervisors will expect a formal plan with a 
reasonable implementation date from the latter banks once a 
final rule is developed. But no bank will be required to adopt 
Basel II if it has not yet built the required infrastructure.
    At any time during that period, we can slow down the 
schedule or revise the rules if there is a good reason to do 
so.
    Mr. Chairman, you have asked for the Board's views on H.R. 
2043. We understand and support the bill's objective, to ensure 
that the people sitting at this table work together 
cooperatively and that all of us shape our positions, 
especially at Basel, with a full understanding of the likely 
effects of any decisions on our economy.
    With respect, however, the Board believes that the current 
process achieves those goals and that legislation is not 
necessary.
    Moreover, H.R. 2043 could be counterproductive. In the 
Board's view, the agencies have demonstrated their ability to 
work together, one must admit sometimes not as smoothly as 
perhaps others would like.
    But also, we have demonstrated our ability to change our 
minds on the basis of evidence and persuasion, as you have 
indicated, Mr. Chairman, in your opening remarks. The bill 
would reduce our ability to negotiate with our foreign 
counterparts, eliminate the room for us to disagree and work 
out our differences and involve Congress in technical 
supervisory and regulatory issues that are probably better left 
to the supervisors.
    Obviously, of course, we recognize the appropriate interest 
and role of Congress in aggressive oversight. And in that 
regard, I am obviously pleased to be here.
    Let me now turn to three other issues that have been raised 
about the current Basel II proposal. The first is competitive 
equity.
    While this concern takes several forms, the most frequently 
voiced is the view that competitive imbalances might result 
from what is called a bifurcated set of rules, requiring Basel 
II for large banks, while applying the current capital rules 
for all other U.S. banks.
    The fear is that the banks that remain under the current 
capital rules, with capital charges that are not as risk 
sensitive, might be at a competitive disadvantage compared to 
Basel II banks that would get lower capital charges on less 
risky assets.
    We take this concern seriously and will be exploring it 
through the ANPR. But without prejudging the issue, there are 
reasons to believe that little, if any, competitive 
disadvantage would be brought to those banks remaining under 
the current capital regime.
    The basic question is the role of minimum regulatory 
capital requirements in the determination of the price and 
availability of credit. Our understanding of bank pricing is 
that it starts with the capital allocations that the banks 
themselves make internally, within their own organizations, 
then factors in explicit recognition of the riskiness of the 
credit and is then further adjusted on the basis of market 
conditions and local competition from bank and non-bank 
sources.
    In some markets, some banks will be relatively passive 
price takers. In either case, regulatory capital is mostly 
irrelevant in the pricing decision and therefore, unlikely to 
cause competitive disparities.
    Moreover, most banks--and especially the smaller ones--hold 
capital far in excess of regulatory minimums for various 
reasons. Thus, changes in their own or others' minimum 
regulatory capital, as might occur under Basel II, probably 
would not have much effect on the level of capital they choose 
to hold and would therefore not necessarily affect either 
internal capital allocations or the resulting pricing.
    Finally, the banks that most frequently express a fear of 
being disadvantaged by a bifurcated regulatory regime have for 
years faced capital arbitrage from larger rivals, who are able 
to reduce their capital charges by securitizing loans, for 
which the regulatory charge was too high relative to the market 
or economic capital charge.
    The advanced versions of Basel II to be adopted here would 
provide, in effect, risk-sensitive capital charges for lower-
risk assets that are similar to what the larger banks have, for 
years, already obtained through capital arbitrage. In short, 
competitive realities between banks might not change in many 
markets in which minimum regulatory capital charges would 
become more explicitly risk sensitive.
    Now I do not mean to dismiss competitive equity concerns. 
Indeed, I hope that the comments on the ANPR bring forth 
insights and analyses that respond directly to the issues, 
particularly the observations that I have just made.
    But to take a different view, we need to see reasoned 
analysis, and not just assertions.
    The second area of concern that I would like to focus on is 
the proposed Pillar 1 treatment of operational risk. 
Operational risk refers to losses from failures of systems, 
controls or people.
    Capital charges for such risks have been implicit under 
Basel I for the last 15 years. These risks will, for the first 
time, be explicitly subject to capital charges under the Basel 
II proposal. Operational disruptions have caused banks to 
suffer huge losses and, in some cases, failures--both here and 
abroad. My written testimony provides some recent and familiar 
examples.
    In an increasingly technologically-driven banking system, 
operational risks have become an even larger share of total 
risk. At some banks, they are indeed the dominant risk.
    To avoid addressing them would be imprudent and would leave 
a considerable gap in our regulatory system. The Advanced 
Measurement Approach--or the so-called AMA approach--which I am 
sure we will discuss further, for determining capital charges 
and operational risk, is a principles-based approach that would 
obligate banks to evaluate their own operational risks in a 
structured but flexible way.
    Importantly, a bank could reduce its operational risk 
charge by adopting procedures, systems and controls that reduce 
its risk or by shifting the risk to others through measures 
such as insurance. Some banks, for which operational risk is 
the dominant risk, oppose an explicit capital charge and would 
prefer the operational risk be handled case by case through the 
supervisory review of buffer capital under Pillar 2 of the 
Basel II proposal, rather than being subject to an explicit 
regulatory capital charge under Pillar 1.
    The Federal Reserve believes that would be a mistake 
because it would greatly reduce the transparency of risk and 
capital that is such an important part of Basel II. It would 
lessen potential market discipline and would make it very 
difficult to treat risk comparably across banks because Pillar 
2 is judgmentally based.
    The third concern I would like to discuss is the fear that 
the combination of credit and operational risk capital charges 
for those U.S. banks that are under Basel II would decline too 
much for prudent supervisory purposes. Speaking for the Federal 
Reserve Board, let me undermine that we could not support a 
final Basel II that caused capital to decline to unsafe and 
unsound levels at the largest banks.
    There will be several stages before final implementation, 
at which resulting capital levels can and will be evaluated. At 
any of those stages, if the evidence suggests that the capital 
were declining too much, the Federal Reserve would insist that 
Basel II be adjusted or recalibrated, regardless of the 
difficulties with bankers here and abroad, or with supervisors 
in other countries.
    But let us keep this in mind: supervisors can achieve their 
objective of maintaining the same level of average capital in 
the banking industry either by requiring that each bank 
maintain its Basel I capital levels or by recognizing that 
there will be some divergence levels of capital among banks 
because they will be dictated by different risk profiles of the 
banks.
    To go through the process of devising a more risk-sensitive 
capital framework, just to end with the Basel I result in each 
bank, is pointless. Greater dispersion in required capital 
ratios, if reflective of underlying risk, is an objective, not 
a problem to be overcome.
    Of course, one must also recognize that capital ratios are 
not the sole consideration. The improved risk measurement and 
management and its integration into the supervisory system 
under Basel II are also critical to ensuring the safety and 
soundness of the banking system.
    Let me just say, by way of conclusion, that the Basel II 
framework is the product of an extensive, multi year dialogue 
with the banking industry, regarding evolving best practice 
risk management techniques in every significant area of banking 
activity. Accordingly, by aligning supervision and regulation 
with these techniques, it provides a great step forward in 
protecting our financial system and those of other nations to 
the benefit of our own citizens.
    We now face three choices. We can reject Basel II or we can 
delay Basel II as an indirect way of sidetracking it. Or we can 
continue the domestic and international process, using the 
public comment and implementation process to make whatever 
changes are necessary to make Basel II work effectively and 
efficiently.
    The first two options require staying on Basel I, which is 
not a viable option for our largest banks. The third option 
recognizes that an international capital framework is in our 
self interest, since our institutions are the major 
beneficiaries of a sound international financial system.
    The Fed strongly supports the third option.
    I will be happy to respond to questions. Thank you, Mr. 
Chairman.
    [The prepared statement of Hon. Roger W. Ferguson can be 
found on page 82 in the appendix.]
    Chairman Bachus. I appreciate that.
    Comptroller Hawke?

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

    Mr. Hawke. Thank you, Chairman Bachus, members of the----
    Chairman Bachus. Is the microphone on?
    Mr. Hawke. It is the job of the Fed to help the OCC.
    [Laughter.]
    Chairman Bachus. That was the Vice Chairman that turned 
your microphone on.
    Mr. Hawke. Again, I think it reflects on the fact that they 
have an unlimited budget and they can study things like this.
    [Laughter.]
    Chairman Bachus, thank you, Chairman Oxley, Ranking Member 
Frank and members of the Subcommittee. We appreciate the 
opportunity to participate in this hearing. And I very much 
welcome the interest and involvement of the Subcommittee in 
these important issues.
    I want to assure the Subcommittee that the OCC, which has 
the sole statutory responsibility for promulgating capital 
regulations for national banks, will not endorse a final Basel 
II framework for U.S. banks until we have determined, through 
our domestic rulemaking process, that any changes to our 
capital regulations are practical, effective and in the best 
interests of the U.S. public and our banking system.
    In response to a point that Ranking Member Frank made in 
his introductory remarks about who is in charge here, I think 
it is important to recognize that Congress has clearly 
allocated to each of the federal banking agencies 
responsibility for overseeing the capital of banks within their 
jurisdiction and for adopting capital regulations. The Fed has 
authority over bank holding companies and state member banks; 
the FDIC over state non-member banks; and the OCC over national 
banks. So it is up to each of us, in the final analysis, to 
make our own decision. But the need for achieving agreement 
among the agencies, I think, is recognized by us all.
    My written testimony provides a detailed discussion of the 
background and content of Basel II and the important issues 
with which this Subcommittee is properly concerned. I would 
like to use this time to make several important points that may 
help to put today's testimony into proper focus.
    First, all of the U.S. banking agencies share a concern 
about the potential effect of Basel II on the capital levels of 
large U.S. banks. Our banking system has performed remarkably 
well in the difficult economic conditions in recent years, and 
I believe that is due, in significant part, to the strong 
capital position our banks have maintained. While a more risk-
sensitive system of capital calculation might be expected to 
have the effect of reducing the capital of some banks, we would 
not be comfortable if the consequence of Basel II were to bring 
about very large decreases in required minimum capital levels.
    By the same token, if Basel II were to threaten significant 
increases in the capital of some banks, it could undermine 
support for the proposal itself and might threaten the 
competitiveness of those banks. As things stand today, we 
simply do not have sufficiently reliable information on the 
effect of these proposals on individual institutions or on the 
banking industry as a whole.
    Before we can make a valid assessment of whether the 
results are appropriate and acceptable, we have to know, to a 
much greater degree of reliability than we now have, just what 
the results of Basel II will be.
    The OCC believes that significant additional quantitative 
impact analysis will be necessary. Even if the Basel Committee 
does not itself undertake such a study--and I think that would 
be the preferred approach--I believe it is absolutely essential 
that the U.S. agencies make such an assessment prior to the 
adoption of final implementing regulations. I strongly believe 
that we cannot responsibly adopt final rules implementing Basel 
II until we have not only determined with a high degree of 
reliability what the impact will be on the capital of our 
banks, but have made the judgment that that impact is 
acceptable and conducive to the maintenance of a safe and sound 
banking system in the United States.
    Second, a number of Subcommittee members have commented on 
differences among the U.S. banking agencies and are of the view 
that a new interagency coordinating mechanism is needed. Mr. 
Chairman, you and some of your colleagues have introduced H.R. 
2043, a bill that would establish an interagency Committee 
whose purpose would be to resolve such differences. While I am 
sympathetic to the concerns that underlie this legislation, 
with great respect, I suggest that it is not necessary at this 
time.
    There have, indeed, been some differences among the 
agencies during this process. But I believe the agencies have 
generally worked exceedingly well together on the Basel II 
project for the past 4 years, and I am confident that we will 
continue to do so. To be sure, we have not always agreed on 
every one of the multitude of complex issues that Basel II has 
presented, but that is no more than one would expect when a 
group of experts have brought their individual perspectives to 
bear on difficult and complex issues. Where there have been 
differences, we have worked our way through them in a highly 
professional and collaborative manner. In a few weeks, we will 
be jointly issuing an Advance Notice of Proposed Rulemaking, 
seeking broad comment on the Basel II structure, together with 
draft supervisory guidance for those of our banks that will be 
subject to Basel II. Both the ANPR and the guidance have been 
developed in a collaborative process in which each of the 
agencies has had substantial input.
    I believe we agree on the need for further quantitative 
impact study before Basel II is finally put in concrete 
although I do not want to speak for Governor Ferguson on that.
    I think it is probably correct to say that we at the OCC 
have had some reservations that the Fed does not share about 
the overall approach to Basel. For example, I commented in my 
earlier testimony about the complexity of Basel II. I have a 
concern about complexity because it seems to me that complexity 
could work toward competitive inequalities across countries, 
given the difference in the nature of supervision from country 
to country. Governor Ferguson, I think at the last hearing, 
pointed out that we live in a complex world and we are dealing 
with complex subjects, and complexity is a necessary 
consequence of this process.
    We may have some difference of perspective on time 
schedule. I think the Fed wants--and I do not mean to speak for 
the Fed--but I think the Fed wants to adhere to the current 
time schedule. We certainly would like to, if it is possible. 
But I think we may have the view, more so than others, that 
achieving the present time schedule is a daunting challenge.
    While we had differed on operational risk at earlier stages 
of this process, I want to make clear that we are completely 
comfortable and supportive of the treatment of operational risk 
under the AMA approach in Pillar 1. And I would like to expand 
on that just for a moment because this is such an important 
issue for the Subcommittee.
    As the Subcommittee knows, I had argued earlier in the 
Basel Committee that operational risk should be treated under 
Pillar 2 because it involved qualitative judgments about the 
adequacy of internal control systems. Nobody else on the 
Committee agreed with that. And it was very clear to me that 
that view would not be accepted by the Committee.
    As a result, we and the Fed worked very closely together 
developing the Advanced Measurement Approach to operational 
risk. The product of that collaboration, I think, has been very 
productive. We are completely comfortable that the AMA approach 
to operational risk imports a degree of supervisory discretion 
and judgment of exactly the sort that would come to bear if 
this had been a Pillar 2 issue. Indeed, I think that if 
operational risk were to be treated under Pillar 2, it would be 
essential for us to have a framework for the consideration of 
operational risk that would probably look very much like what 
we presently have under the AMA approach. So I do not think the 
Pillar 1 versus Pillar 2 issue should any longer be a matter of 
significant concern.
    Third, as I said earlier, I think we are all committed to a 
process that has real integrity to it. The current Basel 
Committee timeline presents, as I said, a daunting challenge to 
both the U.S. banking agencies and the banking industry. And 
while it is clearly necessary to address the acknowledged 
deficiencies in the current Basel Capital Accord, the banking 
agencies must better understand the full range and scale of 
likely consequences before finalizing any proposal.
    We have identified in our written testimony a lengthy and 
formidable list of critical milestones that the agencies must 
meet under the current Basel II timeline. They include: first, 
consideration by the Basel Committee itself of the comments 
that have been received on CP-3, its latest consultative paper. 
Next, the preparation and issuance by the U.S. agencies of the 
Advanced Notice of Proposed Rulemaking and draft supervisory 
guidance that goes with it, with a 90-day period for comments. 
At the end of that comment period, we will jointly consider 
those comments, analyze them, and make a judgment about the 
implications of those comments for the final iteration of the 
Basel document.
    The Basel Committee is presently scheduled to meet in 
December, which will give us the opportunity to feed back into 
the Committee the results of that ANPR process. We are also 
going to be requesting comment in the ANPR process on the 
economic impact of Basel II.
    Executive Order 12866 requires that we make an economic 
impact analysis in the case of any significant regulatory 
action, which is defined to mean an action that will have an 
annual effect on the economy of $100 million or more. We are 
soliciting information to enable us to determine whether that 
executive order will be triggered by the Basel proposal. If it 
is, we will conduct that economic analysis as part of this 
process.
    After the Basel Committee issues the definitive paper, the 
U.S. agencies will jointly draft and put out for additional 
public comment the final version of the regulations that will 
implement Basel II. At some point during that process--earlier 
rather than later, I hope--we will conduct an additional 
quantitative impact study to determine exactly what the capital 
impact will be.
    We will then consider all the comments that are received in 
the NPR process and come to a final decision as to whether we 
should issue the final U.S. implementing regulation and what it 
should look like. If we find that our current target 
implementation date of January 1, 2007 is simply not doable, 
consistent with that process--and my personal opinion is that 
realization of that target may be very difficult--we will take 
additional time. But I think it is still too early to draw that 
conclusion.
    The important point here is that we will take great care 
not to let the timeframe shape the debate. If we determine that 
changes to the proposal are necessary, we will make those views 
known to the Basel Committee. And we will not implement the 
accord until those changes are made.
    I would like to make one more point. Some have viewed the 
new Basel II approach as leaving it up to the banks to 
determine their own minimum capital essentially, putting the 
fox in charge of the chicken coop. I do not think that is the 
case by any means.
    While the banks internal models and risk assessment systems 
will be the starting point for the calculation of capital, bank 
supervisors will be heavily involved at every stage of the 
process. We will publish extensive guidance and standards that 
the banks will have to observe. There will be standards set out 
in the Basel documents themselves. We will not only validate 
the models and systems that banks propose to use, but we will 
assure that they are being applied with integrity.
    In my view, the bank supervisory system that we have in the 
U.S. is unsurpassed anywhere in the world, in both its quality 
and in the intensity with which it is applied, and we are not 
going to allow Basel II to change that. In fact, if we do not 
believe, at the end of the day, that Basel II will enhance the 
quality and effectiveness of our supervision, we should have 
serious reservations about proceeding in this direction.
    Moreover, while Basel II has largely been designed by 
economists and mathematicians and while these ``quants'' will 
play an important role in our oversight of the implementation 
of Basel II, the role of our traditional bank examiners will 
continue to be of enormous importance. Such values as asset 
quality, credit culture, managerial competence and the adequacy 
of internal controls cannot be determined by mathematical 
models or formulas, nor can many of the risks that banks face 
be properly evaluated except by the application of seasoned and 
expert judgment. I can assure you that those national banks 
covered by Basel II will continue to be closely monitored and 
supervised by highly qualified and experienced national bank 
examiners who will continue to have a full-time, on-site 
presence.
    I am pleased to have the opportunity to provide our views 
on this important initiative, I would be happy to answer any 
questions you may have.
    [The prepared statement of Hon. John D. Hawke can be found 
on page 141 in the appendix.]
    Chairman Bachus. Thank you.
    Chairman Powell?

STATEMENT OF DONALD POWELL, CHAIRMAN, FEDERAL DEPOSIT INSURANCE 
                          CORPORATION

    Mr. Powell. Thank you, Chairman Bachus and members of the 
Subcommittee for your interest in the new Basel Capital Accord. 
I believe that Basel II ranks among the most important pieces 
of proposed banking regulation in our nation's history.
    The FDIC supports the goal of lining up capital regulation 
with the economic substance of risk that banks take. Basel II 
encourages a disciplined approach to risk management and it 
addresses important weaknesses in our current capital rules. We 
applaud the intense and prolonged efforts that have been made 
to address these important issues.
    Since my testimony before the Subcommittee on Domestic and 
International Monetary Policy, Trade and Technology, on 
February 27, 2003, there has been good progress on the domestic 
implementation efforts. The federal banking and thrift 
regulatory agencies are working hard to issue an Advance Notice 
of Proposed Rulemaking for comment this summer. The proposed 
rulemaking will identify those aspects of Basel II that will be 
proposed for adoption in the U.S. for application to a small 
group of large banking organizations. At this time, we are 
addressing various technical issues, developing interagency 
guidance and conducting industry outreach.
    Specifically, we have conducted outreach sessions to 
banking institutions of varying size at meetings held in 
Chicago, Atlanta and New York. We are approaching a crossroads 
where judgments will need to be made on some critical issues. 
The interagency process and the public comment period will help 
us reach those judgment, and I am confident that our process 
will result in an appropriate outcome. My written testimony 
provides a broad overview of some of the critical judgments 
that will need to be made before the agencies commit to adopt 
Basel II in the United States.
    The first key issue is capital adequacy. The Basel II 
formulas allow, at least in principal, for significant capital 
reductions. The proposals issued by the Basel Committee specify 
that after a phase-in period, there would be no floor on the 
level of risk-based capital that banks would be required to 
hold.
    The level of risk-based capital that banks actually hold 
would depend upon their own internal estimates of risk--
validated by their supervisors--and on the demands of the 
marketplace. It is difficult to predict the ultimate effect of 
Basel II on overall bank capital, but we do know that the 
formulas are forceful tools for affecting risk-based capital 
requirements.
    There is no question the Basel formulas will help the 
regulators segregate risk. But the formulas cannot stand on 
their own.
    Banks face other risks besides credit risk and operational 
risk. Lending behavior can change over time, causing losses to 
escalate in activities perceived as low risk.
    The simple fact is that no one knows what the future holds. 
For these and other reasons, the FDIC believes that Basel II 
must be supplemented by the continued application of existing 
regulatory minimum leverage capital and prompt corrective 
action requirements. I am gratified at the support that my 
fellow bank regulators have expressed for this conclusion.
    We also understand that a leverage ratio alone cannot 
provide protection without the support of sound, risk-based 
capital rules. It will be necessary to better understand the 
impact of the proposals on the capital required for specific 
activities. Finally, maintaining capital adequacy under Basel 
II would be an ongoing task. Validating banks' internal risk 
estimates would be a challenge. Doing so consistently across 
agencies would be a greater challenge, for which an interagency 
process would be needed.
    The other key issue is competitive equity. Basel II has 
been expected to provide some degree of regulatory capital 
relief. The banks that stand to be directly affected by Basel 
II have expressed strong support for such capital relief. They 
have expressed concern where they believe Basel II capital was 
too high.
    The key policy question is: what economic benefits and 
costs would come with changes in regulatory capital 
requirements? Would the economic benefit of lower risk-based 
capital requirements for large banks enhance their competitive 
posture or accelerate industry consolidation?
    We recognize there are differences of opinion about the 
importance of competitive equity issues, and that is why we 
need to pay close attention to the comments we receive on this 
issue. The agencies received a number of comments on both sides 
of this issue at recent industry outreach meetings, and this 
dialogue will continue.
    With respect to proposed House legislation, the FDIC 
appreciates the goal of H.R. 2043, ``The United States 
Financial Policy Committee for Fair Capital Standards Act.'' We 
share in Congress's desire to ensure that uniform U.S. 
positions are developed and communicated to the Basel 
Committee. However, we do not believe that H.R. 2043 is the 
best means to accomplish this end. The legislation would, in 
effect, move the important task of capital regulation away from 
the agencies with decades of experience in this arena to the 
United States Treasury Department.
    This could compromise the independence of the federal 
banking regulators and impair our ability to handle an 
important function of prudential regulation at a particularly 
sensitive time.
    As our testimony indicates, we are working with the other 
regulatory agencies to develop interagency positions regarding 
the domestic application of Basel II. The bank regulatory 
agencies are actively engaged in an almost daily dialogue on 
issues and concerns. We will take whatever time is necessary to 
seek input from all interested parties prior to the final 
adoption of the new framework in the U.S., especially the 
concerns of banks that may feel they will be disadvantaged in 
competing with Basel II banks.
    In short, the ingredients for the success of Basel II 
continue to be: one, appropriate minimum capital standards; 
two, a consistent approach to validating banks' risk estimates; 
three, an adequate vetting of competitive issues; and four, 
time to address these and other policy issues as we finalize 
our views on this new Accord.
    We will continue to work closely with our fellow regulators 
to work through these important issues and reach the right 
conclusions. We are committed to evaluating the cost and 
benefits of the Basel II proposal and their impact on the U.S. 
banking industry and the safety-and-soundness of the financial 
system. Thank you for the opportunity to present the views of 
the FDIC.
    [The prepared statement of Hon. Donald Powell can be found 
on page 167 in the appendix.]
    Chairman Bachus. All right.
    Director?
    Thank you. Thank you.
    Mr. Gilleran, I am sorry.

    STATEMENT OF JAMES GILLERAN, DIRECTOR, OFFICE OF THRIFT 
                          SUPERVISION

    Mr. Gilleran. Mr. Chairman, Ranking Member Frank, thank you 
for including me in this panel.
    Chairman Bachus. I think we have a microphone problem.
    Mr. Gilleran. I think all of the concerns that I have--the 
OTS has--have been already expressed. So I will just make some 
general comments before we turn it over to questions. I would 
ask that my written comments be included in the record.
    Up until this time, the OTS has not been involved in the 
international accord efforts, even though we have had people 
who have been involved in Subcommittee work here in the United 
States. Bill McDonough did invite me to attend the last Basel 
meeting as an observer, which I did.
    And subsequently, I have asked the replacement for Mr. 
McDonough as head of the Basel Committee, who is now the head 
regulator in Spain, for an official seat on the Basel 
Committee. And I am told that that is a definite possibility 
for the future.
    I think it is important that the OTS be included as a full 
voting member on Basel because of the OTS unique focus on the 
mortgage industry. And our interest is, number one, to share 
with others our perspective on mortgage lending here in the 
United States and internationally, since at least one of our 
major thrifts will be included within the Basel Accord, if it 
is adopted.
    And we also have a focus on interest rate risk that is 
unique in the industry. And each quarter, we mark to market our 
entire industry, from an interest rate-risk point of view. So I 
think that that also is a contribution to the understanding of 
interest rate and the whole subject of risk and capital.
    My own personal views on Basel are that I believe that the 
Basel work to date has moved the ball forward in terms of 
understanding the relationship of risk and setting capital. 
Basel I was a simple method, but very effective really, since 
it was first adopted because Basel I capital has held up very 
well over very tumultuous economic times.
    And it has produced capital levels that are now viewed as 
being quite substantial. And in fact, the financial services 
industries have just completed 2 years of probably the best 
results it has ever had. And in addition, this year looks 
awfully good too.
    So Basel I has functioned well, even though I think that 
almost everybody would admit that if we just stayed with Basel 
I, we would want to make additions to it, so that it takes into 
consideration more of the kinds of differentiation of risks 
that we now have in the financial services industry. So I 
completely support the fact that we would have to do additional 
work on Basel I if that was the only thing that we had.
    It has been expressed here that Basel II would only be 
applicable to 10 of the major international banks in the United 
States and perhaps 10 others who will opt in. I have received 
information from a number of people that there will be 
literally hundreds of other banks that will make application to 
the regulators to be able to use Basel II because I think it is 
perceived that Basel II will result in lower capital levels.
    And I think everybody--almost everybody--concludes that 
lower capital levels will mean greater competitiveness. It is 
also an issue too in connection with what happens to the 
community banks in the United States.
    Because if the major banks are allowed to have lower 
capital levels but the community banks will continue with 
higher capital levels under Basel I, then that will mean that 
they can be acquired, quite simply, by the major banks. And we 
will have a further roll-up of the community banking system 
here in the United States. And that has to be evaluated by 
Congress, along with everything else, as to whether or not that 
is a good thing to have happen.
    So I believe we have to do a lot of work. I believe a lot 
of work has been done.
    I salute those who have really been working on it so hard 
in the past. We intend to be part of it going forward in the 
future. And I believe that your attention to this matter is 
very well deserved.
    Thank you for inviting me. I look forward to questions.
    [The prepared statement of Hon. James E. Gilleran can be 
found on page 114 in the appendix.]
    Chairman Bachus. Thank you. At this time, we will start 
questions.
    And Vice Chairman Ferguson, my first question is, you have 
commented--let me read testimony from yesterday's hearing in 
the Senate. D. Wilson Ervin, Credit Suisse First Boston, are 
you aware of his testimony on Basel II?
    Mr. Ferguson. I am generally aware of it. But it would 
certainly be helpful for you to read the quote that you want me 
to respond to.
    Chairman Bachus. He said the proposed accord is not a minor 
refinement to the banking regulatory process, but is instead a 
wholesale reform of bank regulation, a regime that covers 
roughly $2 trillion of capital and is a key economic engine. Do 
you agree with that?
    Mr. Ferguson. I believe that what the proposed accord is 
doing is to catch up with where the leading edge banks are. So 
yes, it is a change. It is a change from Basel I, without 
question.
    We have to move from Basel I because we believe it is no 
longer appropriate for our largest banks. It does not give good 
signals on the risks that they are undertaking. I do believe it 
is a major change, yes.
    It is, however, a change that is catching up with what the 
leading edge banks are doing. The ideas embedded in Basel II 
are not things that we, as regulators, thought up independently 
from the industry. It is a catching up to where the industry 
is.
    But yes, it is a major change.
    Chairman Bachus. All right. What I guess I am having 
trouble seeing is--and you said that Basel II is an 
acknowledgment of what the largest banks are doing today.
    Mr. Ferguson. What the leading edge largest banks are 
doing--not all of them, but what many of them are doing.
    Chairman Bachus. Many of them. And your part of your 
testimony--is designed to have a regulatory capital system that 
reflects what the largest banks are doing today. And I think 
Senator Sarbanes asked you. And you saw it as just an 
acknowledgment about what they were doing today.
    You mean what they need to be doing today or what they are 
doing today?
    Mr. Ferguson. I am trying to use the word ``leading edge.'' 
Out of the many banks that we have, there are some--not all, 
some--that are using the kind of quantitatively-driven 
approaches to estimating their own internal capital, economic 
capital, getting a much better feel for the risks in their 
lending behavior, their credit behavior.
    Importantly, we had a discussion at the Federal Reserve 
Bank of New York about 10 days ago, almost 2 weeks ago now, 
where we saw again some leading edge banks are doing exactly 
the same kind of quantified approach to operational risk that 
is being proposed under the AMA. So both on the credit risk 
side and the operational risk side, there are examples of banks 
that are moving very much in this direction.
    There are some large banks that I think are further behind, 
some that are further ahead. So it is a validation, in a sense, 
that we reflect, and we encourage banks and give them 
incentives to continue to move in this direction. And we think 
it is quite doable because there are a number of banks that 
have already started to move in this direction.
    It still will require the, supervisory validation of the 
databases that they use, the approaches that they use to 
quantify. So as my colleague, Comptroller Hawke has indicated, 
there is still a great deal of room for supervisory oversight 
to guarantee that what comes out seems appropriate.
    And, it is important to recognize that the information that 
the banks provide is an input to formulas that the supervisors 
put forward. So that ultimately, it is the supervisors and the 
supervisory approaches and formulas that determine the capital.
    Chairman Bachus. Let me ask you this. The same gentleman 
testified that the current Basel proposal is unnecessarily 
complex and costly. But you are actually saying that----
    Mr. Ferguson. I am the first to admit that it is complex. I 
am not denying in any sense the complication here.
    I think it is too simple to say that, in my view, it is 
complex because we live in a complex world. That is partially 
true. But that is----
    Chairman Bachus. Can you tell me some banks that would 
comply with this today? You say that some of the leading edge 
banks already are?
    Mr. Ferguson. Well, would comply with every component of it 
today? I am not sure there are any banks that would comply with 
every component.
    Chairman Bachus. With the major components.
    Mr. Ferguson. There are a number that are moving in this 
direction relatively quickly. I am a little cautious here to 
give out confidential information. But I will assure you that 
there are some banks that we have looked at. And we are 
comfortable that, certainly by the implementation date, they 
will be ready.
    Chairman Bachus. But all your major banks today----
    Mr. Ferguson. I am sorry, sir?
    Chairman Bachus. All your major banks today are sound.
    Mr. Ferguson. This is not a question of sound----
    Chairman Bachus. I understand that. But their own models 
show that several of them are going to have to raise 
significant amounts of capital. Do you disagree with their 
models?
    Mr. Ferguson. That they are going to have to raise capital? 
I think what will happen is that some will find that their 
regulatory minimum capital goes up. Some will find that the 
regulatory minimum----
    Chairman Bachus. Right. Some go up, some go down. But for 
those that go up----
    Mr. Ferguson. But that is not a bad sign. It means that 
their regulatory capital is going to reflect what many of them 
already recognize as what they need to hold internally.
    I do not think there are any banks that are going to have 
to go out and raise new capital. They will simply have 
regulatory capital that is adjusted either up or down. But it 
is not inconsistent with their own view, necessarily, of their 
risk.
    Chairman Bachus. Okay. All right. Let me ask you this. This 
is probably, maybe, the most important question I will ask you 
today.
    Comptroller Hawke and Chairman Powell said that we will 
take whatever time necessary to reach a consensus. Do you agree 
with that statement?
    Mr. Ferguson. I do. As Comptroller Hawke was describing 
areas of agreement and disagreement, I sent him a little note 
and perhaps a little body language that suggest otherwise. But 
I think we are in close agreement on exactly that point.
    I have said in my opening statement here that the original 
timetable of trying to meet in November is unreasonable at this 
stage, and seems likely to slip. He described it as daunting. I 
would not have made it to this table if I were not prepared to 
take on a daunting challenge, so I am not intimidated by it.
    But I know we will have a lot of work to do. I am 
cautiously optimistic that we will get to the end of the year 
and have plenty of time to look at the comments, listen to the 
comments and respond to them, and develop a negotiating 
position.
    If it turns up that we cannot, then we will take the time 
required.
    Chairman Bachus. Okay. So we do not have--there is no 
deadline out there. We cannot say we have to do it by a 
certain----
    Mr. Ferguson. Let me be very clear. As with anything in 
life, there are cost and benefits. It is appropriate to get the 
benefit of taking a sufficient amount of time, sir. But it is 
also important for all of us to recognize that there are great 
costs of uncertainty to our banks.
    There are a number of banks that want to know where they 
should be investing, what kind of databases are required. So we 
have to move ahead as expeditiously as possible, in order to 
minimize the uncertainty in the banking industry.
    This is not a matter to take lightly on either side. It is 
not a matter to rush into and ignore the comments, which we 
would not do. Nor is it a matter to go too slowly and leave 
uncertainty in the banking industry. Having seen 4 to 5 years 
of consultative papers, outreach meetings, quantitative impact 
studies, they are asking for a certain amount of certainty.
    And one of the things that you certainly will have seen, 
because you followed yesterday's testimony as well, while there 
are a range of views, when it is wrapped up, everyone 
recognizes that we need to move off of Basel I, both on the 
first panel and the second.
    I think Senator Sarbanes asked the question, in which the 
agreement was yes. Everyone recognizes that we need to move to 
a framework that is quite like Basel II, without question.
    There is still room to discuss a lot of the details. But 
the concept of moving in this direction is well accepted, both 
by the regulators and, I think, in general the private sector.
    And we have to be careful not to slow it down 
unnecessarily, slow it down enough to listen to the comments, 
but not unnecessarily to the point that we are leaving 
uncertainty in the banking industry and leaving our largest 
banks on an old accord that we know has passed its useful life, 
as far as the largest banks are concerned.
    Chairman Bachus. Thank you.
    Ms. Maloney? Mr. Frank, I am sorry.
    Mr. Frank. Thank you, Mr. Chairman. I know there has been 
frankly some effort to say that there really is agreement and 
you are all going to be able to work this out.
    But I would just make a suggestion to you. If this is an 
agreement, if you guys ever disagree, sell tickets, because it 
will be a hell of a show.
    Mr. Powell on June 9th said in a memo that we have, ``The 
framework is being rushed into place with discussions of 
significant alternatives now virtually ruled out by the 
timeline and by the international collaborative nature of the 
project.'' You do say, in a generous show of courtesy, you 
acknowledge the recognition by Vice Chairman Ferguson that this 
may, indeed, be the case.
    You know, virtually anything may indeed be the case in this 
world. But then Mr. Ferguson expressed his view that this great 
rush to judgment may indeed be the case, in his answering memo, 
by saying, ``The Fed believes it is important to move on to the 
next step in an international process that has already created 
too much uncertainty.''
    I mean, there is clearly more disagreement here than people 
are acknowledging. And I do not understand what you think you 
gain by that. And I understand there are some constraints and 
let's be polite.
    But I have to say, Mr. Ferguson, you lose some credibility 
with me when you say, ``We are all together here.'' There seems 
to be much more disagreement.
    I do have a couple of specific questions.
    Mr. Hawke, you say that when you were for Pillar 2 instead 
of Pillar 1, you were the only member of the Committee who felt 
that, so you were outvoted. Mr. Powell, did you have a horse in 
that race between Pillar 1 and Pillar 2?
    Mr. Powell. I did not.
    Mr. Frank. You did not. So Mr. Hawke, you were outvoted one 
to one.
    Mr. Powell. I am sorry?
    Mr. Frank. Then Mr. Hawke was outvoted one to one. I mean, 
there were three federal agencies on this. You did not have a 
vote.
    Mr. Powell. I came into the process late. But I would have 
to refer to some of our folks that were in the process. But I 
think we were in support of Pillar 2.
    Mr. Frank. You were for Pillar 2? And Mr. Hawke, you were 
for Pillar 2. And Mr. Ferguson was for Pillar 1. So Pillar 2 
lost one to two.
    Mr. Hawke. Pillar 2 lost, Congressman Frank, in the Basel 
Committee. Pillar 2 lost by----
    Mr. Frank. Oh, not within the United States, but 
internationally, is that?
    Mr. Hawke. Yes.
    Mr. Frank. Okay, so the United States position----
    Mr. Hawke. I made that argument in the Basel Committee.
    Mr. Frank. I was not clear about that. The other question I 
would have for the gentleman from the OTS, you said you were 
asked to be made a voting member of the Basel Committee.
    Mr. Gilleran. I was not a voting member, no. Not.
    Mr. Frank. You said you had asked to be one.
    Mr. Gilleran. Yes.
    Mr. Frank. Well, who are the voting members of the Basel 
Committee. Are the other three? I mean, there is an 
international Basel Committee. You are all voting members. I am 
now unclear.
    Mr. Gilleran. There are three U.S. members.
    Mr. Frank. What?
    Mr. Gilleran. One is the head of the New York Fed. And then 
there is a Washington----
    Mr. Frank. Excuse me, are you asking to be a voting member 
of the International Basel Committee or the American Basel 
Committee?
    Mr. Gilleran. I would like to be either. But I will take 
the U.S.
    Mr. Frank. So you are asking to be a voting member of the 
U.S. Committee. But they do not seem to count the votes. I 
mean, that is like--I do not know why you want to vote.
    Then I continue to be perplexed by this. And let me ask, 
Mr. Ferguson, both Mr. Powell and Mr. Hawke seem to have severe 
reservations about the current timeline. At least, that is--can 
you tell us that until they agree, their agencies agree that we 
are ready to go, that we are not going to go? Is that something 
we can----
    Mr. Ferguson. I can tell you that. Yes.
    Mr. Frank. Okay. Then let me ask you another question. And 
I understand, Mr. Powell, you make a point about getting 
Treasury into it. And that is something I will think about.
    But I still have to say, this is the most incoherent 
decision making process I have encountered on very important 
issues. And by the way, who will it be up to to make him a 
voting member?
    Do you know? You said you talked to the guy from Spain. I 
mean, is he deciding who is a voting member in America?
    Mr. Gilleran. Right. Well, he is the Chairman of the 
Basel----
    Mr. Frank. But does he decide who gets a vote in the United 
States?
    Mr. Gilleran. He has a vote. And he is now Chairman. So he 
will determine when other countries and whether or not----
    Mr. Frank. But what is his input into whether you get a 
vote in the United States Committee? I mean, I thought you said 
you were trying to get to be a voting member of the U.S. 
Committee. And we are going to ask a guy from Spain to do that?
    Mr. Gilleran. Well, I did.
    Mr. Frank. That is why I think we need some clarity.
    Now Mr. Ferguson, one substantive question. I understand 
one of your arguments has been--and I appreciate the 
willingness you have had to meet with us and talk and explain 
these things. I mean, it can be frustrating because these are 
complicated and we do not ever know as much about them as you 
do because of the difference in our focus of attention--and 
maybe even our attention span, but I will speak only personally 
there.
    On the question, you have said, well, the amount of capital 
may not be that much. It would not be necessarily increased. 
But there is a big gain in transparency.
    And you and I have had this conversation, that you said 
that you thought some of the institutions, while they might now 
have capital, have not been transparent about it. I relayed 
that concern to some of the institutions that had raised this 
with me.
    And I am told that one of them, State Street Bank, said 
that they would be willing to work on ways to increase the 
transparency of the capital. And that did not seem to resonate 
much.
    So are there not ways or are there ways that we could 
require these institutions--talking about operational risk 
now--to increase the transparency of the capital that might be 
helpful here? And I was frankly--I encouraged them to go and 
talk to you about that. And the impression I got was that they 
did not think this really meant as much to you as I had thought 
it did.
    Mr. Ferguson. Transparency always means a great deal to me. 
And there should not be any doubt about it.
    And yes, the institution that you talked to called me the 
other day to say they would be interested in pursuing ways to 
have more transparency. Recognize the benefits of Pillar 1, 
which is what we are talking about, versus Pillar 2 are in part 
because of transparency, not exclusively.
    Mr. Frank. Right.
    Mr. Ferguson. I am sorry, Congressman Frank, may I finish?
    Mr. Frank. I am sorry. I thought you were finished.
    Mr. Ferguson. No, not yet.
    Mr. Frank. My attention span again. I apologize.
    Mr. Ferguson. There are a number of other benefits from 
Pillar 1 that are important. One is that it allows for greater 
comparability because it is important to have framework----
    Mr. Frank. Okay. In other words, what you are saying is 
that even if they could resolve the transparency issue, that 
would not affect your view on----
    Mr. Ferguson. No, I did not say it did not have any effect 
on my view. What I said, Congressman, is not that it would not 
have an effect on my view. Obviously, it would have an effect 
on my view.
    I think it is not the only reason to favor Pillar 1.
    Mr. Frank. Okay.
    Mr. Ferguson. And as you have heard now at this stage, the 
regulatory group in front of you----
    Mr. Frank. By a vote of one to two.
    Mr. Ferguson. No, Congressman Frank, that is unfair.
    Mr. Frank. How did the American--what was----
    Mr. Ferguson. It is unfair because, as I think you heard 
the Comptroller say, we collectively developed what we think of 
as a very solid middle ground.
    Mr. Frank. After he felt he had been outvoted, he said 
that.
    Mr. Ferguson. He had been outvoted by the entire Committee.
    Mr. Frank. But let me--if the Comptroller thinks I am 
misquoting him, he is free to interrupt me. I give him that 
permission.
    The last question I have is this. You say one of the 
reasons for speed or for moving quickly, despite others' 
reservations, is----
    Mr. Ferguson. Can I interrupt you? I did not say ``moving 
quickly.'' I said ``reasons to move ahead.''
    Mr. Frank. Okay. But you said one of the problems was the 
uncertainty that the financial institutions are suffering from. 
I just want to give you a comment.
    Not a single bank has called me up and said, ``Hey, I am 
really feeling angst here from the uncertainty. Would you move 
quickly?''
    So you say that it is important to move quickly because you 
want to relieve the uncertainty of the banks. But they are 
calmer than you think they are.
    Mr. Ferguson. It is a good thing we have calm regulators 
and calm banks. I did not say ``move quickly.'' I said to 
``continue to move.''
    Mr. Frank. I understand. But you said a reason for progress 
and not as much delay.
    Mr. Ferguson. Right.
    Mr. Frank. Are you not in disagreement with your colleagues 
about how much delay?
    Mr. Ferguson. No, I am not in disagreement with my 
colleagues at all.
    Mr. Frank. Dr. Ferguson, I have to say I do not believe 
that. I mean, you are not leveling with us. There is clearly a 
difference of opinion on how quickly this ought to go.
    Mr. Ferguson. No, Congressman Frank, there is not a 
disagreement on how quickly this should go. We all agree that 
we have to put out an ANPR in about----
    Mr. Frank. Okay, well then----
    Mr. Ferguson. We all agree that we need to have a comment 
period. We all agree----
    Mr. Frank. Report to----
    Mr. Ferguson. Sir, may I finish?
    Chairman Bachus. Let me say this, we have actually got 2 
minutes left on the floor.
    Mr. Frank. All right. I apologize.
    Mr. Ferguson. No, I think it is fair to ask questions. But 
I am giving you honest answers. I am not, in any sense, 
disagreeing with what anyone else here----
    Mr. Frank. That is not what these two memos clearly 
suggest.
    Chairman Bachus. Could I interject? Vice Chairman, could 
you--would you write Chairman Oxley and Chairman Frank a letter 
and just confirm what you have said this morning?
    Mr. Ferguson. That we will have a comment period?
    Chairman Bachus. That you will not----
    Mr. Ferguson. Of course.
    Chairman Bachus. That you will not move forward until----
    Mr. Frank. Mr. Chairman, I will return to listen, not to 
ask any questions. But I owe them. I will return after I vote 
to listen.
    Chairman Bachus. We will return. And we ask the panel--we 
will reconvene at a quarter till 12. Thank you.
    [Recess.]
    Chairman Bachus. The hearing will come to order. We welcome 
our four witnesses back. And at this time, two of the witnesses 
wanted to respond to Mr. Frank. So I will recognize the ranking 
member for that purpose.
    Mr. Frank. I simply--both Dr. Ferguson and Mr. Gilleran had 
comments to make. And I, having used up my time, I hope they 
will get as much time as they need to respond.
    Mr. Gilleran. I just wanted to clarify the record is that 
the OTS is fully engaged with the other regulators here going 
forward in the United States. And we are a party to the ANPR 
that will be coming out.
    And it is the international piece in Basel that I was 
talking about, that we have not been--had a seat at the table. 
I have been informed by Comptroller Hawke that Basel has never 
really ever taken a vote.
    So you cannot be a voting member. But we would like to be 
at the table going forward, so that we can add our unique 
perspective on the mortgage market to the group.
    Mr. Frank. Dr. Ferguson may have felt that I did not give 
him a chance. So I apologize.
    Mr. Ferguson. I have the impression that some of my 
colleagues here want to deal with some of your questions.
    Mr. Powell. May I make a comment, Congressman? With regard 
to the different views and differences of opinions, clearly 
that is true.
    In my short period in Washington, I have watched; there is 
not much consensus on very many issues. And time builds 
consensus. People have an opportunity to express their views.
    I indeed did send that memorandum to Vice Chairman Ferguson 
and to Comptroller Hawke and expressed our views. And I have 
met with Vice Chairman Ferguson at least on two different 
occasions, going over some of my concerns and some of my views.
    He has accepted those concerns and views in the spirit they 
were given. On one occasion, he called me back and said that he 
is doing some more study about one of the specific issues that 
I talked about.
    I am confident--I am confident--in the process. As 
Comptroller Hawke mentioned, people of good will, in fact, have 
differences of opinion. And I think it is important that we 
express our differences of opinion.
    But I am confident that the process will ultimately get us 
to a consensus. There will be give and take in this process, 
and as each of the panel members here have expressed, we will 
not be governed by the timeline just in order to make a certain 
timeline. Governor Ferguson, Comptroller Hawke, Director 
Gilleran, and I do have differences of opinion. But we have 
worked through other issues. And I am confident we will work 
through these issues.
    Mr. Frank. Let me just--you do not then feel pressured by 
any timeline? You feel you have adequate time to work it out?
    Mr. Powell. No, sir. I do not feel pressure in any way.
    Mr. Frank. And you will not feel pressured to give in 
before you are satisfied?
    Mr. Powell. Nor do I feel pressure to change my views, nor 
feel any pressure not to express my views.
    Mr. Frank. I have never noticed a deficiency in your 
willingness to deal in those regards.
    Mr. Powell. Thank you.
    Chairman Bachus. Let me clarify something. Right before we 
left, Vice Chairman, I asked you--in fact, Chairman Powell's 
statement just then sort of reminded me that he is confident. 
And Comptroller Hawke has said he is confident that you all 
will come to a consensus at some point.
    And you assured us that--I believe I have heard that you 
have assured us that you will not sign off until there is 
consensus and agreement between the regulators?
    Mr. Ferguson. That is correct.
    Chairman Bachus. Now in that regard, we are talking about 
the same thing, and that is the international Basel agreement?
    Mr. Ferguson. Yes, that is correct.
    Chairman Bachus. Okay. Thank you.
    So you will not sign the international agreement until 
there is.
    Mr. Ferguson. I cannot. I mean, you have to understand that 
the Fed is only one of the regulators here. We cannot, 
independently of the other regulators, move forward. We need to 
have exactly what you want us to have, which is a common view 
before we go ahead.
    Chairman Bachus. But there is a U.S. agreement on how you 
regulate between the regulators. There is also the 
international agreement which you sign.
    And what I am focusing on is that you will not sign.
    Mr. Ferguson. First, there is nothing to sign. But we will 
not agree to anything that we are not all appropriately 
comfortable with.
    Chairman Bachus. Okay.
    Comptroller Hawke?
    Mr. Ferguson. Are you comfortable with that, sir?
    Chairman Bachus. Yes.
    Mr. Hawke. Mr. Chairman, let me go back to the timeline of 
the process itself. The comment period on our ANPR closes in 
October. There is a meeting of the Basel Committee scheduled in 
December. We will take a broad range of comments that come out 
of that ANPR process and make an initial judgment about whether 
and to what extent we think changes should be made in the final 
document that is going to come before the Committee in 
December. The Committee will then put that out as the final 
document. The Committee, in the 4.5 years that I have been on 
it, has never taken a vote on anything. Things seem to get done 
by osmosis.
    That document will be the Committee's view on the final 
paper. We are not obligated to apply it to U.S. banks until we 
complete our domestic rulemaking process that implements Basel 
II through our rules.
    The final step in that rulemaking process will be the 
Notice of Proposed Rulemaking, which will come after the 
issuance of the Basel paper. That is when we are going to do 
the final quantitative impact study that will measure the 
impact on capital of the Basel paper. If that quantitative 
impact study returns information to us that suggests that the 
impact on U.S. bank capital is going to be unacceptable, as the 
Vice Chairman said, there are a number of things that we can 
insist on with the Basel Committee before we go final with our 
implementing regulations.
    So there are a number of decision points along the way 
before we get to the very end of the line, which is the 
adoption of the U.S. regulations implementing Basel II.
    Mr. Frank. Mr. Chairman, would you yield to me for 30 
seconds for a question? Because that is interesting to me. And 
I must say, my impression before the Comptroller spoke was that 
once the agreement was signed, our flexibility was not very 
great.
    I mean, how much could you undo? Are you not bound by--are 
you talking about details? Or could you say, ``Well, we do not 
want operational risk capital'' or ``We do not want this?''
    Subsequent to signing, when we do our regulation, how much 
are we constrained by international obligation? How free are 
we?
    Mr. Hawke. Well, first of all, this is not a treaty where 
we have a legal obligation. But I think it is probably fair to 
say that once the Basel Committee goes out with its final 
paper, we either should object to it if we have fundamental 
reservations, or we should acquiesce in its being published. 
But during the subsequent domestic rulemaking proceeding and 
the quantitative impact study that will accompany that, we are 
going to have to make a very important judgment, and that is: 
what is the impact of this paper going to be on the capital of 
our banks? We have not had a reliable----
    Mr. Frank. How free will you feel to undo parts of what you 
agreed to?
    Mr. Hawke. Well, I would feel free if we conclude as a 
result of the quantitative impact study that the capital impact 
on our banks would be unacceptable--unacceptably high or 
unacceptably low to simply not implement it.
    Chairman Bachus. And that would mean, even if it resulted 
in some competitive disadvantages for certain banks over other 
banks or if it impacted specialty banks or if it impacted banks 
with high commercial real estate holdings.
    Mr. Hawke. Those are issues, Mr. Chairman, that I think we 
ought to have a better hold on at the end of the ANPR process. 
We are going to be receiving comment on the competitive impact 
before the end of this year. So we ought to be informed on 
those issues before we go back to the Basel Committee in 
December.
    Mr. Frank. Can we hear from Dr. Ferguson on that, Mr. 
Chairman?
    Mr. Ferguson. Let me first agree with the direction that 
Comptroller Hawke was going in response to your question, 
Congressman Frank. We should have a strong sense of agreement 
about the broad contours before the Committee wraps up its 
work, without question.
    I agree with him that the proposal or the approach for next 
year will be to put out a notice of proposed rulemaking; to 
start a quantitative impact study; to get the comments from 
that notice of proposed rulemaking; to get the input from the 
quantitative impact study; to collectively make a judgment as 
to whether or not there is a need to go back and reopen; to do 
what we call recalibration, which is to adjust some of the 
weights in one way or the other, to make other adjustments that 
we think are appropriate before we sign on.
    And as the Comptroller has indicated, this is not self-
executing. It needs some rules here in the U.S. And before we 
finalize those rules, I think it is important to do the 
process.
    Mr. Frank. But you are assuming----
    Mr. Ferguson. And, if we need to, go back and renegotiate. 
And we have said that. This is not the first time we have said 
that.
    Mr. Frank. When you talk about the timetable, you are 
assuming that this would be done by the end of this year, the 
international agreement.
    Mr. Ferguson. As the Comptroller says, it is a daunting 
task. We have to work hard to see if we can get there. We will 
go to the December meeting with our collective reflections on 
the comments and lay out to our negotiating partners what the 
U.S. positions are. And we will see how far we can get.
    The expectation, the commitment the Committee has made to 
the world, is that we will attempt to get some finality the end 
of this year. I want to try to live up to that if we can.
    If it turns out that we cannot reach a consensus on the 
Committee, then so be it.
    Let me add one other point on this. If I can take another 
minute to give the Committee a really clear view, because I see 
this is an issue of some uncertainty.
    Not only is 2004 a chance where we will have a quantitative 
impact study. But as I said in my opening statement, there will 
be--I think--a quantitative impact study in 2005. There will 
probably be one in 2006.
    At each one of those, we will get a better handle on the 
impact on our banks and the banking system overall. And 
frankly, I believe that if we have to go back and reopen and 
recalibrate to some degree, we have the right to do that. We 
have been clear that we intend to do it.
    Chairman Bachus. When you say you think that we have that 
right.
    Mr. Ferguson. No, we intend to do it. We have the right.
    Chairman Bachus. We do have the right?
    Mr. Ferguson. We have the right to do it. We will, if we do 
not like and are uncomfortable with the quantitative impact on 
the banks in the U.S., go back and recalibrate. Period. Full 
stop. Declarative sentence. I hope it is clear.
    Mr. Hawke. Mr. Chairman, can I just add one point on that?
    Chairman Bachus. Yes.
    Mr. Hawke. Up until now, the Committee itself has done 
three quantitative impact studies, but they have not had a 
final document to work against. So it has not been possible to 
calculate the impact of Basel II on our banks because we were 
dealing with a work in progress. It will not really be possible 
to calculate the impact until our banks get all their systems 
up and running and we have a fully operational system. But 
after the Committee comes out with the final version of the 
paper, we will be in a much better position to go through a 
quantitative impact study, that will be carefully overseen by 
the regulators, to make a judgment about what the impact will 
be. That is an absolutely essential step, in my view, and 
satisfactory results will be a precondition to our final 
adoption of the implementing regulation.
    Chairman Bachus. Thank you. And let me say this, what I am 
going to do at this time, Mr. Toomey, the gentleman from 
Pennsylvania, is going to take the chair and recognize Mr. 
Gilleran. He has been wanting to respond.
    What we are doing, as you have noticed, is we are going to 
give each member remaining here 10 minutes of questioning 
because these are very important matters. And I think, Mr. 
Frank, I would agree, we have taken close to 10 minutes.
    [Laughter.]
    Mr. Frank. Is 12 close to 10?
    [Laughter.]
    Chairman Bachus. So what we will do is Mr. Toomey will take 
the chair. He will have his 10 minutes to question. Then we 
will go to Ms. Maloney and the other two members that are here.
    And the other members that arrive after that will have 5 
minutes.
    Mr. Toomey. [Presiding.] Thank you, Mr. Chairman. At this 
time, I would recognize Mr. Gilleran to respond.
    Mr. Gilleran. I just want to say that Basel II is no 
different than Basel I as far as it relates to the authority of 
the U.S. supervisors to request capital and to obtain capital 
that they think is necessary. If Basel I came up with the 
calculation that the regulators disagreed with, the regulators 
are not bound by Basel I, in terms of the capital that is 
required.
    And they would not be bound by Basel II in any different 
way. And I think it is very important to point that out, that 
Basel II is a technique to get to a number. But it does not 
bind the regulators as to what is required in any specific 
instance.
    Mr. Toomey. Thank you. I would like to begin my questions 
following up on the question of the question of the impact on 
the competitiveness of American banks if we were to proceed 
with the Basel II proposals. And specifically, it is my 
understanding that the majority of the institutions that engage 
in the asset management operations, for instance, do not come 
under Basel requirements at all. It does not apply to them.
    And in addition, it is my understanding that the actual 
capital required by the market for the conduct of this business 
is considerably less than what the Pillar 1 requirement under 
Basel II would impose. So I guess my first question for either 
Mr. Ferguson and/or Mr. Hawke would be, number one, does this 
discrepancy between what the market requires and what the Basel 
proposal proposes, does that suggest a flaw in the 
requirements?
    And secondly, if we were to adopt this Pillar 1 
requirement, wouldn't that put our American institutions at a 
significant competitive disadvantage and have all the 
unintended consequences that flow from that, including creating 
incentives to push this business elsewhere to avoid this 
capital requirement?
    Mr. Ferguson. Was that question addressed to me, sir?
    Mr. Toomey. Actually, if you and Mr. Hawke would both 
address the question, I would appreciate that.
    Mr. Ferguson. Okay. Well, I hope we get the same answer.
    First, we will be asking questions about the competitive 
impact broadly. And it will include, by implication, the kinds 
of issues that you have just raised. So we will get the facts, 
as far as the industry sees them.
    Secondly, I would say, recognize that there are already 
bank and non-bank participants in the asset management 
activity. As far as I can tell, the capital requirements are 
probably slightly different because the market has slightly 
different requirements versus what the banks have to hold.
    There are reasons that we have capital requirements for 
banks, obviously, because they are regulated institutions. They 
have access to a variety of things that deal with the safety 
net. And so as we think about the competitive differences, we 
have to calibrate it against what currently exists, as opposed 
to an ideal world.
    To try to respond to a technical question, just to make 
sure you understand what the accord calls for, it calls for 
capital with respect to the credit elements of the asset 
management activity. Insofar as a bank that is an asset manager 
makes a loan as part of that activity, that would require 
capital.
    General asset management as an activity does not, I 
believe, attract capital. And the way that gets calculated will 
depend very much on the inputs, the probability of default, et 
cetera, that are involved.
    Mr. Toomey. I may have misspoke. I was referring to the 
operational activities generally.
    Mr. Ferguson. Oh, operational activities generally. Oh, I 
am sorry. So your issue then is about operational risk.
    Mr. Toomey. That is right.
    Mr. Ferguson. Oh. I thought you said asset management.
    Mr. Toomey. I am sorry. I did, I think.
    Mr. Ferguson. Let me then, since you and I know 
Congresswoman Maloney is also interested in this issue, I will 
also continue a bit on operational risk.
    The first point to make is operational risk already 
attracts an implicit capital charge. We are not doing something 
new by having capital for operational risk.
    Excluding or even leaving what the regulators call for, 
large financial institutions, large banks in particular, 
already hold economic capital, the capital they themselves 
determine, in order to deal with the challenge of operational 
failures. We have done a survey that shows in the world at 
large, for larger institutions, out of their economic capital, 
the capital they impose upon themselves, about 14 to 15 percent 
of that capital is being held for operational risk matters.
    So just to get the lay of the land, there is already 
regulatory capital for operational risk, regulatory minimum 
capital and the banks themselves impose their own economic 
capital.
    Mr. Toomey. But that is a significantly lower number than 
what is contemplated by Pillar 1?
    Mr. Ferguson. No, that is not true. No, that is not true.
    Mr. Toomey. Oh, it is not.
    Mr. Ferguson. I think there may be a little bit of a 
misunderstanding. There was a time, several drafts ago, when 
operational risk charges were either tied to gross revenue or 
you may be thinking of a number of 20 percent that was floated 
at one point.
    That is not the proposal. The proposal under the Advanced 
Measurement Approach, the AMA approach, as I have described it 
and as Comptroller Hawke, who was part of developing this idea 
described a bit, is a principles-based approach that does not 
have implicit in it a specific target number of capital.
    Rather, it asks the banks to use some quantification that 
we as regulators can replicate, that we can understand, that is 
not purely top-down, judgmental, a guess, if you will. But 
based on an analysis of their own experience, the experience of 
others, what is called scenario analysis and a few other 
techniques that are relatively common in this area, to 
determine their perception of the operational risks they might 
face.
    Mr. Toomey. Okay.
    Mr. Ferguson. And then how they offset it. And that will 
lead to a capital charge. But it will not necessarily be 
higher. We do not know if it is going to be higher or lower 
than the 15 percent that--or 14 to 15 percent--of economic 
capital that is currently held, that I have just alluded to.
    Mr. Toomey. Okay.
    Mr. Ferguson. I hope that is clear.
    Mr. Toomey. Yeah, it is surprising. I was under the 
impression that it is extremely likely that it would be 
considerably higher than the economic capital that the market 
requires today. But that is----
    Mr. Ferguson. I do not think we can have a point of view 
that it is extremely likely to be one thing or another until 
the banks work their way through it. A number of banks have 
already developed some of these approaches and are moving 
along, which gives me some comfort that what we are proposing, 
what is being proposed with this AMA approach, is really quite 
doable.
    But it is, I think, premature to say it is extremely likely 
to lead to a particular number in the industry.
    Mr. Toomey. Okay.
    Mr. Hawke, is that your view as well?
    Mr. Hawke. I generally agree with Governor Ferguson. I 
would just make a couple of points.
    We already have differences today between regulated 
financial institutions that carry on such things as asset 
management activities and non-regulated institutions that carry 
on the same activities. There are pluses and minuses in each 
case. The regulated institutions have access to the discount 
window. They have the benefit of the federal safety net and the 
like. The non-regulated institutions do not have the burden or 
regulatorily imposed minimum capital requirements.
    We are going to be seeking comment on the competitive 
effects in the Advanced Notice of Proposed Rulemaking 
proceeding. We would be concerned if one of the consequences of 
Basel II were to cause the de-banking of banks that were 
engaged in these activities. So this is an issue that we are 
going to focus on in this process.
    Mr. Toomey. Okay. So do you share the view that it is not 
possible to determine, generally speaking, that these rules 
would require greater capital than the market currently 
imposes?
    Mr. Hawke. I think it is premature to make that judgment. 
The AMA approach has a lot of complexities to it. We have very 
extensive supervisory guidance that is about to be put out for 
comment that details this whole process. Until that guidance is 
finalized and we get a final Basel paper, I think it is 
premature to make a judgment about what the ultimate capital 
impact is going to be from the operational risk charge.
    Mr. Toomey. My next question for you, Mr. Hawke, is that 
you had mentioned earlier that you had previously argued 
against the Pillar 1 capital for operational risk, if I 
understand correctly. And I am not aware of what has changed 
with regard to the arguments that have historically been made 
against that. So I am just wondering what your thought process 
was to cause you to come to a different conclusion.
    Mr. Hawke. Well, in part--and I do not mean to be 
facetious--but in part, it was deference to the shortness of 
life. I argued in the Committee for 4 years that because 
operational risk was a subject that involved the need to make 
qualitative judgments about a bank's internal control systems, 
it was appropriate to deal with it under Pillar 2.
    The Committee does not take votes, but I can tell you that 
there was nobody on the Basel Committee--25 people--who shared 
that view. It was not going to prevail. So rather than 
continuing to make the argument, we and the Fed worked 
together, I think very constructively, to develop the AMA 
approach.
    I am completely comfortable with the AMA approach to 
operational risk because I think it imports exactly that degree 
of supervisory discretion and supervisory qualitative analysis 
that I would have hoped for under Pillar 2. And I made the 
point earlier that even if this were a Pillar 2 issue, we would 
still have to have a framework for the supervisors to assess 
operational risk. My guess is that that framework would end up 
looking a lot like what we have in the AMA approach.
    Mr. Toomey. Okay. Well, thank you very much. My time is 
running out.
    I would be happy to recognize the gentlelady from New York.
    Mrs. Maloney. Thank you, Mr. Toomey. Thank you. And I thank 
all of the panelists.
    What I am most concerned about is the competitiveness 
feature. And apparently, all of you agree that it will not be a 
disadvantage to American financial systems.
    I would just want to know what proof there is. You 
mentioned we have had two quantitative studies. There is 
another one that will be ongoing.
    So I would like to ask Mr. Ferguson and Mr. Hawke, I would 
like to see the proof and the studies that you have done to 
make sure that American institutions are not disadvantaged. You 
testified that the capital requirement would be lower under the 
number two accord.
    Is that correct? Requirements for American banks? I heard 
someone say that. No?
    It will not be? Okay, but----
    Mr. Hawke. That remains to be seen.
    Mrs. Maloney. It remains to be seen. And what studies have 
you done and what proof do you have--beginning with Mr. 
Ferguson--to show that we will not be at a competitive 
disadvantage? What was your process to determine that?
    Mr. Ferguson. First, what we are expressing is an opinion. 
We will be asking questions in the ANPR to determine how others 
view this.
    Let me explain a bit of how at least I have come to the 
opinion at this stage that----
    Mrs. Maloney. Do you have anything in writing that supports 
your opinion? Any studies or research that support the opinion 
you came to?
    Mr. Ferguson. Well, if you would let me, I will tell you 
what I have and then you can tell me if it is sufficient. Does 
that work?
    Mrs. Maloney. Great.
    Mr. Ferguson. Good. Here is why I had the view that I have. 
First, the reason we are engaged in an international exercise 
is to create a level playing field across nations. If we chose 
one capital approach and other countries chose another, the 
probability of an uneven playing field would go up.
    So the entire goal of having an international accord that 
is hammered out over 4 years and has a variety of approaches 
that you have heard about, is to increase the probability of a 
level playing field internationally. Because large, 
internationally active banks will be on a comparable set of 
rules, by and large.
    Secondly, one of those rules involves transparency, which 
is to say banks disclosing not just the regulatory minimum 
capital under the set of rules, but also disclosing some of the 
inputs--not anything that is competitively sensitive, but some 
of the inputs--so that market analysts can observe the inputs 
of Bank A versus Bank B, whether or not the capital outcome 
looks the same. So it is not just that the rules are, broadly 
speaking, similar, but also the disclosure allows the market to 
do some comparisons across institutions.
    The third thing that we have tried to do in order to 
minimize the risk of disparities is create a process within 
this Committee, called the Accord Implementation Group that 
brings together the various regulators from around the world 
that are involved in this to talk about how they are making 
judgments on things, such as: How do you validate the inputs? 
What data does one look at? That type of thing, to try to 
create a strong sense of a level playing field among, if you 
will, the umpires, the regulators internationally. So that we, 
here in the U.S., are to some degree encouraging improved 
supervisory oversight that we think will come closer to ours, 
which again should give us some comfort.
    The fourth degree of comfort frankly is that if it turns 
out that this is not the case, that these three things I have 
just talked about are not the case, we will certainly hear from 
our institutions if they are feeling competitively 
disadvantaged. I have not heard that at this stage. But it will 
be the ultimate control.
    And finally, as I said, we will be asking questions to see 
if the industry or others see within the accord and the 
approaches that we are planning to take to implement it, any 
flat spots, any lacunae, any gray areas where they can see some 
room for competitive disadvantage.
    I believe that those different approaches should be 
sufficient to give us a much better feel in response to your 
question. And you may have other questions. But that is the 
basis on which I have based the opinion I have so far.
    Mrs. Maloney. Well, are you concerned that the vigor with 
which the Basel Accord is implemented in the U.S. by our 
regulators, which are very vigilant, could be a potential 
disadvantage for other international banks where their 
regulators are not as stringent? That could be a possible 
disadvantage to our banks.
    Mr. Ferguson. Are you addressing that question to me or to 
someone else?
    Mrs. Maloney. Yes, to anyone.
    Mr. Ferguson. Well, I will answer. But then I would be more 
than happy to have some of my colleagues on the panel answer as 
well.
    Mrs. Maloney. It may be applied differently in different 
countries.
    Mr. Ferguson. That is the reason why we have developed this 
Accord Implementation Group, to try to create a more consistent 
application of this accord across borders. I would say one 
other thing as well, I believe that we have the world's 
strongest banking system, some of the most sophisticated banks.
    Mrs. Maloney. Without a doubt.
    Mr. Ferguson. Without a doubt.
    I believe that is partially the case because they are, by 
their nature, well managed. In fact, much of it is due to that.
    I think some of it is due to the fact that we have very 
solid regulators here that are pushing the best practice. I 
think there is--and one can look at other countries where their 
banking system is, to use a colloquial term, ``flat on its 
back'' because they have had frankly perhaps lax--too lax--
regulations.
    Mrs. Maloney. Exactly, that is my point.
    Mr. Ferguson. Exactly. But let me finish. I understand. And 
the point I am making is that a strong banking system does not 
result from lax regulation. A strong banking system results 
from good regulation.
    We are going to continue to do good regulation here, 
supporting a strong banking system. And, through this Accord 
Implementation Group, encouraging others to maintain a level of 
supervisory behavior --
    Mrs. Maloney. In all due respect, I have noticed our 
country, through the United Nations and through other means, 
try to impress other countries with certain standards. And they 
really have not listened to us, from the Presidents, the 
premiers, their elected government. But I would like to hear 
from Mr. Hawke. I am specifically interested in written 
documentation that I can read that shows that our financial 
institutions will not be placed at a disadvantage.
    This is tremendously important to me. The financial system 
is the main employer in the district that I represent. And they 
are domestic banks, international banks.
    And I am concerned that there be some type of way, that 
either with this capital charge or the operational charge or 
whatever, we could be placed--or even with regulatory, more 
severe regulatory oversight, placed at a disadvantage. And I am 
interested in any written documentation that shows the process 
that we will not be disadvantaged.
    Do you know of any? Or have you done any, Mr. Hawke?
    Mr. Hawke. Congresswoman Maloney, I do not know that there 
is any--or could be any--written documentation of the sort that 
you are asking for. Let me say that I completely agree with 
everything that Governor Ferguson has said. I think he gave a 
very complete and cogent answer to the question of competitive 
equality. The whole purpose of this Basel effort is to try to 
bring about competitive equality.
    I do share the concern that differences in the nature of 
supervision from country to country could result in disparate 
application of Basel II, but the Accord Implementation Group 
will be one of the safeguards there. Frankly, I think the Basel 
Committee itself needs to address standards of supervision in 
member countries. That is certainly something that we will be 
arguing for.
    But I cannot hold out that there is any documentation that 
could be created or that exists of the sort you are looking for 
on these issues. We are going to be making a quantitative 
impact study that will look at the impact of Basel II on the 
capital of our banks. We will have to make a judgment whether 
that is acceptable or not acceptable and what it does to the 
competitiveness of our banks.
    Mrs. Maloney. So that will be written evidence when you 
complete this study.
    Mr. Hawke. That will be some evidence that will enable us 
to make a judgment, that is right.
    Mrs. Maloney. Can I ask, Mr. Hawke, how would a regulatory 
capital charge, as contemplated by Basel II, have benefited a 
bank located near the World Trade Center on September 11th? Can 
you explain what benefit and operational risk-based capital 
charge could have played in preventing the financial impact of 
the terrorist attack?
    Specifically, are you concerned that requiring banks to 
hold capital for such extreme events as September 11th could 
divert resources from contingency planning and development of 
backup facilities?
    Mr. Hawke. No, not at all. I think, with great respect, 
that pointing to the September 11th events and catastrophic 
events of that sort misses the point. The point is that every 
bank has operational risks that adhere in the nature of the 
business to one extent or another.
    The objective is to focus banks' attention on how they 
manage those risks. How does the bank itself get prepared to 
deal with a whole variety of different types of operational 
glitches, whether it is the defalcation of a key employee or a 
system going down because of some external event? And the 
objective is to assure that the bank is holding capital that 
would help it protect itself against those risks. So you cannot 
really say that operational risk is going to do something 
specific with respect to a catastrophic event like----
    Mrs. Maloney. Well, then another specific question for you 
and Mr. Ferguson on operational risk, as it now stands, the 
capital proposal includes a charge for the potential costs 
associated with U.S. tort liability, discrimination, 
suitability and similar laws that we have passed. Many of the 
protections are not available to individuals in the EU or Japan 
or other countries.
    In the U.S., these protections are the result of decades of 
work to promote civil rights. And do you think a capital charge 
for this will have an adverse competitive impact on U.S. banks 
and perhaps reduce the compliance efforts?
    In other words, is there a danger that we are encouraging 
other countries not to protect civil rights or undermining our 
own protections by requiring capital for these kinds of suits? 
And what is the evidence that the costs associated with 
litigation has resulted in a bank failure?
    Mr. Ferguson. I guess I will take the first pass to that. 
And let me echo and reinforce something that Comptroller Hawke 
said.
    The purpose of having capital is not to prevent. We could 
not possibly with capital prevent something like September 
11th. That is not what capital does.
    Mrs. Maloney. I want to talk about the response from it.
    Mr. Ferguson. Let me--let me----
    Mrs. Maloney. Okay.
    Mr. Ferguson. The point of this focus, as Comptroller Hawke 
has indicated, on operational risk is that it is a real risk. 
In my statement, I have included 10 examples. A few of them 
were ones in which banks failed because of an operational 
problem--fortunately, small and medium-sized banks, not large 
banks.
    A number of them are examples where an operational failure, 
failure to comply with laws, failure to run a system smoothly, 
led to a large reduction in or could have led to a large 
reduction in capital, costing literally $600 million, $700 
million--hundreds of millions of dollars. So part of the 
challenge here is to build a sufficiently strong capital base 
to deal with a risk of an operational failure.
    The advantage, as Comptroller Hawke implied and I will try 
to make clear, and we saw this on September 11th, is that 
institutions that have a strong capital base continue to have 
access to markets so they can get the liquidity that they need 
to keep their ongoing operations. It will not prevent a 
failure.
    Now the second part of it, the second reason to have this 
focus on operational risk and to have a capital charge 
associated with it, is that a number of banks have indicated 
and we have seen as an independent supervisory judgment, that 
the need to understand the operational risk that an institution 
might be subject to does, in fact, do just what you want to 
have does, in fact, do just what you want to have done. That 
understanding gives those banks an incentive to comply with 
laws, to build the kinds of safeguards to avoid defalcation, to 
move their backup sites to locations that are more secure, et 
cetera.
    All of that gets an advantage under these kinds of accords, 
the AMA that we are talking about. Or purchasing insurance also 
will give an advantage.
    So the entire structure of the AMA is meant to give 
incentives to make the investments, to comply with laws, et 
cetera, that you have indicated. It does not undercut it. In 
fact, it reinforces the kinds of good management behavior that 
you and we both want to reinforce in these operational areas.
    Mr. Hawke. Can I just add one point? I think there is some 
misconception about how this works.
    We are not going to tell a bank that they have to have an 
operational risk charge that deals with tort liability and 
another charge that deals with some other potential risk. We 
are going to be asking the banks, first of all, to assemble 
data about the kinds of losses that they have had in the past 
and to look at where the losses have been with other banks. We 
are going to be looking at their internal risk management 
systems and how they themselves address these operational 
risks.
    If tort liability is a risk that U.S. banks have that their 
foreign counterparts do not have, that is not caused by bank 
regulators. That is caused by our legal system. The practical 
reality is that it is a risk that our banks have that other 
banks do not have. The question that we ask is how are our 
banks managing that risk? How are they responding to that risk? 
The idea of an operational risk charge is to make sure that the 
capital base of our banks takes into account the whole variety 
of operational risks that our banks face.
    Mr. Ferguson. And one other thing, international banks that 
operate here in the U.S. should be holding capital for the 
kinds of risks they face here in the U.S. And so if they are 
operating in the U.S. and are subject therefore to the kinds of 
concerns that you have just raised, one would expect, their 
regulators should expect and we should expect their local 
subsidiaries, if they are on this approach, to be holding 
capital. So there is no international inequity that would 
emerge in this.
    Mrs. Maloney. Okay, my time is up. But these small banks 
that you say failed would not have been covered by Basel II.
    Mr. Ferguson. There are large banks. The whole goal here is 
not only to avoid failure. It is also to deal with having a 
capital cushion so that when you have a large hit of hundreds 
of millions of dollars, and if you look at my chart, you see 
hits as big as $1.2 billion--$1.1 billion, $1.3 billion you can 
survive.
    It is true, medium-sized banks have failed. But it is also 
true that large banks have been asked to leave the United 
States or have had a change of ownership or have also had some 
difficulties, for which we want and they should have a capital 
base, even if they do not suffer a failure.
    One should not think of this as an on-off switch. Either 
you fail or you do not. There is also a risk of a severe 
reduction in capital for which you want to build a cushion to 
avoid failure.
    And so you should not think of this as purely: did they 
fail or did not they fail? You should also think of whether or 
not you need the capital base to keep ongoing operations and 
avoid failure. And that is what capital does. It allows you to 
continue in the market and continue to thrive, to fund 
yourself.
    So that failure is not the only test that matters here. It 
is also significant loss of hundreds of millions of dollars 
that would eat into the capital base.
    And there is a great deal of evidence of losses of the $400 
million, $500 million, $600 million amount, that we as 
regulators should not simply ignore because it was not a 
failure.
    Mrs. Maloney. My time is up.
    Chairman Bachus. [Presiding.] Thank you.
    Mr. Ferguson, I am going to ask you one question. Then Mr. 
Watt will conclude the panel's questions.
    You have indicated on page five of your testimony that we 
have concluded that despite our supervisory judgment on the 
potential risk of these exposures--I am talking about the 
commercial real estate loan capitalization--that we could not 
support requiring a higher minimum capital charge on these 
loans. And we will not do so.
    What do you see the final standards will look like on the 
capital charge for commercial real estate?
    Mr. Ferguson. The proposed accord has the possibility of 
two different types of capital charges for commercial real 
estate, some higher and some lower, depending on the nature of 
the real estate. Based on the data that has come forward--and 
there may be some new data that comes--but based on the data 
that has come forward, I believe the proposal will have most 
commercial real estate on what is called the low volatility 
curve or a lower curve that is similar to the C&I, the 
commercial and industrial loan curve. And that is, I think, 
quite consistent with the input from a number of banks.
    There may be some kind of high volatility real estate--
acquisition, development and construction loans of certain 
sorts--where the data still suggests they should have a 
slightly higher charge. But I think the vast majority of 
commercial real estate will be on the lower curve and have a 
charge similar to commercial and industrial loans.
    Chairman Bachus. And you know I have expressed my concern 
to you before. And I appreciate the changes that you all have 
made, based on this new evidence.
    We do not want to retard growth. And in some areas of the 
United States, they are growing very rapidly. And you mentioned 
construction loans. Obviously, that is new construction. And 
that is evidence of growth.
    And I hope that you will continue to look at that.
    I am not sure that construction lending, in my mind, is as 
risky--and I am just anecdotally--because that represents 
someone's investing in a new project.
    Mr. Ferguson. We do not want to retard growth at all. We 
want capital to reflect risk. And as you know, because you were 
referring to it, when the data come in, we change our minds if 
the data are supportive of a change of opinion. We will 
continue to watch this pretty closely.
    We have already shown a great deal of flexibility. And if 
new data sets suggest that we should rethink the position we 
have now, you have my commitment that we will do that because 
we have already given evidence that we have done it in the 
past.
    Chairman Bachus. Because as you know, we have states that 
are growing at 20 percent every 10 years in population, unlike 
most parts of Europe, where they do not have those.
    Mr. Ferguson. Well, this is an area, sir, where there is 
national discretion. So we will develop a capital approach with 
respect to real estate and these two different curves that 
reflect U.S. data primarily.
    Chairman Bachus. Thank you.
    Mr. Watt?
    Mr. Watt. Thank you, Mr. Chairman.
    I want to assure the Chairman that I will not take the full 
10 minutes, unless you all take it answering two questions. And 
I want to apologize to the witnesses for not being here for the 
testimony.
    Unfortunately, I would much have preferred to have been 
here. I was in a hearing about whether we should prohibit 
lawsuits against--on behalf of people who get fat against 
McDonald's and other fast food providers.
    [Laughter.]
    No pun intended, a very heavy responsibility.
    Just two questions. First of all, I have noted in Mr. 
Ferguson's testimony and Mr. Powell's testimony--and I did not 
get a chance to look at Mr. Gilleran's testimony. I did not see 
anything on it in Mr. Hawke's testimony. At least Mr. Ferguson 
and Mr. Powell think that H.R. 2043 could be counterproductive.
    I wanted to see if that was the uniform opinion of 
everybody on the panel. I have Mr. Ferguson and Mr. Powell. 
What about Mr. Hawke?
    Mr. Hawke. Congressman Watt, in my oral statement, I said 
that while I am sympathetic with the underlying concerns that 
led to H.R. 2043, we did not think that it was necessary at 
this time. There has been a very collaborative process that has 
been followed by the regulators. There are dozens and dozens of 
issues that come up, most of which we agree on, some of which 
we do not agree on. The need for some external process to force 
resolution of issues, I think, is not there.
    We have a collaborative process going forward that is going 
to involve joint notices of rulemaking and joint publication of 
supervisory guidance. I think we are very much together on 
these issues going forward.
    In addition, there is an executive order that requires 
certain kinds of economic analysis to be made in connection 
with any rulemaking that would have a substantial effect on the 
economy. That is defined to mean an effect of $100 million or 
more annually. We will be soliciting comment in our Advance 
Notice of Proposed Rulemaking to give us the information to 
determine whether this rulemaking will actually have that kind 
of impact. And if it does, then much of the same kind of 
economic analysis that would be called for in H.R. 2043 would 
be provided under that executive order.
    So, with great respect, we do not think that legislation of 
this sort is needed at this time.
    Mr. Watt. Mr. Gilleran?
    Mr. Gilleran. As I said in my written testimony, to the 
extent that the OTS is mentioned in it, we completely agree 
with it, and that is that we be part of the process going 
forward. I think that the regulators have shown----
    Mr. Watt. Have you not been part of this process?
    Mr. Gilleran. We have not been part of the international 
process up until this time. We have been part of the working 
groups here in the United States. And we will be part of it 
going forward, in the sense that we will be a party to the ANPR 
that we have put out and the deliberative process that will 
take place going forward. So your support in that regard is 
welcome.
    On the issue of how this decision is made going forward, I 
believe that the regulators have shown the ability to 
cooperate, to deliberate and come to very, very reasonable 
conclusions. So that I believe the process of Basel II, with 
your strong oversight and interest, I believe your interest has 
made a difference already. And I believe the Senate Banking 
Committee's interest has made a difference.
    But I believe that the process, going forward, should be 
left to the bank regulators.
    Mr. Watt. Now while you have the floor, I noticed that when 
Ms. Maloney was asking questions, you raised your hand at one 
point. And apparently, nobody saw you. I wanted to make sure 
you got a chance to make the point, whatever that point was, 
that you wanted to make.
    Mr. Gilleran. Thank you. Well, I was just going to, on the 
point of international competitiveness, I wanted to react to 
that. Because in a prior career, I was superintendent of banks 
in California and worked with a great number of international 
regulators.
    And it is my view, as has been already expressed here in 
our written documents and in person, that the United States is 
the strongest bank regulator, without question. And we have 
countries out there where bank regulation is weak and that they 
have not applied concepts that we apply here in the United 
States correctly.
    There are countries out there that have not written off 
loans and that are just starting to react to the loans they 
have in their bank portfolios now. Their inability to have a 
strong international banking system has been to their 
detriment.
    Because what has happened in those countries that do not 
have one is that they have a misallocation of capital within 
the country. They keep funding companies that are losing and 
not funding new technology.
    So I think that they are the biggest losers of not 
correctly allocating capital. And I believe that since there 
are countries that are not doing it well now, there will be 
countries that will be not doing it well in the future.
    I do not think it disadvantages the United States or United 
States banks because I think we are the winner for strong bank 
supervision.
    Mr. Watt. Thank you.
    Finally, a natural segue from my first question about H.R. 
2043 and your responses to the need for that, in general, is 
there anything that you can identify that this Subcommittee, 
the full Committee or Congress needs to be doing as you keep 
going through the schedule that is outlined in your testimony? 
And if there are any things that we need to be particularly 
aware of, it would be helpful for at least me to know that.
    Mr. Hawke. I think, Congressman Watt, that the Financial 
Services Committee's involvement has been very healthy for this 
process. It has certainly strengthened our hand in the Basel 
discussions.
    Some of the other countries that are participating in this 
process have had their legislatures involved from the very 
outset. And some members of the Basel Committee were 
constrained in the positions that they could take in the 
Committee by their parliaments right from the beginning of the 
process. We were not. We have worked together as a group of 
regulators and participated in that process.
    But I welcome the oversight and the interest of the 
Committee in the process. I think the Committee's continued 
dialogue with the regulators is important. I think ultimately, 
it will strengthen our position vis-a-vis the Basel Committee. 
We look forward to it.
    Mr. Watt. Mr. Powell, anything else you can think of that 
we need to be doing? Mr. Gilleran? I am going to come back to 
Mr. Ferguson and give him the last word on this.
    Mr. Gilleran. I think you should continue what you are 
doing. I think your interest and your oversight is important to 
us. I think that we should have a meeting like this sometime in 
November or early December, so that we can report back on our 
findings and assure you that whatever those findings are, that 
we are in a position to go forward.
    Mr. Watt. Mr. Ferguson?
    Mr. Ferguson. I would echo many of the comments from 
Comptroller Hawke. And I would add one other, which is that in 
a democracy, it is extremely important, I think, to have these 
kinds of hearings, to give some legitimacy to a regulatory 
process.
    I realize that I and we have all been appointed by the 
President and confirmed by the Senate. But to have both sides--
Senate and House--asking tough questions and being educated, I 
think gives us a greater sense of legitimacy to the industry 
overall because they know that we have had to come here and 
deal with some very tough questioning.
    And I think, therefore, this kind of oversight is very 
useful, not just because of the ability to talk to our 
negotiating partners overseas about the messages we are 
receiving, but also frankly our ability to talk to each other 
and to the U.S. population about the fact that indeed, we have 
gone through a full process that has not just the usual 
external comment period, but this kind of give and take. So I 
do also endorse your interest and thank you for the opportunity 
to----
    Mr. Watt. Any suggestions about any other things we need to 
be doing, other than maybe getting a follow-up report at some 
point?
    Mr. Ferguson. I would say--well, there are two things that 
I am sure you will do. One is I am sure you will keep those 
cards and letters coming. And so, by definition, I welcome 
that.
    And secondly, I think----
    Mr. Watt. Only to the extent our banks keep those cards and 
letters coming--and constituents keep those cards and letters 
coming.
    Mr. Ferguson. And I am sure they will because that is what 
this is all about. And I would say just asking for feedback in 
the form we all collectively think would be appropriate, 
obviously is the other thing.
    Mr. Watt. Thank you.
    Chairman Bachus. Thank you, Mr. Watts. At this time, we 
will discharge the first panel. We very much appreciate your 
testimony. And I very much agree with you that the Committee's 
activity has been productive.
    So I appreciate all of your candor and participation in 
this important issue. And we are confident that you all will 
come to a consensus.
    Thank you.
    At this time, we will call our second panel. I want to 
welcome our second panel. I am actually going to introduce 
three of the panelists. And then Ms. Hart is going to introduce 
Mr. Elliott.
    The first panelist or the second panelist, seeing as Mr. 
Elliott is going to be introduced by Ms. Hart, is Dr. Benton 
Gup. He is the Chair of Banking at the University of Alabama. 
Prior to that, he was the Chair of Banking at both the 
University of Virginia and the University of Tulsa.
    Prior to that, he was a staff economist for the Federal 
Reserve Bank of Cleveland and has been the author of so many 
books, it would be impossible to list them, many of them used 
widely in the banking industry and also in the university. His 
publications have appeared in a number of journals.
    So we welcome you, Dr. Gup.
    Mr. Gup. Thank you.
    Chairman Bachus. Our second panelist or our next panelist 
is Micah Green of the Bond Market Institute. And I notice, 
between our third and fourth panelists, is that you both have 
your doctorate degree from George Washington University, so 
both graduates. That is correct, isn't it?
    Mr. Green. My law degree. But thank you for the----
    Chairman Bachus. Law degree. I consider that a graduate 
degree or post-graduate degree. Micah Green is President of the 
Bond Market Association. That is an association of 220 member 
firms, which collectively account for 95 percent of the 
nation's municipal security underwriting and includes all the 
primary dealers and other key participants in the U.S. 
government and federal agency security market and all major 
dealers and municipal and corporate debt securities, mortgage 
securities and money market instruments. And you will be 
testifying on behalf of the Bond Market Association.
    He received his J.D. and bachelor's degree from George 
Washington University.
    Our final panelist is Ms. Karen Thomas. She is Director of 
Regulatory Affairs and Senior Regulatory Counsel for the 
Independent Community Bankers of Alabama--not of Alabama, of 
America, a national trade association representing 5,000 
community banks. She has frequently published articles in the 
Wall Street Journal, American Banker and quoted in American 
Banker and BNA's Report for Executives and appeared on numerous 
TV shows--CNBC, Nightly News, et cetera.
    You are a graduate of the College of William and Mary and 
received her J.D. with honors from George Washington 
University's Law Center. So you are both law graduates from 
George Washington.
    So I welcome you both.
    At this time, I am going to turn the chair over to the 
gentlelady from Pennsylvania, Ms. Hart. And we will try to 
expedite this hearing. Thank you.
    Ms. Hart. [Presiding.] Thank the Chairman also for allowing 
me to introduce Mr. Elliott, who is from my area. Steven G. 
Elliott is Senior Vice Chairman of Mellon Financial 
Corporation. He is responsible for the corporation's asset 
servicing and human resources services businesses, including 
global security services, securities lending, foreign exchange, 
Mellon investor services, Buck Consultants and Mellon HR 
Solutions.
    The corporation's finance, treasury, technology and real 
estate and Mellon's venture capital businesses also report to 
Mr. Elliott. And he serves on the Board of Directors of Mellon 
Financial Corporation and also on the Board of Directors of 
Mellon Bank, N.A.
    Mr. Elliott joined Mellon in 1987 as Executive Vice 
President and head of the Finance Department. He was named CFO 
in 1990, Vice Chairman in 1992 and Senior Vice Chairman in 
1998. There was clearly no age requirement for that job.
    Previously, Mr. Elliott served in executive positions at 
First Commerce Corporation, Crocker National Bank, Continental 
Illinois National Bank and First Interstate Bank of California. 
He is a member of the American Institute of CPAs, the Financial 
Executives Institute and the Financial Services Roundtable.
    He also serves on the boards of the Pittsburgh Cultural 
Trust and the UPMC Health System. That is the University of 
Pittsburgh Medical Center Health System.
    He is a native of Delta, Colorado. Mr. Elliott also 
received a bachelor's degree in finance from the University of 
Houston and a master's in business administration from 
Northwestern University's Kellogg School of Management.
    I will also add, it is nice to see the reverse migration 
from Colorado to Pittsburgh, instead of from Pittsburgh to 
Colorado. Thank you for joining us also, Mr. Elliott.
    Is that a vote? Okay. We are going to have a vote. But I am 
going to let you start, Mr. Elliott. And we may suspend in just 
a little while so that members can actually get over to the 
vote.

 STATEMENT OF STEVEN G. ELLIOTT, SENIOR VICE CHAIRMAN, MELLON 
                     FINANCIAL CORPORATION

    Mr. Elliott. Thank you very much, Representative Hart.
    Mellon is a financial services company with 22,500 
employees in 21 countries. As indicated, we provide 
institutional asset management, mutual funds, private wealth 
management, asset servicing, human resources and treasury 
services. Mellon has approximately $2.9 trillion in assets 
under management, administration or custody, including $566 
billion under management.
    It is indeed a pleasure to appear today before you to 
discuss our views on the pending changes to the capital, 
supervision and disclosure rules. Although complex, sometimes 
very much so, these new rules will have a profound impact on 
the competitiveness of U.S. financial services firms and on the 
products they provide to American consumers, companies and 
investors.
    Basel will have a particularly dramatic impact on Mellon's 
lines of business, where U.S. banks now have a global 
comparative advantage through aggressive investment and leading 
edge technology and the sophisticated risk management and 
related systems developed to support these activities.
    Basel's rules also will have a profound impact on the 
global economy. Although the rules are not now scheduled to go 
into effect before 2007, they will in fact have a major impact 
on financial markets far more quickly. Thus, your review--and 
that of other panels in the Congress--is timely and 
commendable.
    At the outset, I would like to express Mellon's gratitude 
to all of the regulators--U.S. and global--that spent literally 
thousands of hours crafting these revisions. Of particular note 
is the new emphasis on a more balanced approach to bank 
regulation--what Basel is calling the Three Pillar Approach.
    I strongly agree that capital rules are not the sole 
touchstone of bank safety and soundness. Indeed, undue reliance 
on capital adequacy can divert attention from latent, serious 
problems in internal controls, strategic decision-making and 
other key risk areas.
    Thus, Basel's decision to look not only at capital, but 
also at supervision and disclosure, will result in a far 
stronger global financial system going forward. All of the hard 
work is also justified by the worthy goal with which Basel 
started: an end to regulatory capital arbitrage.
    All sophisticated banks and their holding companies--Mellon 
included--have gotten better in the past decade at spotting 
inconsistencies between the regulatory capital standards that 
bind us and the economic ones that are demanded by the broader 
markets. Better alignment of regulatory and economic capital 
will reduce this dichotomy and ensure that capital requirement 
incentives promote the laudable supervisory goal of increased 
bank safety and soundness.
    Unfortunately, since Basel started, its goals appear to 
have changed. As recently stated in a document released by U.S. 
regulators, the Basel goals now are improving internal controls 
and capital allocation, promoting market discipline and adding 
a new capital charge for operational risk.
    Mellon strongly supports the first two goals. But the 
third--a new one--in fact undermines the first two by creating 
perverse incentives to undue risk taking. The operational risk-
based capital requirement could also put U.S. banks at a 
serious competitive disadvantage versus non-banks here--and I 
want to emphasize versus non-banks here--and non-U.S. financial 
services firms around the world.
    The U.S. decision not to impose the most flawed operational 
risk-based capital proposals does not negate the fact that 
these will be mandated elsewhere, with potential serious 
safety-and soundness results. Setting operational risk-based 
capital as a simple percentage of gross revenue creates 
perverse incentives to risk taking, as I have mentioned in my 
written testimony. And the U.S. should fight hard against this 
in Basel II to ensure that all of the world's large banks are 
under a proper regulatory capital regime, not just those here 
in the United States.
    Systemic risk must be an overriding consideration as Basel 
II is finalized. And the operational risk-based capital 
proposal thus poses especially serious challenges, in our view. 
As requested by the Subcommittee, I shall focus my comments 
today on issues of particular importance in the U.S., with a 
focus on recommendations for the pending advance notice of 
proposed rulemaking to be released by the bank regulators.
    I would recommend: first, complete elimination of the 
Pillar 1 operational risk capital charge. The goal of promoting 
internal controls and capital allocation can far better be 
achieved through addressing operational risk-based capital in 
Pillar 2; namely, improved bank supervision.
    Second, the U.S. should not force all large banks into the 
most advanced versions of Basel II, as these are also the most 
complex and not necessarily appropriate for all large banks. 
Specialized banks like Mellon, for example, which holds less 
than $5 billion of loans in our lead bank, do not require the 
advanced internal ratings-based approach for our credit book. 
The standardized approach for credit risk that will be used by 
the European Union appropriately controls regulatory arbitrage 
for specialized banks.
    Third, there is no need to continue the arbitrary eight to 
10 percent capital ratio or the overall leverage capital 
standards. To achieve the end of the regulatory arbitrage that 
Basel and the U.S. regulators rightly seek, low-risk banks 
should hold regulatory capital appropriate to this position, 
which could be well below current regulatory levels set in 
1988.
    On the other hand, high-risk banks should similarly hold 
the appropriate amount of capital, likely far more than what 
they currently do. A simple, overall capital ratio undermines 
the goal for which Basel and the U.S. have worked so hard for 
so long.
    Finally, operational risk-based capital should not be used 
as a Pillar 1 or a Pillar 2 top off to credit risk capital. 
Each bank should hold regulatory capital appropriate to its 
risk profile, with market forces and the bank's judgment 
determining when more than the risk-determined amounts of 
capital be held.
    Thank you. And I would be pleased to answer any questions.
    [The prepared statement of Steven G. Elliott can be found 
on page 66 in the appendix.]
    Ms. Hart. Thank you, Mr. Elliot. At this time, we are going 
to recess the Committee so that the members can vote. And we 
are going to reconvene at 1:45, with a pretty long series of 
votes. So if the panel wants to maybe grab lunch or something, 
feel free to do that.
    But we will be back at 1:45.
    [Recess.]
    Chairman Bachus. [Presiding.] The Subcommittee on Financial 
Institutions and Consumer Credit will come back to order. I 
apologize to our panelists for the interruption. We had votes 
on the floor.
    It is my understanding, Mr. Elliot, that you testified.
    And Dr. Gup, we look forward to your testimony. And I 
recognize you at this time for your testimony.

   STATEMENT OF BENTON GUP, CHAIR OF BANKING, UNIVERSITY OF 
                            ALABAMA

    Mr. Gup. Mr. Chairman and members of the Committee, thank 
you for the opportunity to testify here. I am going to 
summarize my written comments that I would like included in the 
record.
    The 1988 Basel Accord provided a minimum capital standard 
of eight percent of risk weighted assets for internationally 
active banks to ensure an adequate level of capital and provide 
competitive equality. The ``one size fits all'' capital 
standard was a good starting point.
    But as banks face a growing range of risks and new 
technologies, it became clear that the capital requirements had 
to be made more risk sensitive. The result is Basel II.
    Federal Reserve Vice Chairman Ferguson said on June 10th 
that regulators expect to require 10 or more of the largest 
banks to use the Basel II Advance Internals Risk-Based approach 
for credit risk. Other large banks may elect to use the 
Advanced IRB approach. And the remaining banks will continue to 
use the 1988 capital standards.
    In my written testimony, I said the regulators would 
require about 20 banks to meet the new standards. The 
difference in the number of banks required to use the advanced 
IRB does not affect my conclusions.
    The major point is that about 70 large banks, with assets 
of $10 billion or more, those banks whose stocks are actively 
traded believe that if they want to be considered major league 
players by equity analysts and their stockholders must use the 
advanced IRB approach. In addition, they must declare that they 
are using it in their financial reports.
    The advantage to banks using the advanced IRB approach is 
that they may have lower capital charges on certain loans than 
banks using the 1988 capital standards. This creates 
competitive inequality.
    The disadvantage is the high cost of implementing Basel II, 
which ranges from $10 million to $150 million.
    The treatment of real estate loans in Basel II is another 
problem because real estate loans constitute a large portion of 
the portfolios of large regional banks. The U.S. bank 
regulators' perception of risks associated with real estate 
loans are based in part on the loss experiences of the late 
1980's and early 1990's.
    During that period, the losses on real estate loans were 
highly concentrated geographically in Texas, Massachusetts and 
Connecticut and mostly in small banks. It is important to keep 
in mind that this occurred before deregulation and significant 
changes in financial technology.
    Thus, looking at the 1980's and early 1990's to determine 
capital requirements for today is analogous to driving down a 
steep, winding mountain road by only looking out the back 
window; a crash is inevitable.
    Today, real estate lending at large regional banks is 
different for the following reasons: banks can expand 
geographically and avoid excessive concentration; they can buy 
or sell mortgages via securitization; they can hedge with 
derivatives; they can have low loan-to-value ratios and they 
can use high credit scores, such as FICO scores.
    Fannie Mae and Freddie Mac provide examples of how these 
tools may be used. In addition, Fannie Mae and Freddie Mac have 
only three percent capital requirement.
    In conclusion, the Basel II capital requirements create an 
uneven playing field, giving an advantage on capital charges to 
those banks using the advanced IRB approach. The capital 
charges on commercial real estate loans in Basel II are 
excessive. A risk weight of 150 percent may mean that a bank 
must hold more than eight percent capital on such loans.
    However, as noted previously, banks can manage their 
portfolios using the same tools as Fannie Mae and Freddie Mac. 
And these government-sponsored entities have only three percent 
capital requirement.
    The bottom line is that there will be competitive 
inequality in bank capital under Basel II.
    Thank you very much. And I will be glad to answer any 
questions.
    [The prepared statement of Benton E. Gup can be found on 
page 128 in the appendix.]
    Chairman Bachus. Appreciate that.
    Mr. Green?

    STATEMENT OF MICAH S. GREEN, PRESIDENT, THE BOND MARKET 
                          ASSOCIATION

    Mr. Green. Thank you, Chairman Bachus, for the opportunity 
to testify today on Basel II.
    As you indicated earlier, the Bond Market Association 
represents the U.S. and global bond markets. Together with our 
affiliates, the American and European securitization forums, we 
also represent many of the major participants in the growing 
securitization markets in the United States and Europe.
    The following comments focus on those issues related to 
Basel II that are most important to our membership. First, let 
me say the association supports the Basel Committee's overall 
goal of rationalizing the current risk-based capital regime and 
aligning regulatory capital requirements more closely to actual 
risk.
    We are grateful to the Federal Reserve Board in particular, 
Vice Chairman Roger Ferguson and other U.S. bank regulatory 
agencies for working with us to address the issues presented by 
the proposed capital accord revisions that are important to our 
membership. We are still concerned, however, that if not 
amended, Basel II will diminish the economic benefits derived 
from large and growing sectors of the capital markets, benefits 
which accrue to consumers, as well as businesses.
    And I also want to congratulate you, Mr. Chairman, and 
Chairman Oxley and Congressman Frank, for bringing this 
Committee hearing together today. It really has been important 
to the process of elevating the dialogue between regulators, 
the Congress and the affected parties. And I think it is a very 
positive development.
    I will first make one general comment on the direction of 
Basel II and then focus on two areas of most importance to us--
securitization and the repurchase agreement and securities 
lending market.
    With regard to Basel II broadly, we believe it is important 
that this agreement not be viewed as the last word on 
regulatory capital. Risk management techniques are continually 
evolving. And the financial markets need a regulatory capital 
accord that evolves with them.
    Basel II must therefore be crafted in a way that ensures it 
can better adapt to changing market products and development. 
Ultimately, the global financial community will need to move 
toward a broader reliance on internal risk models to determine 
appropriate capital levels.
    On securitization, which is a process of converting 
illiquid financial assets, like loans or other receivables, 
into securities which can be traded in the capital markets, it 
is a large and growing marketplace, with tremendous economic 
benefits for consumers and businesses.
    Securitization lowers borrowing costs for consumers and 
others, improves risk management, draws new sources of capital 
to the lending markets. Consumers benefit from these 
efficiencies with lower interest rates; in a sense, bringing 
the high finance, the technology of finance down to the 
consumer level through lower cost home mortgage.
    To give you an example of the size of the markets, in the 
last 7 years, the U.S. securitization market has grown fivefold 
to $2.7 trillion. In Europe, it has grown twentyfold--to a 
smaller level--but twentyfold to $151 billion. And in Asia, 
where the securitization market is just getting started, it has 
grown in the last 7 years 510-fold to $51 billion.
    Financial institutions participate in this marketplace as 
issuers and investors and as part of their risk management 
functions. For securitization generally under Basel II, the 
proposed risk weights for securitization positions held by 
banks are simply too high in light of the actual credit risk 
presented by these products.
    The proposed rules use unrealistically conservative 
assumptions that cumulatively would require financial 
institutions to set aside excessive levels of capital. 
Considering who ultimately benefits from a vibrant 
securitization market--home and car buyers--this is very 
important.
    These concerns must be addressed. And they are addressed 
fully in our written testimony.
    Lastly, repo and securities lending transactions, although 
little known outside the wholesale financial markets, are vital 
to our capital markets' liquidity and efficiency. Repo and 
securities lending transactions allow market participants to 
finance and hedge trading positions safely, cheaply and 
efficiently. In fact, the Federal Reserve uses this marketplace 
to implement monetary policy.
    Basel II may require banks to take capital charges 
inconsistent with the actual level of risk present in repo and 
securities lending transactions. Financial institutions should 
have greater flexibility to employ supervisory-approved 
internal risk models created to assess counter party risk in 
order to accurately reflect risks present in these 
transactions. These issues are also dealt with in more detail 
in my written testimony.
    And finally, we agree completely that the current 
regulatory scheme for bank capital--Basel I--needs significant 
revision. The current regulations are outdated and inflexible.
    Updating the regime can produce significant benefits, 
including the promotion of fair global competition, incentives 
for better internal risk management and an economically 
efficient allocation of capital. Getting it wrong, however, and 
implementing capital regulations which do not reflect modern 
practices or true credit risks on banks' balance sheets will 
diminish or eliminate market efficiencies that benefit 
everyone.
    The Basel Committee is on the right track in developing new 
capital standards. But significant work still needs to be done.
    In order to preserve the efficiency of our capital markets, 
the treatment of securitization, repo and securities lending 
products, it needs to be amended. We intend to continue our 
active dialogue with U.S. and international bank regulators on 
the issues addressed above. We have every hope that these 
issues can and will be resolved before Basel II becomes final.
    Thank you for the opportunity to testify, Mr. Chairman.
    [The prepared statement of Micah S. Green can be found on 
page 122 in the appendix.]
    Chairman Bachus. Thank you. I would say this, Mr. Green, 
securitization, which we also are hearing that a lot in our 
FCRA hearings, because with many auto loans, as well as 
mortgage loans and in consumer loans, securitized, it is 
important that we have a national uniform credit reporting 
system too.
    And I had heard, in those hearings we have been conducting, 
amazing testimony on how much that does bring down interest 
rates. It is quite amazing. So I just point that out. I 
appreciate that.
    Ms. Thomas?

 STATEMENT OF KAREN M. THOMAS, DIRECTOR OF REGULATORY AFFAIRS 
AND SENIOR REGULATORY COUNSEL, INDEPENDENT COMMUNITY BANKERS OF 
                            AMERICA

    Ms. Thomas. Mr. Chairman, thank you very much. I am pleased 
to appear today on behalf of the Independent Community Bankers 
of America, to discuss Basel II and its implications for 
community banks in the United States.
    First and foremost, ICBA applauds the U.S. regulators for 
their announced intention to limit the scope of application of 
Basel II in the U.S. and not to require it for second-tier and 
community banks. Capital adequacy rules must be appropriate to 
the size and complexity of operations of the bank.
    The Basel I Accord has worked well for community banks and 
generally remains well suited to assess capital adequacy for 
these banks. The significant and far-reaching changes to the 
capital adequacy framework contemplated by Basel II are unduly 
complex and costly for U.S. community banks and would be 
unnecessarily burdensome.
    Stated simply, Basel II is overkill for non-complex 
community banks. And the cost and burdens of adhering to Basel 
II would outweigh the benefits--if any--of moving to the new 
accord.
    The internal ratings-based approach is simply infeasible 
for community banks. Community banks do not have the resources 
to use costly, sophisticated internal risk rating models.
    A community bank is not likely to have a sufficient volume 
of credits to maintain a sophisticated, statistically valid 
model with sufficiently meaningful risk refinement to justify 
the high cost of extensive data collection, recordkeeping and 
model maintenance.
    The standardized approach, despite its additional 
complexity over Basel I, may not materially affect a non-
complex bank's minimum capital requirements once the additional 
charge for operational risk under Basel II is taken into 
account. But as with any change, the standardized approach 
would present the burden of learning and mastering a new 
scheme, changing systems and software, and retraining 
management, boards and employees with little corresponding 
benefit to justify the cost for community banks.
    Even though we are pleased with the decision regarding the 
scope of application of Basel II in the U.S., that does not 
mean we do not have some concerns about the impact of Basel II 
on community banks. In particular, we are concerned that Basel 
II may place community banks at a competitive disadvantage.
    Basel II will yield lower capital requirements for retail 
credit, including mortgages and other loans to individuals and 
small businesses. These are the very credits where community 
banks compete with large banks.
    Regulatory capital is a key factor in profitability and 
return on equity. There is a cost to a bank for maintaining 
capital. The lower capital requirements for retail credits may 
result in a cost advantage and correspondingly, a pricing 
advantage for large banks that are subject to Basel II.
    Our concern is heightened by the Quantitative Impact Study 
3, which compares the average risk weights and capital charges 
under Basel I and Basel II. Total retail credit capital charges 
under the advanced IRB approach are estimated to decrease by 50 
percent, including 60 percent for mortgages and 41 percent for 
non-mortgages.
    ICBA urges U.S. regulators to examine the question of 
competitive impact on Basel I banks closely. Small and medium-
sized institutions play an important role in the economy by 
providing credit to consumers and small and medium-sized 
businesses.
    For this reason, it is imperative to consider the 
competitive impact and implications Basel II will have for 
second-tier and community banks, as well as for their 
customers. To balance any competitive inequities, regulators 
may have to consider making appropriate adjustments for Basel I 
banks, such as additional risk buckets or changes in risk 
weights to increase risk sensitivity.
    In addition, regulators should consider whether to allow 
second-tier banks and community banks the option to apply the 
Basel II standardized approach in order to avail themselves of 
its lower risk weights for retail credit. Problems with the 
operational risk charge under a standardized approach would 
have to be addressed, however.
    In sum, ICBA supports limiting the scope of application of 
Basel II in the U.S. At the same time, the concerns about 
competitive equity between Basel I and Basel II banks must be 
carefully examined and addressed.
    Thank you for the opportunity to appear before you today. I 
would be happy to respond to your questions.
    [The prepared statement of Karen M. Thomas can be found on 
page 182 in the appendix.]
    Chairman Bachus. Thank you. I am going to ask the first two 
questions of the entire panel. And I will start with Mr. 
Elliott and answer in order. And you do not have to, if you do 
not want to respond to either one of these two questions, you 
do not have to.
    First, would you share with the Committee your 
organization's involvement in the development of the Basel 
Capital Accords and the third consultative paper, if at all. 
Did you meet with all the regulators involved? Or only with 
some of them? And do you feel that the concerns you raised were 
properly addressed in the third paper?
    Mr. Elliott. At Mellon, we have been very actively involved 
in not only the most recent paper, but all of the previous 
papers as well. I had a number of dialogues with the 
regulators. For us, our primary regulators are the Comptroller 
of the Currency and the Federal Reserve Board.
    Not only have they visited us at our headquarters in 
Pittsburgh, but we have gone to a series of outreach meetings 
that they have conducted. And there has been a lot of ability 
to be part of the process.
    So I think from a process perspective, Mellon is 
comfortable that the regulators have been giving us adequate 
opportunity to have our views heard.
    Chairman Bachus. Were your concerns addressed?
    Mr. Elliott. No. We still have a major concern as it 
relates to the operational risk charge. Part of it obviously is 
with our mix of businesses, where we do very little lending 
directly. And thus, the operational risk issue becomes larger.
    And the one in which we have difficulty is that most of our 
competitors, many of them are non-banks and would not be 
subject to the same type of capital requirements, not only 
here, but also globally. And a lot of the risks that are 
currently part of Pillar 2 supervisory, like interest rate 
risk, liquidity risk, strategic risk, these will continue to be 
dealt with in Pillar 2.
    And we are puzzled, if you will, as to why operational risk 
by itself is being singled out for an explicit capital charge. 
Our view is that it should be back in Pillar 2, along with 
these other major type of risks that affect all institutions.
    Chairman Bachus. So you feel like this could actually put 
you at a competitive disadvantage?
    Mr. Elliott. Yes, we do.
    Chairman Bachus. Dr. Gup, I do not guess--you have not 
actually been part of the process?
    Mr. Gup. Well, the University of Alabama has no direct 
interest in this.
    Chairman Bachus. Sure.
    Mr. Gup. I have a research interest in this. I am working 
on a book of selected readings and invited articles by myself 
and others on the subject of Basel. We will have a panel that 
presented some of this in a meeting last week in Ireland, 
dealing with Pillar 3, which has not been discussed here.
    At the Financial Management meeting in Denver in October, 
we are having a panel of government regulators, academics and 
others, practitioners, discussing Basel II. The following year 
in Zurich, we are having another panel on this.
    So we are presenting a wide variety of views. I will be 
presenting some of my views also to the Australian Institute of 
Banking and Finance, which is like the American Bankers' 
Association Down Under, later this summer. So we are getting a 
global perspective. And I am trying to get some research input 
into this area.
    Chairman Bachus. You said that you talked to your 
colleagues in Europe about Basel II when you were in Ireland?
    Mr. Gup. Asia, all over. Yes, sir.
    Chairman Bachus. What can you share with the Committee 
about what you learned over there in Ireland?
    Mr. Gup. I could not find anybody that likes it. Everybody 
seems to agree that Basel I is outdated and we have to move 
forward. But the degree of complexity is a major disadvantage 
of using Basel II. It has a lot of problems.
    It is a good starting point. It is a work in progress.
    Chairman Bachus. So the Europeans have some of the same 
concerns?
    Mr. Gup. Absolutely.
    Chairman Bachus. Okay.
    Mr. Green?
    Mr. Green. Mr. Chairman, the Bond Market Association, since 
our principal focus--not our sole focus, but our principal 
focus--has been around the product areas I mentioned, has been 
deeply involved for a long time, particularly in the United 
States, working with the Federal Reserve, as well as the New 
York Fed, where President McDonough was so deeply involved in 
the Basel Committee for many years. And there has been very 
good dialogue over that period of time.
    Also, since the U.S. securitization market was so well 
formed already, there was a sense that the European 
participants in Basel may not be fully aware of the impact that 
would have on the European securitization market. And our 
affiliate organization, the European Securitization Forum, 
which is a purely European-based organization, has had regular 
ongoing dialogues with European regulators to try to ensure 
that they have a full and complete understanding of that 
market. And together, we have also had discussions with them on 
the repurchase agreement side.
    Also, the Bond Market Association, both through its office 
London but also in its membership in the International Council 
of Securities Association, which is made up of 25 or 26 various 
associations and self-regulatory organizations from around the 
world, meets a couple of times a year. And Basel has been a 
subject matter of discussion for many years to ensure that, at 
the association representational level, there is some degree of 
coordination.
    Are we there yet? I am not sure we would be here 
testifying, saying that it needs improvement, if we were fully 
satisfied with the Third Consultative Paper.
    Our hope is that on the issues that we have talked about on 
securitization and repurchase agreements, that between Third 
Consultative Paper and the final Basel agreement, there will be 
continued improvement to address those issues. Because the 
issues that we feel are our focus affect real people and 
consumers who need to buy homes and buy cars and need access to 
capital.
    In fact, the University of Alabama may, in fact, care about 
that. And we would hope that before Basel is complete, these 
issues can be addressed.
    Chairman Bachus. If the Basel Accord went into effect, as 
presently constituted, and there are no more changes with 
regard to securitization, what will be the impact on the 
securitization market?
    And number two, will the Bond Market Association support 
Basel II, even if the changes you have suggested are not 
adopted or included?
    Mr. Green. Answering your second question first, there is 
unanimity among the market participants in our organization 
that Basel I is outdated and inflexible. And therefore, the 
status quo is not good.
    The general direction of Basel II is very promising. And 
the specifics--in a sense, the details--need improving. But the 
general direction is an improvement upon the status quo, which 
is why we are supportive of the general direction of Basel II.
    If the issues that we have raised are not fixed, the impact 
would be focusing on securitization. Financial institutions, if 
they have to charge more risk capital on their balance sheet 
than what is appropriate, based on the actual risk, then their 
ability to participate in that marketplace will be hampered.
    The depth of liquidity in that marketplace will be 
hampered. That affects the pricing in that marketplace.
    And since that marketplace is where home mortgages and car 
loans and credit card receivables are securitized, when you 
adversely affect the pricing in that market, it will raise the 
cost of borrowing in that market, which then gets down to the 
consumer level.
    So I am not going to say the sky is going to fall out of 
the sky. But pure market logic would have it that if you 
inhibit their ability to participate and you inhibit liquidity, 
you change pricing and you increase the cost of capital, which 
affects consumers.
    So that will happen. And that is why we are here today. And 
we appreciate the opportunity.
    Chairman Bachus. Yeah, thank you. Well, that would not only 
maybe drive up the loans, it would also--would it affect the 
amount of funds available to make loans?
    Mr. Green. Absolutely because one of the principal purposes 
of the securitization marketplace is to ensure that on 
financial institutions' balance sheets are not loans that are 
just stagnant. And they can get rid of those loans on their 
balance sheet and get fresh capital.
    They can also, in a very sophisticated way, manage their 
risks and match their assets with their liabilities much 
better. So by inhibiting their ability to participate in that 
marketplace, it will in fact lower the supply of lendable 
capital.
    Chairman Bachus. And that would, I think, affect your lower 
and middle income families probably disproportionately.
    Mr. Green. Certainly, as any consumer who needs a car or a 
house or a refinanced mortgage or a credit card, yes.
    Chairman Bachus. Okay. Thank you.
    Ms. Thomas, do you recall the original question?
    Ms. Thomas. Yes, I do.
    [Laughter.]
    Chairman Bachus. Would you like to respond?
    Ms. Thomas. Certainly. ICBA has had a number of 
opportunities and a variety of opportunities to meet and talk 
with the regulators about Basel II. This has included a number 
of our banker members as well.
    We have met with individual agencies on an informal basis. 
We have met with all the agencies on an interagency basis 
together, as well. We have participated in the comment letter 
process regularly on this issue.
    And we know that the regulators' door is always open to us 
if we have any questions. If we need to be briefed, if we have 
any concerns we want to express, we know well that we can do 
that.
    The other thing I would like to mention is that ICBA was 
the only U.S. trade association that participated in a meeting 
with the Basel Committee itself in July 2001. The Committee 
convened a meeting of representatives of small and medium-sized 
banking institutions around the world to hear our concerns.
    So we had an unprecedented opportunity to speak directly to 
the Basel Committee itself. And it was there that the U.S. 
regulators first signaled their intention not to apply Basel II 
to community banks.
    And at that point, that was our major concern. We saw 
incredible increase in regulatory burden, if that were the 
case. Our concerns were certainly addressed there, as the 
agencies have announced that they do not intend to do that.
    I think now one of the main issues that we see is the 
competitive impact. And I think you heard from the first panel 
that they intend to take a close look at that issue.
    And they have been looking at it. And they intend to look 
at it closely, moving forward, particularly in the ANPR 
process.
    Chairman Bachus. And that is on small lending, mortgage 
lending and residential mortgage----
    Ms. Thomas. For our bankers, we are concerned about those 
retail credits, which are defined as mortgages and other loans 
to individuals and small businesses.
    Chairman Bachus. Okay. And even though the agreement does 
not specifically apply to you, it would wash over and could 
affect your competitiveness on that market?
    Ms. Thomas. Yes. We see that the Basel II banks, they plan 
on using the changes in Basel II to more finely price their 
products and services. They want the ability to price according 
to economic, as opposed to regulatory capital, try to match the 
economic capital more to regulatory capital.
    Our concern is that smaller banks, not being subject to 
Basel II, are going to have higher capital requirements for 
those same loans and credits. And all other things being equal, 
a larger institution will be able to price something lower but 
still achieve the same return on capital as the smaller bank, 
which has to price it at a higher level.
    So we are concerned about the competitive impact there. 
Some of the larger community banks that are publicly traded, 
they compete in the capital markets for capital. And they need 
to realize certain returns on equity in order to be 
competitive.
    And so we do see that as an issue. And one of the answers 
may be to make some additional adjustments for Basel I banks to 
address those inequities.
    Chairman Bachus. Have you suggested any change in Basel II 
to address your concern about these business lines?
    Ms. Thomas. Not so much in the Basel II. I think we think 
that it will be more appropriate to make an adjustment for the 
Basel I banks.
    Chairman Bachus. All right. Thank you.
    Ms. Maloney?
    Mrs. Maloney. Thank you very much. My biggest concern with 
Basel II is the impact on the competitiveness of the U.S. 
financial services industry. And I understand some banks 
support it and some have questions.
    But as a whole, I think this competitiveness issue is the 
most important to address before the accord is implemented. And 
I want to be clear that I am not looking for an American 
advantage. I just want to make sure that our industry does not 
face a disadvantage.
    With this as a priority, I worked with the Chairman to 
introduce H.R. 2043. And one of the primary aspects of the bill 
establishes an interagency Committee, made up of the Treasury 
Secretary, the Federal Reserve, OCC and FDIC, to develop a 
uniform position on issues before the accord, before Basel II.
    If the members of the interagency Committee could not agree 
on apposition, the position of the Secretary of the Treasury 
would be the determinative position. It also requires a report 
to Congress before a decision is made; not that we could stop 
any decision, but at least we would be informed of what it is.
    And I was particularly concerned about not having any 
concrete evidence on the fact that our financial institutions 
were not disadvantaged. I would like to ask any of the 
panelists if they would like to comment on the legislation, if 
you think it is necessary or not.
    Mr. Elliott. One place where this may be into the 
competitiveness issue that you are referring to is that Basel 
II, as designed, really is only on the banking institution 
component of financial services. There are many parts of 
financial services here in the U.S., as well as globally, that 
Basel II would not apply to.
    And an institution like Mellon that I am associated with, 
many of our competitors are non-bank financial institution 
competitors. And here is where we feel the real inequality of 
the proposal.
    Our hope would be that, from a regulatory perspective, the 
regulators would be able to come to an agreement that would not 
penalize the banking sector, if you will, of financial services 
and that hopefully legislation would not be required.
    But having said that, at the same time, we are looking very 
much in terms of how competitive we can be. If our capital is 
higher, that means our return on equity is lower. That means 
our stock to investors is not viewed as attractively.
    And our ability then to access the capital markets to, in 
essence, grow the institution, is in essence hindered. In many 
ways, many of these risks we have been talking about, earnings, 
current earnings basically cover all of the risks. And we think 
that is a part of the dimension that they really have not 
addressed.
    Mrs. Maloney. Well, Mr. Elliott, just following up on it, 
we had quite a discussion earlier with the regulators. And they 
seem to be in agreement now on the Pillar 1 approach to 
operational risk.
    And I want to know, on a daily basis, what do you do to 
manage operational risk? And how will a Pillar 1 approach lead 
to greater transparency? Or will it not?
    Could you--if you heard that earlier comment on operational 
risk.
    Mr. Elliott. Yes, I did. Obviously, risk management for any 
financial institution has to be a core competency at the end of 
the day. And if you were to look in terms of not only the human 
capital that we put against it--you know the human intellect--
as well as our internal systems, this is something that we are 
constantly enhancing and spending a great deal of money on, on 
a current basis.
    And we do not feel an explicit capital charge is going to 
enhance that process. In fact, if you think about it, it is 
really paying for it twice. You are paying for it in capital. 
And you are paying for it through earnings by having a very 
robust risk management system.
    So our view would be that disclosure, which is part of the 
Pillar 3, which we really have not talked about a whole lot 
today. This transparency issue, we think, is very important. We 
are very willing. And we think frankly that most financial 
institutions are leaders in transparency.
    The tradeoff in transparency is if you have too much, in 
essence, there is too much overload possibilities of all your 
disclosures. So they do have to be focused. They do have to be 
on the relevant things.
    Obviously, from a regulatory perspective, the regulators 
have access to all of our internal systems, all of our internal 
ways of looking at risk, be it either operational risk or 
interest rate or liquidity. And our view is that the strength 
of the regulatory system basically is the way that you address 
this, as opposed to a capital charge that is difficult, if not 
impossible, to calculate and then compare from institution to 
institution.
    Mrs. Maloney. Thank you.
    Would Mr. Green like to comment on the legislation?
    Mr. Green. Congresswoman Maloney, while we appreciate the 
spirit with which the legislation was introduced, we do not 
have a formal position on it. I would just comment, and again, 
from our relatively narrow markets' perspective, but I would 
just comment, thinking about the last 2 days. I testified at 
the Senate hearing yesterday.
    And the combination of these two hearings has probably done 
a great deal to achieve the underlying purpose, and that is 
developing a dialogue with the regulators, sending a signal to 
the regulators, allowing those affected by Basel II to have a 
forum to speak and have the regulators and legislators hear 
that. And I think we are all coming from these hearings with a 
clearer direction of what needs to happen between the Third 
Consultative Paper, the final Basel Accord and then the 
ultimate national implementation of it.
    So we applaud what you have done to this date. And for that 
reason, in our narrow market's perspective, we do not have a 
position on the legislation.
    Mrs. Maloney. Would anyone else like to comment? And the 
Chairman has informed me that we need to get ready for the next 
hearing.
    They gave us additional time on this incredibly important 
issue. And I thank the Chairman.
    If anyone else would like to comment, fine.
    Chairman Bachus. Thank you. I would make just one final 
comment.
    Dr. Gup, I notice that you mentioned that some of our banks 
that do not participate in Basel II could be competitively 
disadvantaged. And Ms. Thomas, I think you have some of the 
same concerns.
    And I did note--and I do not know whether it was in the 
Senate testimony or in the submitted testimony today--that 
Director Gilleran, actually one of the concerns he expressed is 
that this may result in a wave of acquisitions, which is 
obviously a concern.
    That could even happen to a larger institution that was 
maybe, like Mellon Bank, that your business model was such that 
it caused you to be non-competitive. And you might actually, 
you know, your one alternative would be to be acquired, I would 
think. I am not sure that would happen.
    The other thing I would say, Mr. Elliott, the Federal 
Reserve or the regulators have never expressed any concern over 
how you address operational risk today, I would not think. Have 
they? Not to a great extent.
    Mr. Elliott. Mr. Chairman, I am not sure I understand your 
question.
    Chairman Bachus. Okay, have you--maybe I will ask another 
way. Have you ever had a problem or a concern with your 
management of operational risk? Or have they ever had a problem 
or concern?
    Mr. Elliott. With respect to our organization, no, they 
have had no concerns as to either our management of operational 
risk or how we would invest in the risk process. We get very 
high scores with respect to how we manage that aspect of our 
business.
    Chairman Bachus. Right. And yet, under this agreement, they 
would substitute basically, with a complex and costly formula, 
for how you presently manage that risk.
    Mr. Elliott. And part of the costliness would be adding a 
capital charge to our organization that, in essence, we would 
have to pass on to our customers or, in essence, be 
uncompetitive against our competition that would not have such 
a charge.
    Chairman Bachus. Certainly, the description that this will 
simply bring some of our larger banks in is simply a reflection 
of what they are already doing. That is certainly not the case 
with Mellon.
    Mr. Elliott. That is correct, yes.
    Chairman Bachus. Thank you.
    If there are no further questions, I thank the second panel 
for your testimony. And you are discharged at this time. Thank 
you.
    [Whereupon, at 2:35 p.m., the Subcommittee was adjourned.]

                            A P P E N D I X



                             June 19, 2003

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