[House Hearing, 109 Congress]
[From the U.S. Government Publishing Office]




 
                      BASEL II: CAPITAL CHANGES IN
                      THE U.S. BANKING SYSTEM AND
                    THE RESULTS OF THE IMPACT STUDY

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

                             JOINT HEARING

                               BEFORE THE

                            SUBCOMMITTEE ON
               FINANCIAL INSTITUTIONS AND CONSUMER CREDIT

                                AND THE

                            SUBCOMMITTEE ON
                       DOMESTIC AND INTERNATIONAL
                 MONETARY POLICY, TRADE AND TECHNOLOGY

                                 OF THE

                    COMMITTEE ON FINANCIAL SERVICES

                     U.S. HOUSE OF REPRESENTATIVES

                       ONE HUNDRED NINTH CONGRESS

                             FIRST SESSION

                               __________

                              MAY 11, 2005

                               __________

       Printed for the use of the Committee on Financial Services

                           Serial No. 109-27



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                 HOUSE COMMITTEE ON FINANCIAL SERVICES

                    MICHAEL G. OXLEY, Ohio, Chairman

JAMES A. LEACH, Iowa                 BARNEY FRANK, Massachusetts
RICHARD H. BAKER, Louisiana          PAUL E. KANJORSKI, Pennsylvania
DEBORAH PRYCE, Ohio                  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           DENNIS MOORE, Kansas
DONALD A. MANZULLO, Illinois         MICHAEL E. CAPUANO, Massachusetts
WALTER B. JONES, Jr., North          HAROLD E. FORD, Jr., Tennessee
    Carolina                         RUBEN HINOJOSA, Texas
JUDY BIGGERT, Illinois               JOSEPH CROWLEY, New York
CHRISTOPHER SHAYS, Connecticut       WM. LACY CLAY, Missouri
VITO FOSSELLA, New York              STEVE ISRAEL, New York
GARY G. MILLER, California           CAROLYN McCARTHY, New York
PATRICK J. TIBERI, Ohio              JOE BACA, California
MARK R. KENNEDY, Minnesota           JIM MATHESON, Utah
TOM FEENEY, Florida                  STEPHEN F. LYNCH, Massachusetts
JEB HENSARLING, Texas                BRAD MILLER, North Carolina
SCOTT GARRETT, New Jersey            DAVID SCOTT, Georgia
GINNY BROWN-WAITE, Florida           ARTUR DAVIS, Alabama
J. GRESHAM BARRETT, South Carolina   AL GREEN, Texas
KATHERINE HARRIS, Florida            EMANUEL CLEAVER, Missouri
RICK RENZI, Arizona                  MELISSA L. BEAN, Illinois
JIM GERLACH, Pennsylvania            DEBBIE WASSERMAN SCHULTZ, Florida
STEVAN PEARCE, New Mexico            GWEN MOORE, Wisconsin,
RANDY NEUGEBAUER, Texas               
TOM PRICE, Georgia                   BERNARD SANDERS, Vermont
MICHAEL G. FITZPATRICK, 
    Pennsylvania
GEOFF DAVIS, Kentucky
PATRICK T. McHENRY, North Carolina

                 Robert U. Foster, III, Staff Director
       Subcommittee on Financial Institutions and Consumer Credit

                   SPENCER BACHUS, Alabama, Chairman

WALTER B. JONES, Jr., North          BERNARD SANDERS, Vermont
    Carolina, Vice Chairman          CAROLYN B. MALONEY, New York
RICHARD H. BAKER, Louisiana          MELVIN L. WATT, North Carolina
MICHAEL N. CASTLE, Delaware          GARY L. ACKERMAN, New York
EDWARD R. ROYCE, California          BRAD SHERMAN, California
FRANK D. LUCAS, Oklahoma             GREGORY W. MEEKS, New York
SUE W. KELLY, New York               LUIS V. GUTIERREZ, Illinois
RON PAUL, Texas                      DENNIS MOORE, Kansas
PAUL E. GILLMOR, Ohio                PAUL E. KANJORSKI, Pennsylvania
JIM RYUN, Kansas                     MAXINE WATERS, California
STEVEN C. LaTOURETTE, Ohio           DARLENE HOOLEY, Oregon
JUDY BIGGERT, Illinois               JULIA CARSON, Indiana
VITO FOSSELLA, New York              HAROLD E. FORD, Jr., Tennessee
GARY G. MILLER, California           RUBEN HINOJOSA, Texas
PATRICK J. TIBERI, Ohio              JOSEPH CROWLEY, New York
TOM FEENEY, Florida                  STEVE ISRAEL, New York
JEB HENSARLING, Texas                CAROLYN McCARTHY, New York
SCOTT GARRETT, New Jersey            JOE BACA, California
GINNY BROWN-WAITE, Florida           AL GREEN, Texas
J. GRESHAM BARRETT, South Carolina   GWEN MOORE, Wisconsin
RICK RENZI, Arizona                  WM. LACY CLAY, Missouri
STEVAN PEARCE, New Mexico            JIM MATHESON, Utah
RANDY NEUGEBAUER, Texas              BARNEY FRANK, Massachusetts
TOM PRICE, Georgia
PATRICK T. McHENRY, North Carolina
MICHAEL G. OXLEY, Ohio
 Subcommittee on Domestic and International Monetary Policy, Trade and 
                               Technology

                       DEBORAH PRYCE, Ohio, Chair

JUDY BIGGERT, Illinois, Vice Chair   CAROLYN B. MALONEY, New York
JAMES A. LEACH, Iowa                 BERNARD SANDERS, Vermont
MICHAEL N. CASTLE, Delaware          MELVIN L. WATT, North Carolina
FRANK D. LUCAS, Oklahoma             MAXINE WATERS, California
RON PAUL, Texas                      BARBARA LEE, California
STEVEN C. LaTOURETTE, Ohio           PAUL E. KANJORSKI, Pennsylvania
DONALD A. MANZULLO, Illinois         BRAD SHERMAN, California
MARK R. KENNEDY, Minnesota           LUIS V. GUTIERREZ, Illinois
KATHERINE HARRIS, Florida            MELISSA L. BEAN, Illinois
JIM GERLACH, Pennsylvania            DEBBIE WASSERMAN SCHULTZ, Florida
RANDY NEUGEBAUER, Texas              GWEN MOORE, Wisconsin
TOM PRICE, Georgia                   JOSEPH CROWLEY, New York
PATRICK T. McHENRY, North Carolina   BARNEY FRANK, Massachusetts
MICHAEL G. OXLEY, Ohio


                            C O N T E N T S

                              ----------                              
                                                                   Page
Hearing held on:
    May 11, 2005.................................................     1
Appendix:
    May 11, 2005.................................................    45

                               WITNESSES
                        Wednesday, May 11, 2005

Bies, Hon. Susan Schmidt, Governor, U.S. Federal Reserve Board of 
  Governors......................................................     9
Curry, Hon. Thomas J., Director, Federal Deposit Insurance 
  Corporation....................................................    15
Follain, James R., Senior Vice President of Mortgage Valuation, 
  Fidelity Hansen Quality........................................    34
Riccobono, Richard M., Acting Director, Office of Thrift 
  Supervision....................................................    11
Small, William J., Chairman and CEO, First Federal Bank, 
  Representing America's Community Bankers.......................    33
Williams, Julie, Acting Director, Office of the Comptroller of 
  the Currency...................................................    13

                                APPENDIX

Prepared statements:
    Oxley, Hon. Michael G........................................    46
    Bachus, Hon. Spencer.........................................    48
    Bies, Hon. Susan Schmidt.....................................    52
    Calem, Paul S. and Follain, James R..........................    63
    Curry, Hon. Thomas J.........................................   103
    Petrou, Karen Shaw...........................................   130
    Riccobono, Richard M.........................................   147
    Small, William J.............................................   166
    Williams, Julie..............................................   173

              Additional Material Submitted for the Record

Bachus, Hon. Spencer:
    Additional questions for the record for Karen Shaw Petrou....   193
    Conference of State Bank Supervisors, prepared statement.....   194
    ``In Focus: Stress Shows At Fed with Basel II Drive 
      Sputtering'' article from American Banker, August 29, 2005.   198
Barnett Sivon & Natter, prepared statement.......................   202
Independent Community Bankers of America, prepared statement.....   212
National Association of Realtors, prepared statement.............   223
The Real Estate Roundtable, prepared statement...................   220
Petrou, Karen Shaw:
    Response to questions from Hon. Spencer Bachus...............   228


                      BASEL II: CAPITAL CHANGES IN
                      THE U.S. BANKING SYSTEM AND
                    THE RESULTS OF THE IMPACT STUDY

                              ----------                              


                        Wednesday, May 11, 2005

             U.S. House of Representatives,
             Subcommittee on Financial Institutions
                               and Consumer Credit,
                                     joint with the
         Subcommittee on Domestic and International
             Monetary Policy, Trade, and Technology
                           Committee on Financial Services,
                                                   Washington, D.C.
    The subcommittee met, pursuant to call, at 10:04 a.m., in 
Room 2120, Rayburn House Office Building, Hon. Spencer Bachus 
[chairman of the subcommittee] presiding.
    Present: Bachus, Oxley, Leach, Pryce, Gillmor, Biggert, 
Kennedy, Feeney, Hensarling, Pearce, Neugebauer, Price, 
McHenry, Frank, Maloney, Lee, Moore of Kansas, Ford, Baca, 
Matheson, Green, and Wasserman Schultz.
    Mr. Bachus. [Presiding.] Today, the Subcommittees on 
Financial Institutions and Consumer Credit and Domestic and 
International Monetary Policy are meeting to examine the 
proposed Basel II capital accord and its potential effects on 
the domestic and international banking systems, as well as on 
the recently completed fourth Qualitative Impact Study, QIS-4.
    I expect that Chairman Pryce will be here in about 20 
minutes. She will submit a statement for the record. I 
appreciate her participation in this hearing.
    Today's hearing is the fourth one that the Financial 
Services Committee has held on Basel II proposals since the 
106th Congress. Prior hearings have highlighted disagreements 
among the Federal financial regulators, as well as substantive 
problems.
    During the last Congress in response to concerns about the 
Basel process, I, along with Congresswoman Maloney, Chairman 
Oxley, and Ranking Member Frank, introduced H.R. 2043, the 
United States Financial Policy Committee for Fair Capital 
Standards Act. The legislation, which passed out of the 
committee I serve as chairman by unanimous vote, mandated that 
the Federal banking regulators develop a unified U.S. position 
among the agencies prior to entering into negotiations in the 
Basel committee.
    In March, Congressman Maloney and I introduced the same 
legislation, H.R. 1226, with 36 cosponsors. Let me start by 
applauding the bank regulators for delaying the notice for 
proposed rulemaking to implement Basel II in response to the 
results of QIS-4. I have been concerned that the regulators 
have been overly committed to an arbitrary timeline and have 
been making decisions that fit into their schedule without 
fully understanding the consequences.
    Many banks that may choose to adopt voluntarily Basel II 
have expressed concerns about being forced to make significant 
investments without having the full knowledge of the impact 
Basel II may have on their operations. As I said before, I am 
encouraged that the regulators have recognized some of these 
problems with Basel II and hope that common sense will continue 
to prevail, even if it means delaying the implementation of 
Basel II beyond the January 1, 2008 deadline.
    The goal of Basel II is to develop a more flexible and 
forward-looking capital adequacy framework that better reflects 
the risk facing banks and encourages them to make ongoing 
improvements to their risk assessment capabilities. Over the 
past 6 years, the United States Federal banking regulators have 
engaged in negotiations with their foreign counterparts on 
possible improvements to the standards that govern the capital 
that depository institutions must hold against their assets.
    The Federal Reserve, the Office of the Comptroller of the 
Currency, the Federal Deposit Insurance Corporation, and the 
Office of Thrift Supervision participated in those negotiations 
on behalf of the U.S. Their representatives will be testifying 
on our first panel. It is expected that when ultimately 
implemented, Basel II will apply mainly to the largest, most 
internationally active banks and others that voluntarily adopt 
it. The remaining institutions in the United States will 
continue to operate under the original Basel accord, or Basel 
I.
    A growing international consensus has developed that Basel 
I is outdated and represents a one-size-fits-all approach to 
regulation, causing some banks to hold too much capital and 
thus diverting capital from productive lending activities. 
Additionally, the Basel accord has been criticized for 
worsening credit crunches, creating incentives for banks to 
undertake destabilizing short-term lending in emerging markets, 
for not taking into consideration risk mitigation, creating 
incentives for banks to securitize expensive assets, and for 
not addressing credit risk transfers through derivatives.
    I applaud the intent and objectives of the Basel II 
agreement to ensure solvency of our banking institutions and 
protect against substantial losses by creating a more risk-
sensitive regulatory capital framework and to create 
international standards to manage risk better by aligning 
regulatory capital to economic risk.
    Nonetheless, I and other committee members have concerns 
regarding Basel II for several grounds.
    First, we believe it is unnecessarily complex and costly, 
with inflexible formulas replacing current rules and 
supervisory examinations. You can see from the formula that we 
have displayed that it highlights some of that complexity.
    Neither the U.S. regulators nor the Basel II committee 
members nor the banks can estimate the cost of implementing the 
Basel II due to costs associated with scaling for different 
size banks and difficulties in assessing which costs would 
already have been undertaken by the banks in the ordinary 
course of business.
    No U.S. banking regulator nor any member of the Basel 
committee has indicated whether sufficient resources exist to 
implement Basel II. The documents and charts in front of you, 
as I say, illustrate this point. There are 187 publicly 
available documents related to Basel II weighing 127 pounds. 
While some ideas included in these documents have evolved, the 
amount of paper demonstrates the complexity and micromanagement 
that Basel II represents.
    In addition, the chart with all the letters and numbers is 
the Basel II formula itself. I have no doubt that there are 
very few people who understand this formula or its 
implications. It looks like a formula for micromanaging the 
banking business, rather than one designed to align regulatory 
and economic capital assessments. In addition, I believe that 
the current draft would create an uneven playing field, one 
that unfairly penalizes many banks in the country, particularly 
our regional banks.
    Many believe that Basel II banks will have a significant 
competitive advantage because they will need to hold less 
regulatory capital for certain asset classes, for example 
credit cards, corporate lending, and mortgages, and because 
mortgage participants will perceive Basel II banks to be better 
managed than Basel I banks. I am also concerned that bank 
consolidation could be accelerated solely because of the 
regulatory capital benefits associated with Basel II 
implementation.
    The uneven playing field would carry over across borders, 
since the proposal expressly contemplates over 50 opportunities 
for local regulators to tinker with this formula. What is more, 
the Basel committee itself has not yet figured out how 
regulators will communicate and work together with each other 
to set meaningful regulatory capital requirements for globally 
active banks that have operations in multiple countries. How 
one could end up with an international common standard in this 
situation is difficult to perceive.
    Another concern that we have with the proposal is the 
treatment of operational risk. It is my belief that a 
supervisory assessment by the regulator, as opposed to a 
regulatory capital cover, is the better approach to limiting a 
bank's operational risk.
    It is my understanding that the databases are 
insufficiently robust for banks to provide meaningful input 
into the QIS process. If so, how can we implement these 
requirements without knowing how they will impact real banks 
and real portfolios? How can the regulators have confidence 
that the systems will be in place by the supposed 
implementation date? What if the data at that stage generates 
unexpected answers as they do now, as the credit risk numbers 
have done for QIS-4? What do we do then?
    At today's hearings we will hear from a distinguished panel 
of regulators, including Federal Reserve Governor Susan Bies, 
Acting Comptroller of the Currency Julie Williams, FDIC 
Director Tom J. Curry, and Acting Office of Thrift Supervision 
Director Richard Riccobono, as well as a panel of private 
sector witnesses. I look forward to hearing from today's 
witnesses, and thank them for taking time from their busy 
schedules to join us.
    I am now pleased to recognize the Ranking Member. Actually, 
in his absence, I am going to recognize the gentlelady from New 
York, Ms. Maloney.
    [The prepared statement of Hon. Spencer Bachus can be found 
on page 48 in the appendix.]
    Mrs. Maloney. Thank you, Mr. Chairman.
    I thank all our witnesses and everyone who is here that is 
concerned about this issue. This is the fourth hearing that we 
have called. This is very much of a bipartisan concern. We have 
had several that have focused on it.
    The first Basel Capital Accord established minimum 
standards for banks that operate internationally. Basel II is 
an attempt to update this accord by allowing financial 
institutions to hold capital in a balance more reflective of 
risk and changing market conditions. From the beginning of the 
negotiations, I have been concerned, as many of my colleagues 
have been, that the U.S. regulators need to address these 
negotiations from a consistent and coordinated viewpoint and to 
start from the premise that the new standards do not put 
American financial institutions or any segment of them at a 
competitive disadvantage.
    In the last Congress, we legislated. We held hearings that 
really called upon U.S. regulators to develop a uniform 
position before negotiating in the Basel committee. Once 
implemented, the final capital accord will have profound 
consequences for the banking industry, our constituents, and 
the economy of our country. We must take the time and the focus 
to get this right.
    The results of the QIS-4 study I find very disturbing. It 
shows that some banks adopting the proposed Basel II standards 
will be able to reduce their regulatory capital considerably 
and, thus, gain a competitive advantage with other domestic 
banks that may not be in Basel. More disturbingly, the amount 
by which a bank might be able to reduce its regulatory capital 
varied widely among banks that appeared to be very similar, to 
have similar portfolios, and should, in theory, be treated 
equally under the new standards.
    These results do not support, and indeed actually cut 
against, the reassurances we have consistently received from 
the regulators that the new standards have been designed to 
treat like-risk alike and establish an international level 
playing field. I am concerned that they also suggest that the 
complexity of the new standards makes them more prone to widely 
differing interpretation and results.
    The stacks of paper that have been put there by the 
majority staff, that is the proposal for Basel II. It is very 
long, and over here is the formula. If you look at the number 
of variables in this formula on this chart, each of them 
represents an opportunity for a regulator to tweak the 
definition of that variable so to put a home bank at an 
advantage. This, at least, is a formula for confusion.
    I am very concerned. I know that our regulators are going 
to be very tough on American institutions. I am not so 
convinced that foreign regulators are, in very small countries 
and in other countries. I am afraid that that might put us at a 
disadvantage. If the regulators themselves do not understand 
the reason for the differences that came out in the QIS-4 
study, then how can they hope to effectively monitor and 
supervise compliance? I have not seen any explanation that 
explains why so many like banks with like portfolios came up 
with different conclusions.
    Former Comptroller Jerry Hawke was highly critical of what 
he termed ``the monumental prescriptiveness'' of the Basel II 
standard. Unfortunately, these widely disparate results 
demonstrate that his concerns, which I share, appear to have a 
basis in fact. I hope that we will have this clarified by the 
witnesses.
    I would like to say that why don't we just have a simpler 
rule, just Basel I plus something that applies uniformly, that 
would move more banks, and the United States would be able to 
comply with it? I am very concerned about this highly confusing 
formula that has many opportunities to be tweaked and 
interpreted in various ways by various regulators in other 
countries.
    So I thank you for all of your hard work, and I look 
forward to your testimony.
    I yield back.
    Mr. Bachus. Thank you.
    At this time, I would recognize the ranking member of the 
full committee, Mr. Frank.
    Mr. Frank. Thank you, Mr. Chairman. I appreciate the 
diligence with which you have been pursuing this.
    I have some questions about the technical aspects of the 
formula, but I will defer those and submit them in writing in 
deference to the recorder.
    The concern I do have, though, is touched on by the 
comptroller's testimony and the FDIC's testimony. I have not 
had a chance to read the OTS testimony yet. But in particular 
in the testimony in the FDIC, it is especially the concern for 
the competitive effects. I appreciate Mr. Curry's very 
straightforward statements that if you go ahead with Basel II 
and do nothing else, you put smaller banks at a disadvantage.
    Now we already have a problem. We are in a controversy now 
over deposit insurance. This House passed a bill that would 
increase deposit insurance not by a huge amount, $30,000. The 
likelihood is that that will not survive in the Senate. I 
supported it, but it may not survive. That, smaller banks 
argue, is something of a disadvantage for them. It is a 
perceptual disadvantage from people who have large deposits to 
make and think the bigger the bank, the less likely it is to 
fail, or be allowed to fail; therefore they go toward the 
bigger banks.
    We are, I think, this is not an abstract consideration. Big 
banks are fine, but big banks to the exclusion of little banks 
are not so fine. I want to give a little bit of experience 
here. A few years ago, Mr. Curry would remember, he was there 
at the time, Fleet and Bank Boston merged. There were at the 
time a number of overlapping branches. The question was, what 
do you do with the overlapping branches?
    There was a proposal from the antitrust regulators, both 
State and Federal, that they be packaged together and sold to 
one large outside bank because that would be more competition 
for Fleet and Bank Boston. It seems somewhat nostalgic to talk 
about a large New England bank, doesn't it? But that is where 
we then were, but that is relevant to the pace at which 
consolidation is moving and underlies these concerns.
    Overwhelmingly, my colleagues in Congress and I heard not 
from banks, but from borrowers, small borrowers, local Chambers 
of Commerce, retailers, homebuilders, people who were in the 
local markets: Please do not do that; we do not want to have to 
deal with the very large banks; we want to deal with local 
banks.
    We argued for a divestiture of at least some of those 
overlapping branches to community banks. We were successful in 
getting I think about 12 or 15 percent, but not enough. I 
remember, frankly, the Boston Globe was critical. They said we 
were shilling for Fleet by preventing a big competitor. A year 
later, they had an article saying, well, it turns out that 
there is greater consumer satisfaction with the smaller banks. 
Big banks have their role and so do smaller banks.
    Public policy and the economy and the economies of scale 
and all these other factors are tending to drive us toward 
consolidation. In Massachusetts, as former Commissioner Curry 
knows, the relevant analogous committee to us is called the 
Committee on Banks and Banking. Someone said, are you ever 
going to change the name back here to the Committee on Banks? I 
said no. By that time, we will call it the Committee on the 
Bank because there will be one in the whole country at the way 
we are going.
    It is not in our interest to accelerate that trend. We have 
very strong, very explicit testimony from the regulators, 
particularly those of the smaller banks. The Federal Reserve 
deals with the bank holding companies, but the FDIC, 
particularly the smaller banks, and the Comptroller, both of 
them argue that there is a negative competitive effect. I must 
tell you, I cannot see any argument for going ahead with 
adopting a policy that will increase the pressure on smaller 
banks and increase the competitive advantage that goes to 
larger banks, with no comparable consumer advantage in this 
case, by itself.
    I know people have said, well, after we do this, then we 
can do that. Well, that could come before this as well. So I 
think a heavy burden of proof goes on those who tell us that.
    The final thing I would say is this, Mr. Chairman. I note, 
and Governor Bies, who has been very cooperative and has met 
with us, and I appreciate the Federal Reserve's willingness to 
talk with us about this, but maybe it was one of the others; 
maybe it was Ms. Williams who said: Remember, once we go 
through with Basel II, we still have to adopt it, the bank 
regulators.
    But I will ask, I may not be able to stick around, but I 
would hope you would answer, "Yes, but with what freedom?" If 
we are a signatory to Basel II, are we free to disregard it? I 
mean, it is true that it does not automatically go into effect, 
you tell me, but it does seem to me that we would be under 
serious constraints. The likelihood that we could as we adopted 
it ignore some of the major factors is a problem.
    So this conceded competitive disadvantage for smaller banks 
is a greater obstacle, it seems to me, than any of the 
advantages. At the very least, it rates a very strong argument 
that the timing is out of whack and that there is no reason why 
we should not be able to at least proceed simultaneously. That 
is, I will take a lot of convincing that we should decrease 
capital requirements for the larger banks before we do the 
other.
    One last point, if I could, Mr. Chairman. I would just note 
that there has been some concern expressed in other quarters on 
a matter we are going to be dealing with, the Fannie Mae and 
Freddie Mac, on the danger of them holding mortgages in their 
own portfolio, rather than securitizing it, on the grounds that 
this will add to credit risk. I was very pleased when we wrote 
Governor Bies on this subject because it has something to do 
with Basel and other things. Here is what she said: ``Adopting 
institutions are likely to hold more mortgages on their balance 
sheets after Basel II.''
    This is about Basel II, but it seems to me it has some 
relevance here. ``Since most of the likely increased holdings 
would come from those that are now being securitized, these 
additional mortgages would generally be of high quality, as are 
most residential mortgages that are currently securitized. That 
is while mortgage portfolios of adopting institutions may be 
larger and we would not expect a significant increase in the 
credit risk of bank mortgage portfolios.''
    In other words, when you are talking about mortgages which 
are already of sufficient quality to be securitized, whether 
they are held on the balance sheet of the institution or 
securitized does not affect credit risk. I guess I will need to 
be persuaded by the Federal Reserve why what is sauce for the 
Basel goose is not sauce for the GSE gander.
    Thank you, Mr. Chairman.
    Mr. Bachus. Thank you.
    I now recognize the chairman of the full committee, 
Chairman Oxley.
    Mr. Oxley. Thank you, Mr. Chairman.
    I first want to associate myself with the excellent remarks 
of the ranking member from Massachusetts. I want to thank you 
and Chairwoman Pryce for calling today's hearing on the 
proposed changes to the Basel accord. You have been a real 
leader on the issue of Basel II reform, and it is most 
appreciated.
    Significant changes to the proposal have been made in 
response to your concerns additionally by bringing attention to 
this process. The committee has seen increased cooperation 
among U.S. regulators who are developing Basel II. Basel II is 
critically important to every bank in the United States and the 
rest of the world, and it will determine how much regulatory 
capital must be held to cover risk in bank portfolios, 
domestically and globally.
    Capital standards also influence market perceptions of a 
bank's strength, which directly impacts ratings decisions. I do 
not think you will find much argument that the Basel accord is 
outdated and needs revision. This developed in the late 1980s 
before liquid markets for credit had been developed and before 
the derivatives and securitization markets had taken off. These 
developments have made the Basel accord obsolete and prone to 
abuse.
    The most recent impact study conducted by the U.S. 
regulators, QIS-4, shows major swings in how much regulatory 
capital banks using this new framework might need to hold. 
Participants estimated decreases of as much as 40 percent. 
Others estimated increases of as much as 60 percent from the 
current standard. Even though no bank came close to breaching 
the leverage ratio, these kinds of results are unacceptable. No 
one knows why these results came out the way they did. In other 
words, no one in the regulatory community seems to know how the 
new framework will affect retail credit markets in the United 
States, particularly credit cards and mortgages.
    These market sectors are the backbone of our economy and 
permit the United States to serve as the sole engine of 
economic growth among developed economies in the world. I 
believe it would be irresponsible to proceed quickly under 
these circumstances, and the regulators were wise to pause 
before finalizing Basel II. It would be helpful to know how the 
regulators are progressing with all the various data problems 
and when we will have a greater understanding of the QIS data.
    I would encourage the U.S. regulators to allow time for all 
the data to be understood before making any international 
commitments regarding final text and implementation. Regulators 
also should be discussing how they will cooperate in order to 
implement the new framework.
    Significant changes in Basel II may be needed here and 
abroad before a final proposal is ready. In the meantime, I 
believe that U.S. regulators should continue working on 
updating the Basel accord so that banks in the United States 
can benefit from the changes in the obsolete framework while 
regulators try to put together a functional Basel II proposal. 
It seems that this would be the most equitable way to make 
improvements to the capital standards.
    I am interested in hearing what the witnesses think about 
this. We welcome the distinguished panel of experts and 
regulators who have worked tirelessly to implement and to in 
some cases correct some of the problems that were heretofore 
mentioned.
    I thank the Chair, and I yield back.
    [The prepared statement of Hon. Michael G. Oxley can be 
found on page 46 in the appendix.]
    Mr. Bachus. I thank the chairman.
    Are there any other members who wish to make opening 
statements?
    Mr. Gillmor. Mr. Chairman?
    Mr. Bachus. Mr. Gillmor?
    Mr. Gillmor. Mr. Chairman, I want to take the opportunity 
to introduce a constituent of mine who will be on the second 
panel, Bill Small from the Fifth District of Ohio. Bill is the 
President and the CEO of First Financial, which is based in 
Defiance, Ohio. Today, he is testifying on behalf of America's 
Community Bankers, an organization on which he serves as a 
board member and also on several committees.
    Bill Small has also recently served as the President of the 
Federal Reserve's Thrift Institutions Advisory Council, and he 
contributes significantly to our community, working with 
Defiance College, Defiance YMCA, the Rotary Club, and others. I 
appreciate his service to the district, and I am sure that his 
comments today will be very helpful to this committee in its 
deliberations.
    Thank you, Mr. Chairman, and I yield back.
    Mr. Bachus. Thank you, Mr. Gillmor.
    Hearing no other members that wish to make opening 
statements, at this time I will introduce the first panel. I am 
going to go from my left.
    Our first panelist is the Honorable Susan Schmidt Bies, 
Governor of the U.S. Federal Reserve Board of Governors. I want 
to personally say that since your appointment to head up this 
at the Fed, that I think our relationship, at least our 
communications, has improved, so I commend you for that.
    Mr. Richard M. Riccobono is Acting Director of the Office 
of Thrift Supervision.
    Ms. Julie Williams is Acting Director of the Office of the 
Comptroller of the Currency.
    And the Honorable Thomas J. Curry is Director of the 
Federal Deposit Insurance Corporation. I want to commend OTS, 
the OCC, and the FDIC for your concerns that you have expressed 
as to the affect that these proposals will have on your member 
institutions. I very much appreciate the focus you have given 
this. I think you have been a large reason why we have not 
rushed into this headlong and made some great errors. So I 
commend you.
    At this time, I recognize Governor Bies. We will start with 
you for your opening statements. The opening statements, 
although we say 5 minutes, one or two have mentioned that your 
opening statement may be 6 or 6 1/2 minutes. We are not going 
to strictly enforce that 5-minute rule.

 STATEMENT OF HON. SUSAN SCHMIDT BIES, GOVERNOR, U.S. FEDERAL 
                   RESERVE BOARD OF GOVERNORS

    Ms. Bies. Thank you, Mr. Chairman. Good morning Chairman 
Bachus and Chairman Pryce and members of the Subcommittees.
    It is my pleasure to join my colleagues here today to 
discuss the current status of Basel II in this country. My 
comments are going to be brief, and I ask that my full 
statement be placed in the record.
    The agencies' joint decision to delay the scheduled mid-
year release of the notice of proposed rulemaking for Basel II 
was prudent and necessary. Our most recent study of the 
potential quantitative impact of the proposal, QIS-4, suggested 
much larger than desirable reductions in capital and a 
surprisingly wide dispersion in the estimates of the risk 
parameters that are used to determine regulatory capital under 
the proposal. As responsible regulators, we believe it is 
appropriate to improve our understanding of these results and 
to consider what changes might be needed to our proposal before 
we move forward on the NPR.
    However, delaying the NPR and related documents creates a 
dilemma. Without them, core and potential opt-in banks do not 
have the blueprints to complete the databases and systems for 
the regulators to fully assess how banks would operate under 
Basel II. With limited databases and systems, banks provided us 
in QIS-4 their best estimates. We need to learn what we can 
from reviewing their responses, but there are limits to what we 
can learn as we do this review.
    Consequently, we should, as soon as feasible, continue with 
the development of the NPR and related supervisory guidance. 
These documents are essential to the ultimate provision to us 
of the credible inputs we need to evaluate the effects of Basel 
II. We hope thereafter that we can stay as close as possible to 
the 2008 start date for the so-called transition run. The 
ability of banks to do so is one of the questions we propose to 
ask in the NPR. If evolving developments require we delay this 
schedule, we will of course do so and announce it as soon as 
the decision is made.
    As described in some detail in my statement, the 
implementation process that has been proposed would have banks 
providing us credible inputs based on real databases and 
systems over at least a 3-year period. We know banks' evolution 
in these processes is proceeding very quickly. A lot can be 
accomplished in this timeframe.
    For individual banks, implementation can only occur as soon 
as supervisors are satisfied with each bank's systems and 
processes. If a bank does not meet these standards, they will 
not be allowed to go into Basel II. The delay in the NPR and 
this implementation schedule are fully consistent with the 
policy the agencies have followed throughout the development of 
Basel II. We have made many changes that incorporate comments 
that we have received and tried to base our decisions based on 
the best evidence available at the time. We have announced that 
we would not move to final implementation until we are 
confident that Basel II was consistent with a safe and sound 
U.S. banking system.
    Basel II is an important supervisory advance. The current 
framework is being arbitraged aggressively and provides us with 
less and less reliable measures on which to base a regulatory 
capital requirement for our largest and most complex banking 
organizations. Our banking system and financial markets are 
strong and safe now, but they were not always so in the past 
two decades. We need now to take the steps to ensure that the 
current safety and strength is extended for our large global 
banking organizations.
    Members of the subcommittee, the FDIC has underlined the 
importance of supplementing the risk-based capital requirement 
of Basel II with a minimum leverage ratio and prompt corrective 
action as part of a prudent supervisory regime. I want to be 
quite clear that the Federal Reserve concurs in the FDIC's 
view. We need for reasons I have described the risk measurement 
and risk management infrastructure and risk sensitivity of 
Basel II, but experience suggests that we also need the 
supplementary assurance of a minimum equity to asset base for 
entities that face the moral hazard of the safety net.
    All of us are aware of the concern of thousands of banking 
organizations that will not be subject to Basel II that they 
will be placed at a competitive disadvantage. The results of 
QIS-4 have only heightened these concerns. The Federal 
Reserve's research published in our competitive studies has 
identified competitive impacts in the small business and 
residential mortgage markets. The agencies are as a result 
developing simple modifications to the current rules that will 
make them more risk sensitive to address these competitive 
concerns.
    We hope to publish a proposal to amend Basel I for those 
banks that will not be in Basel II at the same time that the 
Basel II NPR is released. In this way, the public can review 
both proposals, compare them, and give us comments on each, 
particularly around the competitive impacts. Let me make clear 
that these modifications would in no way make such revised 
current rules substitutes for the needed reforms for the 
sophisticated financial products and services provided by our 
large complex internationally active organizations.
    I will be pleased to answer any questions. Thank you.
    [The prepared statement of Hon. Susan Schmidt Bies can be 
found on page 52 in the appendix.]
    Mr. Bachus. Thank you.
    Now, Director Riccobono.

 STATEMENT OF RICHARD M. RICCOBONO, ACTING DIRECTOR, OFFICE OF 
                       THRIFT SUPERVISION

    Mr. Riccobono. Good morning, Chairman Bachus, Chairman 
Pryce, Chairman Oxley, and Ranking Member Maloney. I want to 
first thank you for holding this hearing on Basel II and for 
your continued interest in this issue. I would ask Chairman 
Bachus if I could submit my written testimony into the record.
    I particularly want to thank you, Chairman Bachus, for your 
legislative efforts in H.R. 1226. We fully support it, 
including the provision you have in there regarding OTS's 
representation on the Basel committee. It is important that 
OTS's international role be formalized for numerous reasons, 
not the least of which is the potential impact of Basel II on 
the institutions and holding companies we regulate.
    OTS is experienced in regulating institutions that 
specialize in residential mortgage-related lending, now 
representing almost 40 percent of the assets of the entire U.S. 
banking system. It provides us with a unique supervisory 
perspective. In addition, our experience regulated diverse 
holding company structures recently recognized by the European 
Commission when it quoted OTS equivalent under the EU's 
financial conglomerates directive as another important reason 
for OTS's representation on the committee. Although we are more 
than 2 years from its projected implementation, now is a good 
time to update you on our progress and the issues that U.S. 
institutions may face under Basel II.
    We very much support Basel II and are committed to 
implementing a prudent and sensible framework for it in the 
U.S., but there is much to be done before we are ready to 
implement it. While Basel II provides an opportunity for our 
largest U.S. institutions to move to a more logical risk-based 
capital framework, it is equally important to identify ways to 
improve the risk sensitivity of Basel I for the thousands of 
institutions that will remain subject to it. These objectives 
are not mutually exclusive, but rather mutually dependent in 
order to prevent potential competitive inequalities between 
Basel II adopters and non-adopters.
    Risk-sensitive capital requirements are as important for 
community banks as they are for large internationally active 
institutions. Achieving greater risk sensitivity for one part 
of the banking system and not the whole will create competitive 
distortions. While global regulatory convergence of capital 
standards is extremely important, we must not ignore its 
effects and potential impact on U.S.-based institutions that 
are not operating internationally.
    OTS is pleased that an initiative we advocated for years, 
the so-called ``Basel I rewrite,'' has ripened into a 
commitment by all the Federal banking agencies to modify Basel 
I for U.S. institutions not adopting Basel II. The goal of this 
initiative is to achieve greater risk sensitivity without undue 
complexity. This can be accomplished by applying more accurate 
risk weights for a wider range of asset buckets and by applying 
commonly understood criteria for assessing the relative risk of 
various loan types. We strongly support amending Basel I in 
conjunction with Basel II, but sooner if Basel II timeframes 
are pushed back.
    On the issue of timing, the results of QIS-4 suggest that 
Basel II is very much a work in progress in the U.S. It is 
appropriate at this juncture to ask whether we may be moving 
too quickly, and if so to reassess and determine how to adjust 
existing timeframes. Although implementing a more risk-
sensitive capital framework is an important objective, we must 
do so mindful of an equally important objective of doing no 
harm to our existing banking system.
    Given what we have learned so far from QIS-4, prudential 
supervision suggests that a longer implementation period may be 
needed to gain the necessary data and confidence we require 
before implementing such a major change to our capital 
framework. We believe as a matter of good public policy that 
the Basel II timeframes should be viewed as guidelines, not 
hard targets.
    QIS-4 also did not capture the impact of interest rate risk 
largely because Basel II treats interest rate risk differently 
than other risks. As noted earlier, the banking and thrift 
industries currently have almost 40 percent of their assets in 
residential mortgages and mortgage-related assets. Interest 
rate risk, especially important for mortgage products, must be 
addressed uniformly with guidance from the Federal banking 
agencies on how to measure and manage this risk.
    Any discussion of Basel II is incomplete without a 
discussion of the interrelationship between leveraged and risk-
based requirements. Unfortunately, the issue has spawned a 
substantial amount of dialogue about whether there should be a 
leverage requirement at all. OTS does not advocate eliminating 
a leverage requirement. I am going to say that again. OTS does 
not advocate eliminating a leverage requirement.
    However, the current one-size-fits-all approach to a 
leverage ratio runs at cross-purposes with Basel II. Leverage 
treats all assets on the balance sheet identically. It provides 
too little incentive to manage risk for both very low and very 
high credit-risk institutions, and off-balance sheet activity 
is untouched by existing leverage requirements. Moreover, a 
capital framework with a risk-insensitive leverage ratio may 
have the unintended consequence of perversely motivating low 
credit-risk lenders to pursue riskier lending.
    Likewise, layering in a variety of permanent 
countermeasures such as arbitrary floors and multipliers into 
Basel II to offset capital reductions in low credit-risk 
portfolios undermines the overarching goal of creating a more 
risk-sensitive framework. It is critical that we address the 
leverage requirement and the Basel II floors as a complete 
seamless and integrated time framework.
    We will continue to work with you, the other Federal 
banking agencies, and our colleagues in the international 
community to ensure that we do not sacrifice safety and 
soundness for the sake of delivering a timely, but potentially 
flawed capital framework.
    I will be happy to answer any questions that the committees 
may have. Thank you.
    [The prepared statement of Richard M. Riccobono can be 
found on page 147 in the appendix.]
    Mr. Bachus. Thank you.
    Acting Director Williams?
    We appreciate your testimony, Acting Director Riccobono.

  STATEMENT OF JULIE WILLIAMS, ACTING DIRECTOR, OFFICE OF THE 
                  COMPTROLLER OF THE CURRENCY

    Ms. Williams. Chairman Bachus, Chairwoman Pryce, 
Congresswoman Maloney, members of the Subcommittees, thank you 
for inviting the Office of the Comptroller of the Currency to 
participate in this very timely hearing.
    In my remarks this morning, I will highlight three areas: 
first, where we stand on implementation of the Basel II 
framework in light of the recent results of the fourth 
quantitative impact study, QIS-4; second, our commitment to 
contemporaneously modernize the current domestic capital rules 
for those banks that will not be governed by the Basel II 
rules; and finally, some thoughts on H.R. 1226.
    Last year, the U.S. banking agencies undertook a fourth 
quantitative impact study, QIS-4, with the specific goal of 
gaining a better understanding--before its adoption--of how 
Basel II might affect minimum risk-based capital within the 
U.S. banking industry. The agencies recently completed a 
preliminary analysis of the QIS-4 data and certain initial 
observations became very evident to us.
    In brief, the QIS-4 data evidenced both a material 
reduction in the aggregate minimum required capital for QIS-4 
participants and a significant dispersion of results across 
institutions and across loan portfolio types. For example, 
aggregating over the QIS-4 participants, the decrease in 
effective minimum required capital was 17 percent, while the 
median decrease among participants was 26 percent. Changes in 
effective minimum required capital for individual institutions 
ranged from a decrease of 47 percent to an increase of 56 
percent. While some dispersion of results in a truly more risk-
sensitive framework is to be expected, we are not convinced 
that the wide ranges indicated by QIS-4 can be fully explained 
by the relative differences in risk among institutions.
    I must pause here to strongly emphasize that the change in 
what we are calling effective minimum required capital 
represents the change in capital required to meet an 8 percent 
minimum total risk-based ratio. It does not reflect that 
individual institutions in fact hold capital in excess of 
regulatory minimums and, therefore, it does not imply that any 
particular institution would actually need to increase its 
capital in order to be capital--compliant.
    Finally, changes in minimum capital requirements--both 
increases and decreases--of certain portfolio types, credit 
cards on the one hand and mortgages on the other, significantly 
exceeded our expectations.
    Based on this preliminary assessment of QIS-4 results, the 
agencies concluded that a delay in the notice of proposed 
rulemaking was the only responsible course of action available 
to us. For that reason on April 29th, we announced that we 
would not publish a proposed rule on the schedule that we had 
previously forecast.
    The obvious question all this raises is, what now? We 
continue to believe in the potential of Basel II to achieve its 
crucial objectives: improved risk management, supported by 
significantly greater risk sensitivity in the regulatory 
capital framework. But, the issues surfaced during our 
preliminary work point to a need to do a more complete 
assessment of the QIS-4 results. This additional work is 
necessary to determine whether the preliminary results reflect 
actual differences in risk, simply reveal limitations in QIS-4, 
are the product of variations in the stages of bank 
implementation efforts, and/or suggest the need for adjustments 
to the Basel II framework.
    The results of our additional work will tell us much about 
the steps that we need to be taking in order to make Basel II a 
reality for U.S. financial institutions. If we believe that 
changes in the Basel II framework are necessary, we have 
consistently said that we will seek to have those changes made 
by the Basel Committee.
    I also want to assure you that the U.S. banking agencies 
recognize that domestic institutions not subject to Basel II-
based capital requirements, including mid-sized and community 
banks, have a strong interest in the ways in which their 
products, pricing, and business strategies might be affected by 
implementation of Basel II by their competitors. That is why we 
have undertaken a separate, but related, effort to update and 
modernize the domestic risk-based capital rules for those 
institutions not subject to Basel II. The agencies are 
developing these two capital rulemaking projects in tandem to 
ensure that appropriate risk sensitivity and consideration of 
competitive effects are considered in each proposal.
    Finally, the Subcommittees have asked for our views on H.R. 
1226. We share the desire of the bill's sponsors to ensure a 
strong and consistent position among the banking agencies in 
our approach to Basel II. We also agree that the types of 
factors listed in the bill are very relevant to evaluating the 
impact of implementing Basel II. However, with the greatest 
respect, we do not believe that legislation is needed to 
achieve these results. Since the beginning of the process that 
led to the adoption of the Basel II framework, the agencies 
have worked closely together. While there have been differences 
in views along the way, I believe these different perspectives 
have, on balance, been constructive. I have confidence that 
this will continue to be the case.
    Also very relevant here is the fact that the OCC, and I 
believe also the OTS, has designated the Basel II rulemaking as 
a significant regulatory action for purposes of Executive Order 
12866, which requires us to prepare a regulatory impact 
analysis (RIA) for OMB review prior to publication of the 
proposal. The RIA will include an assessment of the costs and 
benefits of the proposed regulation, and it will address many 
of the factors that are identified in H.R. 1226.
    In closing, let me emphasize three commitments that have 
been and that remain central to our work on the Basel II 
framework: first, an open rulemaking process in which comments 
are invited and considered, good suggestions are heeded, and 
legitimate concerns are addressed--there is no done deal here; 
second, a reliable quantitative analysis prior to adoption of a 
rule, through which we can assess the likely impact of Basel II 
on the minimum regulatory capital requirements of our banks; 
and finally, a prudent implementation in which we make well 
reasoned and well understood changes to bank capital 
requirements and incorporate those changes with appropriate 
conservatism.
    Thank you for holding this important hearing, and I look 
forward to answering your questions.
    [The prepared statement of Julie Williams can be found on 
page 173 in the appendix.]
    Mr. Bachus. Thank you.
    Mr. Curry?

    STATEMENT OF THOMAS J. CURRY, DIRECTOR, FEDERAL DEPOSIT 
                     INSURANCE CORPORATION

    Mr. Curry. Thank you, Chairmen Bachus and Pryce, and 
Ranking Member Maloney and members of the subcommittees. I am 
pleased to represent the FDIC at this important hearing.
    Basel II is an effort to tie capital requirements more 
closely to risk and promote a disciplined approach to risk 
management at our largest banks. The FDIC supports these goals 
and the process of implementing a revised capital framework in 
the United States.
    First, I would like to mention some concerns the FDIC has 
about the results of the recent quantitative impact study, or 
QIS-4. The issues we discuss today may sound sweeping and 
fundamental, but we believe that they can be resolved. Our 
intention is to work with our fellow regulators to address our 
concerns and to move forward expeditiously when this is done.
    The agencies's review of QIS-4 is not complete. 
Nevertheless, in part because the QIS-4 results are consistent 
with previous FDIC analysis, we have formed some preliminary 
conclusions. In our view, QIS-4 shows excessive reductions in 
risk-based capital requirements. For half of the 26 banks in 
the impact study, capital requirements fell by more than 26 
percent. This is without fully factoring in the benefits of 
credit risk hedging and guarantees that are likely to reduce 
capital requirements significantly more.
    For individual loan types at individual banks, almost half 
the reductions in capital requirements were in the range of 50 
percent to 100 percent. Numbers like this do not give us 
comfort that the Basel framework will require capital adequate 
for the risks of individual activities.
    We are also concerned about what the dispersion of results 
suggests about the difficulty of applying the framework 
consistently across banks. Capital requirements in Basel II are 
very sensitive to inputs. Achieving consistency in Basel II 
depends on the idea that best practices and best data will lead 
to convergence in the capital treatment of similar loan 
portfolios across banks. At present, however, at least as 
indicated by QIS-4, there is little commonality in the 
approaches the various banks used to estimate their risk 
inputs.
    The FDIC has stated on many occasions that there is a 
continued need for a leverage ratio. I would add at this point 
that the QIS-4 results suggest to us that our U.S. leverage 
requirements will be even more important under Basel II. The 
FDIC can support moving forward with this new framework only 
because of the existence of the leverage-based component of 
U.S. capital regulation.
    We also have a concern about the potential competitive 
effects of the new framework. If QIS-4 is representative of 
capital requirements going forward under Basel II, the 
competitive ramifications for community banks and large non-
adopting banks could, in our view, be profound. If Basel II is 
implemented unchanged, the only option for mitigating these 
competitive inequities would appear to be a substantial 
reduction in capital requirements for all insured institutions.
    All of these issues suggest to us that thought needs to be 
given to finding ways to implement this new framework in a 
manner that produces results that are less extreme and more 
consistently applicable across banks.
    With respect to the issue of capital requirements for 
operational risk, I will make one point. Because Basel II's 
advance measurement approach, or AMA, is complex and expensive, 
large banking organizations understandably do not want to 
implement it at each and every insured subsidiary. The FDIC 
believes, however, that every insured institution should 
maintain an adequate level of capital, a point of view that, 
strictly speaking, implies the need for every insured bank to 
have its own AMA.
    In resolving these conflicting goals, we are inclined to 
seek ways of moderating the AMA, rather than compromising the 
important responsibilities of insured banks and their boards. 
For that reason, we will continue to work with our fellow 
regulators to explore simpler, less burdensome approaches for 
insured institutions to meet their requirements for operational 
risk within this new framework.
    In summary, for Basel II to be successful the FDIC believes 
we must preserve a set of straightforward minimum capital 
requirements to complement Basel II, maintain competitive 
equity among large and small domestic and international 
institutions, and find ways to achieve results under Basel II 
that are less extreme and more consistently applicable across 
banks.
    The FDIC, in cooperation with the other banking agencies, 
will proceed in an appropriately deliberative manner and with 
full consideration of the comments of all interested parties. 
We believe these goals can be achieved.
    This concludes my remarks. I will be happy to answer any 
questions from the committee.
    [The prepared statement of Hon. Thomas J. Curry can be 
found on page 103 in the appendix.]
    Mr. Bachus. Thank you.
    Governor Bies, let me ask you the first question. I want to 
go back to one reason that we are having the hearing today, and 
that is an article I read back in January in the American 
Banker. What it said there, it referred to a study that the Fed 
had done. This study says that residential mortgage portfolio 
capital levels will drop so significantly at the 20 or so U.S. 
banks that adopt Basel II, that they will hold a major 
competitive advantage over all other U.S. banks.
    Now we know that that paper was never published. It was 
prepared by two economists, one of which had worked for the Fed 
for 20 years, who no longer works there. They are on our second 
panel. When I read that, it was everything that the other 
regulators had been saying. It was everything that regional 
banks and others had been saying to us, but it was counter to 
what the Fed's position was. It was counter to what Mr. 
Ferguson was saying. So I immediately wondered why the paper 
was never published, because I am very concerned about people 
being able to speak out without any fear of expressing a 
different opinion from someone else.
    Since that time, I have read that even one of the Governors 
of the Federal Reserve in St. Louis expressed the same concerns 
and said that he believed that there was a good chance there 
would be a competitive advantage, a major competitive advantage 
for the large banks. There have been others that have expressed 
this opinion, including other regulators.
    And then you all took another look at it. You did not 
publish the first report. It never was published by the Fed. 
And now you have come out with a second report which basically 
appears to be the opposite of the first report, that says Basel 
II will not tilt the mortgage field.
    Can you give me some background on maybe why, number one, 
the Fed decided not to publish that paper? Number two, I know 
the two gentlemen have left, and I assume, I am sure they left 
voluntarily, but why would economists that had been there 20 
years come up with one conclusion, and then you get another 
group of economists at the Fed and they come up with a 
different conclusion? Did the second report maybe conclude some 
things starting out that the first one did not?
    Ms. Bies. Mr. Chairman, I think you know that if you get in 
a room with several economists, you will get very different 
perspectives. We even get it when we talk about where interest 
rates may go. The one criterion that the Fed sets for all the 
research is the quality of the research. As the paper was 
initially completed, there were some concerns about the 
qualitative aspects of the research itself, not the conclusion.
    I want to make it clear that we encourage information at 
the Fed because of the ability to really understand factually 
what is happening. It is something we rely on whether we are 
dealing with monetary policy, bank supervision, or consumer 
affairs. We look at it all, but we want strong research. We 
encourage it not only at the Board, but each of the Federal 
Reserve banks. That is why we allow the Federal Reserve banks 
to have their own opinions. The only standard we ask is quality 
research.
    Mr. Bachus. Let me say this, I am not saying that that is 
why they left. I have no reason to believe that. I am just 
saying that they concluded one thing and then your next study 
another, and they were experienced economists, well respected. 
And then a different group of economist at the Fed concluded a 
diametrically different conclusion. Doesn't that bother you or 
disturb you that your own economists cannot even agree, that 
some of your economist have said, some that have been there 20 
years in fact?
    I guess it was the two that the Federal Reserve asked to do 
this report. That would lead me to believe you felt maybe, or 
someone at the Fed felt they were the most qualified at the Fed 
to do it. They did it and concluded that it would be a major, 
major competitive advantage for the 20 largest internationally 
active banks over all our other banks. We are talking about 
residential mortgages here, which could have a tremendous 
impact on every American who has a mortgage or wishes to buy a 
home. And then that was not published. Why wasn't it published?
    Ms. Bies. Let me get to the bottom line of the conclusions 
of the research.
    Mr. Bachus. Sure.
    Ms. Bies. I think here what we need to understand is what 
the questions were that were being asked. When we talk about 
the impact on most mortgages in the United States, most of 
those mortgages are securitized today. They are underwritten 
for credit based on Fannie and Freddie standards.
    Mr. Bachus. But you know, there are proposals to change 
that, as Mr. Frank I think mentioned. So you are assuming that 
things are going to go on as they are at the GSEs when there is 
major legislation up here that could change that?
    Ms. Bies. I guess I want to make a distinction there. I am 
talking about the securitization of the mortgages, not whether 
Fannie and Freddie choose to buy back those mortgages that have 
been securitized. That is a separate issue.
    Mr. Bachus. But if we put a cap on their capital, which the 
Treasury for one is proposing that we do that, that would 
affect whether they bought the----
    Ms. Bies. Right. But to the extent they have to fund it 
all, it still would influence rates in a similar way, and that 
is a separate issue.
    I am trying to get at the results of this research. To the 
extent that the loans are still going to be securitized, the 
loans that are being securitized on the standard mortgages are 
priced in markets today. There will be little impact of that on 
financial institutions. The real differentiation is going to be 
the choice that institutions make to hold whole loans on their 
books or to hold mortgages that are not conforming on their 
books.
    As you are well aware in the last couple of years, as the 
housing industry has had strong price appreciation, consumers 
have refinanced, and we have seen evolving structures of 
various types of mortgages. Some of these are riskier than 
traditional mortgages. Others are just as safe. They are just 
bigger than conforming loan sizes are. For the portfolio loans, 
the loans institutions would like to hold on their books, we do 
need to make changes to Basel I or we would end up with an 
imbalance because the 1988 Accord overestimated the kind of 
capital you need around traditional well-underwritten 
mortgages.
    Mr. Bachus. All right. Let me say this. I now agree with 
you, but you cannot assume in a study that you are going to 
make those changes in Basel I and know what that effect is 
going to have when you have not even made the changes in Basel 
I. What you are saying is, if we change Basel I, we probably 
will not have this competitive disadvantage. We have not 
changed Basel I. Do you agree that maybe we ought to change 
that before we make an assumption? Your latest economists, they 
said that basically these small banks could reposition their 
portfolios. Or what you are saying is that we are going to 
change Basel I so they will not be at a disadvantage.
    Ms. Bies. What I am saying, is for the loans that are put 
in the portfolio that will end up being a competitive 
disadvantage for the safest mortgages because the big 
institutions already are taking those loans off their books, 
they are already able to get around the existing capital 
limitations that Basel I puts on them. For smaller banks, it is 
more difficult for them. They do not originate enough deal flow 
to pool these mortgages effectively. So they very often keep 
mortgages on their books, especially non-conforming. That is 
the issue that we are trying to deal with in terms of capital 
on the books.
    Mr. Bachus. I guess what I am saying, this latest Fed study 
which contradicted the first did not say in there, now, we are 
going to change the requirements in Basel I and it will allow 
these small banks to not be at a competitive disadvantage. It 
assumes something without saying it.
    Ms. Bies. It was really focusing on the impact of the 
securitized conforming mortgages. What I am saying is that it 
is a broader question. There is more variety of mortgages today 
and I think by looking at both of these aspects, we can 
understand that banks are trying to innovate to serve their 
various customer needs. And as they innovate we need to make 
sure that the risk framework, whether it is the banks in Basel 
II or the banks in Basel I amended that are going to have the 
flexibility. If there are riskier loans, capital should go up. 
If they are less risky, it should come down, for both sets of 
banks.
    Mr. Bachus. I guess what I am saying, and my time is over, 
but you also assume in this second study that the GSEs and the 
way they do business is going to remain the same.
    Ms. Bies. We made that assumption because it is unclear 
exactly how they would change.
    Mr. Bachus. That is right, but that is a pretty big 
assumption.
    Ms. Bies. It is a big assumption.
    Mr. Bachus. Thank you.
    Ms. Maloney?
    Mrs. Maloney. Thank you.
    Following up on the chairman's questions, Honorable Ms. 
Bies, on page seven of your testimony you note the heavy 
investment in systems and processes that U.S. Basel II banks 
have been making. You express concern that these banks not be 
placed at a competitive disadvantage vis-a-vis a foreign bank 
by a delay in the rulemaking.
    But in light of that recognition and following up on the 
chairman's points, how can the Fed argue that banks which 
compete with non-banks or smaller non-Basel II banks will not 
also be at a disadvantage because they would hold more capital 
than their competitors?
    Ms. Bies. I think I want to differentiate here between what 
we are trying to do on the international front and the domestic 
front. In the U.S., we have chosen to only mandate the very 
large complex organizations to go into the advanced approaches 
to Basel II.
    We did that because we are concerned that for these complex 
organizations, the existing capital framework is so simple 
because it ignores so much of the risk that is off the books, 
that we need to get something that reflects the evolution they 
have. They keep inventing new types of financial instruments, 
new deal structures. Items are off the books so they are not 
visible in the traditional capital framework.
    As they keep evolving in that way, we need to make sure 
that capital reflects risk around the way they are managing 
their product lines and their customer exposures. We do not 
expect that any mid-size or small bank would necessarily make 
these investments in these sophisticated risk tools. But we do 
expect today, under our supervisory framework of safety and 
soundness, that any sophisticated bank that deals with these 
tools has already in place a strong risk management framework. 
So depending on the large banks that you are describing, for 
many of them they are in the process of extending databases, 
but they already have a framework that looks at risk in a very 
sophisticated way.
    The formula, for example, that you mentioned that is posted 
here is one of those aspects on how loan pools are put together 
to look at different risks in different branches. We actually 
proposed at one point a more simplified version of that 
formula, and the banking industry came back and said no, that 
they felt it was not reflective enough of risk and wanted us to 
move to this version of the formula because it better reflected 
the different risk aspects that are used as loans are being 
securitized.
    The fact that these organizations are engaging in this 
sophisticated activity and we already are looking at them and 
expecting them to have systems in place to understand various 
aspects of risk, it is an easier evolution for Basel II for 
these organizations than institutions who would not undertake 
these sophisticated transactions. That is why we have to keep a 
very simple framework for the banks that are not in Basel II, 
but make sure that an answer is comparable on the risk that 
results.
    Mrs. Maloney. But these systems that they have put in 
place, according to this QIS-4, are flawed. They are coming 
forward with very different risk and very different capital 
requirements, and no explanation of why similar institutions 
have such large different results. So it seems that if we keep 
going forward, in a sense, you are encouraging a flawed system 
that would aggregate the competitive problems that we were 
suggested in the QIS-4 study.
    Ms. Bies. I agree that all of the results in QIS-4 for 
every bank are flawed in the sense that today no U.S. bank 
would qualify for adoption of Basel II. None of us would 
qualify any of these banks. Remember what the QIS process was 
designed to do. This is the fourth one we have done. We did 
these periodically so banks who are thinking about going to 
Basel II could use it as a milestone to sort of say how are we 
progressing and what are the issues we need to be focused on. 
We could use it as a check for whether the framework had issues 
we had to deal with.
    If you look at individual banks, and we are still doing 
this, one of the things you find is that, for example, some 
banks did not have a process in place for certain portfolios or 
loan types or risk elements. As a result, it is zero. Well, if 
you put in a zero because you did not complete that part of the 
exercise, you are adding in a zero. And we know that clearly is 
not the answer.
    If we look at banks that we would expect similar results, 
one of the issues we have is their database limitations. Some 
do not go back very far. We have been very lucky in this 
country in the last few years. Credit quality has been 
extraordinarily sound. We are expecting when this gets done 
that the databases for credit risk go through a credit cycle. 
Right now, the databases only have the good years, and when you 
only have the good years, you are necessarily going to have a 
lot less capital than if your database includes the bad years 
in a credit cycle, and that requires more credit.
    Most of the banks in this process did not have that full 
cycle of data underlying their loans, and that is another 
reason. That is what we are trying to do, is to separate out 
the reasons for the differences and begin to focus on where are 
they in their development process and where are we needing to 
make changes in the existing framework.
    Mrs. Maloney. Then why did banks with similar portfolios 
end up with different results? You say that the database had 
limits. Is that the only reason? What about different 
applications? Why did it end up with such different results?
    I would beg the chairman to allow other members of the 
panel to answer because that is the basis of this hearing. It 
is why did we get such different results with similar banks and 
similar portfolios? What is the explanation?
    Ms. Bies. Again, let me just make one other point. This is 
why we are trying to do this delay to find out the facts. We do 
not have all the answers yet. I am saying that the initial 
results, banks we thought should be the same, for example, 
there are parameters and models that are different.
    One of the requirements we say you have to look at what in 
a downturn stress situation of credit losses, what would your 
estimate be. Some banks have not put together any methodology 
to get to it, and actually there is nothing there for that 
effect. If banks are having difficulty coming up with that, 
then that is a signal to us as regulators that we may have to 
mandate an assumption to get everybody who has similar credit 
portfolios to use the same parameters in their models.
    Mrs. Maloney. Okay.
    Would anyone else like to comment on this? Ms. Williams?
    Ms. Williams. Congresswoman, the basic answer to your 
question of why there are these differences is that we do not 
know yet. That is exactly what we are drilling down into right 
now. That is what this whole QIS-4 process is about--enabling 
us to understand better how these processes work. So I would 
like to characterize the QIS-4 process and the results of the 
QIS-4 process as a good thing. This is showing that the process 
that the agencies have in place to work through the 
implementation of Basel II is proceeding in a careful and 
judicious way. We decided we need to slow down here and 
understand better the numbers that we have, and that is what we 
are going to do.
    Mrs. Maloney. Thank you.
    My time is up. Thank you, Mr. Chairman.
    Mr. Bachus. Thank you.
    Chairman Pryce, I want to commend you on your preparation 
for this hearing and your support.
    Ms. Pryce. Thank you.
    I appreciate this opportunity, and I want to thank the 
panel for helping us understand where the regulators believe we 
are in this process. I believe we are at a pretty critical 
stage. There are obviously some significant problems with the 
implementation of Basel II, but there is a possibility of a 
competitive disadvantage for U.S. banks in the international 
marketplace if there are not the appropriate changes currently 
made in the capital requirements.
    My question to you all is, does it make any sense at all in 
ordering that the noncontroversial parts of the accord be 
implemented sooner? Then the regulators can go back and work on 
the remaining provisions that are more controversial for future 
implementation. You know, just kind of pick the low-hanging 
fruit, get started, get up and running, and then work out all 
the details and not have to have the perfect final product 
before we can see some advancement. Has there been any 
discussion of that? If it is a bad idea, can you tell me why, 
any of you?
    Ms. Bies. Let me start. Right now as we look at QIS-4, and 
as we move forward in the Basel II process, we are going to be 
looking at those kinds of issues. Clearly, we are running into 
different issues around different aspects of risk. The one 
example I just mentioned about what do you do with a downturn 
stress situation, a severe recession. Because we did not 
capture the kind of data we want in these models back in the 
1980s, the last time we had such a time, we may need to 
simplify that and put in a temporary assumption until we have 
used these models through a crisis scenario. In that sense, it 
is simplifying and we can get to a decision relatively quickly.
    Another example is the operational risk information. We 
have been collecting data from the banks that are participating 
in the process, and we are putting together at the Federal 
Reserve Bank of Boston a significant database on operational 
risk that has millions of entries to date. This is one way to 
develop deep enough databases that can either be shared with or 
amony banks, so they do not have to incur all the costs on 
their own or as a basis simplify or modify the assumptions. We 
could look at that alternative.
    We are really trying to think outside the box and respond 
to the industry and also be sure that the framework is sound in 
a risk-focused approach, and we will be considering those 
alternatives as we go ahead. I think the one thing we need to 
be careful about doing it piecemeal is that we really think 
through what the implications could be in different product 
markets and the competitive impacts in the United States. We 
need to think that through as we go forward.
    Ms. Pryce. Anybody else?
    Ms. Williams. I'd like to offer a complementary perspective 
on this. The U.S. regulators chose to implement the advanced 
approaches for Basel II because we felt that that ultimately 
was the best way to end up having a truly risk-sensitive 
capital regime. It is very hard to pull apart pieces of an 
advanced IRB approach or an advanced approach for op-risk and 
do a partial implementation.
    What is possible in moving ahead with the implementation 
process is to make sure that you have safety nets, stopgaps, 
prudential provisions in place so that you are comfortable with 
the implementation process as it goes forward. Those are some 
of the things that Governor Bies was mentioning as 
possibilities. What we hope we will discover as a result of our 
deeper analysis of the QIS-4 data is which of those ideas, and 
maybe others, make the most sense to use based on the 
circumstances.
    Ms. Pryce. I hope, because we are moving the timeline 
again, advancing it, and so I hope that some good comes of 
this, that perhaps it will advance some of this as opposed to 
postponing it.
    Let me change gears real quickly. I would like to talk 
about the competitive impact on U.S. financial services firms. 
Last June, there was a hearing on private sector perspectives. 
The subcommittee received testimony that a number of large U.S. 
security firms are going to be subject to Basel II through 
registration with the SEC, pursuant to a new regulatory 
framework for consolidated supervised entities.
    Are you all working with your colleagues at the SEC to 
ensure an equitable application of Basel II as applied to those 
firms? Is the goal to apply Basel II with due recognition of 
the differences between banks and securities firms? Who would 
like to field that one?
    Ms. Williams. There is coordination among the domestic 
regulators. There is also coordination in the international 
arena with the international securities regulators and how 
their implementation of Basel II intersects with the bank 
regulators' implementation. So yes, there is coordination.
    Ms. Bies. Let me just make you aware that as part of what 
Ms. Williams just mentioned, the Basel Banking Committee and 
IOSCO, which is the equivalent, the International Association 
of Securities Regulators, of which the SEC is a member, just 
published a few weeks ago a regulatory capital framework that 
is risk-based for what we call trading book assets, which is 
the biggest part of securities firms' balance sheets.
    The idea is that we will end up with a common risk 
framework between both securities and banking regulators, not 
only in the U.S., but internationally. Those comments are due 
at the end of this month. It will take us a while to look at 
it. Clearly, what we are going to learn from that, we will also 
incorporate into the NPR and Basel II going forward.
    The fact that this being done on an international basis I 
think is another signal that we are trying to make sure that 
similar risks are treated in the same way as we can for risk-
based capital purposes no matter what the charter of the 
organization may be. So we feel that we are making much more 
progress along those lines, and this new proposal that was 
jointly issued by both IOSCO and the Basel Banking Committee I 
think is good testament that we are working together. There are 
other aspects of coordination that we are still working 
through, but this will be the meat of what needs to happen to 
go forward.
    Ms. Pryce. Thank you.
    My time has expired. I want to thank the panel once again, 
and especially thank the chairman for holding this important 
hearing. Thank you.
    Mr. Bachus. Thank you, Chairman Pryce.
    At this time, Mr. Ford?
    Mr. Ford. Mr. Chairman, thank you.
    And welcome again to the panel. I am sorry that I was late 
arriving.
    I wanted to especially extend a welcome and even a belated 
happy birthday wish to Governor Bies, who hails a good part of 
her life from my home city of Memphis. I am delighted to see 
you and welcome you and thank you for your enlightened insight 
in remarks today.
    I know that you have been introduced already, and I 
hesitate to say, but I do my banking at her bank, at her former 
employer where she was a long-time Executive Vice President for 
Risk Management and held a variety of titles at the bank. She 
is widely regarded and thought of back home. As we can all 
deduce from her testimony today, we can all see why.
    I appreciate your emphasis, Governor Bies, on the quality 
of research and your willingness to move at a pace and speed 
that allows us to get all the facts on the table. I was 
interested also in hearing the answer to Chairwoman Pryce's 
question as well. I think you put some of it in perspective for 
all of us.
    My question would really be directed to Director Curry, if 
I could. I know that in your testimony, Director, you mention 
that the FDIC has some concerns about the lack of accounting in 
Basel II's accounting for emerging business lines. I am just 
curious to know if you would elaborate on how great a risk you 
think this poses to the banking system and to the 
implementation of Basel requirements going forward.
    Mr. Curry. Our concern is when you look at some of the 
results of QIS-4, particularly with respect to home equity 
lines of credit, that there have been changes in the 
marketplace in terms that the product itself and some of the 
risks behind it, that the capital levels be representative of 
those risks. The home equity lines is an example, but there are 
additional products being developed in a very dynamic banking 
industry, and our concern is that those measurements reflect 
those risks.
    Mr. Ford. We had, Governor Bies, not long ago before the 
committee, through Chairman Bachus's leadership, a hearing on 
Check 21 and the impact that has on community banks. The head 
of the Independent Community Bankers Association is from 
Dyersburg, Tennessee, David Hayes. He came on behalf of 
obviously his association to express their concerns. They were 
here, and have been here the last 2 days, and even expressed 
some concerns about this as well, knowing that you were coming 
before the committee.
    So I am pleased to hear your remarks and even others, and I 
hope that the committee will take into consideration all that 
has been said and whatever we do to act, that we act in a way 
that will not impact negatively the obvious kind of deliberate 
effort that you have underway.
    I would be remiss if I did not give you an opportunity. I 
know you have had the chance to kind of dominate the talking 
here on the panel, but it is my 5 minutes so I can do what I 
want with it. You have a good colleague with Laricke Blanchard. 
He is from Memphis also, with the Fed Reserve Board.
    But I would love to hear your response to Curry. That is 
FDIC work, but you have had your vantage point on this issue. 
It has been pretty varied like most of your colleagues as 
Governors. How do you respond and how would you react to that 
question as well?
    Ms. Bies. I agree with Director Curry in terms that it will 
be a challenge to look at any new product initiative. We will 
have to determine how and when that gets incorporated into an 
individual bank's capital requirements. As safety and soundness 
regulators, we already are looking at new product introduction 
processes, and we require banks today, if they enter into, say, 
a new loan product, they have to today account for credit risk. 
We would expect that they price for that credit risk. We would 
continue to give guidance on the safety and soundness aspect of 
these.
    I think one of the reasons for the concern for the banks 
that put mortgage loans, for example, in their portfolio is 
they are stretching and putting the higher-risk loans in the 
portfolio because the capital requirement was placed too high 
for the traditional conventional 30-year fixed rate mortgages. 
But stretching to take on riskier loans may make the current 
capital requirement under Basel I too low. That is one of the 
challenges we have with any new product is how do you make that 
determination as to the appropriate level of risk.
    We also know that as banks merge they are going to have 
conversions going on where they standardize products, get their 
systems in conformance. Again, it will be a combination of 
safety and soundness reviews and potentially this is where we 
can use some of our discretion as regulators to put a 
qualitative amount in Pillar 2 if necessary around risk.
    So I think we have a lot of tools. We just have to realize 
that all of this risk framework is not precise because you are 
looking forward using historic data. Any model in that sense 
has got some limitations. But we need to make sure that if 
people are putting long-term risk on their books or 
securitizing long-term exposures, that that is reflected in 
their capital and not just the moment in time. So we will have 
this issue with both Basel I and Basel II.
    Mr. Ford. Thank you.
    Mr. Chairman, I know my time is up. Thank you.
    Mr. Bachus. Thank you.
    I would like to say that Representative Ford and 
Representative Biggert, who is next in questioning, were both 
original cosponsors of the legislation that we have today, H.R. 
1226, which expresses our concerns about some of what we are 
hearing today, and I think substantiates the wisdom of that 
legislation. I want to commend both Representative Ford and 
Representative Biggert as original cosponsors and recognize the 
lady from Illinois at this time.
    Mrs. Biggert. Thank you very much, Mr. Chairman.
    Thank you, Mr. Pearce, for yielding to me.
    Let me start by saying that I am concerned about the state 
of play. In your testimonies, saying that you as the 
supervisory community, it sounds like from your testimonies 
that you could be comfortable with the variances in QIS-4 if 
that variance were driven by portfolio risk rather than model 
differences. Could someone explain to me what is the difference 
between these two choices, since models define portfolio risk?
    Somebody want to take a chance?
    Ms. Bies. I will answer your question. The models that 
banks are using right now are, and let me start by saying we 
are still getting this information, but they are in different 
stages of development. What we are trying to understand is if 
one bank has 30-year conventional mortgages, say, on their 
books and they are modeling credit risk, and another bank has 
the identical kind of credit quality, same kind of mortgages, 
the model that they are running, does it make different 
assumptions; does it have different parameters; is the database 
shorter versus longer? One may include data all the way back to 
the 1980s or throw in proxies for the housing losses that 
occurred in the oil patch, say, in Oklahoma and Texas in the 
1980s as stress scenarios.
    The other bank could be saying, well, all I have in my 
database is the last 2 years, and credit losses are very, very 
low. If you do not include the extreme events in your database, 
you can end up with different answers, even though the loan 
quality is the same. That is because the framework of risk-
based capital looks at the extreme events. In other words, you 
assume that normalized losses and charge-offs banks should be 
able to cover through normal operating earnings every day, 
every month, every quarter.
    What you need capital for, and what we as regulators are 
focused so much on, is do you have enough capital to get you 
through the stress periods, the downturn periods, the really 
rough times? We worry about it as bank supervisors since that 
is when you call on capital to absorb losses.
    So if your database does not include those extreme events, 
you can end up with a different answer. Obviously from the 
Federal Reserve's perspective, as a central bank, we worry 
about systemic risk. If everybody leaves out those extreme 
events, then there are implications that the banking system may 
not have enough capital in tough periods, and additional 
measures may be needed to get the economy turned around if we 
do not have a healthy banking system in a recession.
    So that is an example of even with the same kind of quality 
of the loan portfolio and you could end up with a different 
answer if you do not have similar information going into the 
models.
    Mrs. Biggert. So do you want variance and risk sensitivity 
in the same capital framework?
    Ms. Bies. We want to be able to measure risk in a similar 
way across the banks. One of the challenges that we have today 
is that in Basel I we just look at mortgages from a very simple 
framework, or commercial loans from a simple framework, when we 
know individual borrowers or the facilities structure for 
individual loans to the same borrower expose the institution to 
very different kinds of risk. If we have the same number, what 
is in effect happening is banks to cover that capital will take 
on higher and higher risk in order to leverage it more, which 
adds systemic risk to the banking industry.
    Mrs. Biggert. Then how do you know whether you have crossed 
the line into micromanaging credit decisions and eliminating 
risk altogether?
    Ms. Bies. We will not eliminate risk altogether and realize 
that the term ``risk management'' is chosen for a specific 
reason. We are not telling banks to minimize risk, avoid risk. 
We are saying whatever risk you choose to take, you need to 
manage it well. These models that the banks are building should 
reflect their risk appetite, their ability to manage that risk, 
and the controls they have to make sure the risks they thought 
they were accepting, they have.
    So it is really targeted around their ability to manage 
risk. We are not micromanaging. We just want to make sure 
whatever they are choosing to do, that the risk management is 
appropriate. That is one of the reasons for the smaller banks; 
we do not need to build these sophisticated structures. They 
are into much simpler products. More of their products are on 
the balance sheet, so they are easier to see and visible to 
readers of financial statements and to examiners. It is the 
sophisticated instruments where it is harder to understand the 
risk that we are requiring a stronger risk management process 
of which capital is one piece.
    Mrs. Biggert. There is an old saying that you learn by your 
mistakes. It sounds like the market should not be permitted to 
make mistakes.
    Ms. Bies. No, the market is going to make mistakes. 
Individual institutions will make mistakes. Again, when you 
look at models, the one thing that worries us all is what have 
you not put in the model that could really affect you. That is 
why I think for us to be good supervisors, the capital 
framework has got to be part of the supervisory process. We can 
use supervisory processes to ask questions and check ourselves 
to see what is the model missing. We can overlay the two and 
put another mitigating control for risk exposure in there 
through the supervisory process.
    You cannot really have good risk management processes in 
total by only using risk-based capital. You have to have good 
risk management and supervision with it to try to minimize the 
risk of some severe unexpected event happening, but that does 
not say we can always avoid it. There are always going to be 
surprises.
    Mrs. Biggert. So what you really have to do, then, is tweak 
all the various assumptions and parameters in the complex 
formula. Will you do that in Basel I plus II?
    Ms. Bies. We are in the process of drafting this, and I 
will let some other folks talk about Basel I, but we would 
expect that we would do the same thing, but do it in a very 
simple way, base it off the call report the banks use today and 
not create the need to invest in sophisticated models for the 
banks that do not have sophisticated products like the big 
international banks in Basel II.
    Mrs. Biggert. Okay. Just to go back to the first part of 
the question about the variance driven by portfolio risk rather 
than the model differences, it sounds like it would be the 
portfolio risk, would be the choice.
    Ms. Bies. If everything was done the way we would perfectly 
expect it, if you looked at the risk-based capital of two 
institutions and one was more than another, you could say that 
that institution had either riskier exposures or a larger 
amount of the same exposure. In total, their risk would be 
bigger, but it could come from either way.
    Mrs. Biggert. Okay. Thank you.
    Thank you, Mr. Chairman.
    Mr. Leach. [Presiding.] Thank you, gentlelady.
    Chairman Oxley?
    Mr. Oxley. Thank you, Chairman Leach.
    Governor Bies, you talked about Basel I rules and Basel 
I(A), I guess, in between. Do you have sufficient resources to 
work on both proposals simultaneously? That is, the interim 
effort, as we proceed toward Basel II, are you in a position to 
handle both of those at the same time?
    Ms. Bies. We are in a position to handle both at the same 
time, because I think it is important to implement both of 
these together. We have people that are assigned special 
responsibilities under each one, but the dialogue needs to 
happen among all the staff and Governors involved in this 
process because we are dealing with similar issues for both 
amending Basel I and developing Basel II. We need to constantly 
have a touchstone between the two to make sure that what we are 
moving forward is going to be consistent and deal with some of 
the issues that this committee has already raised.
    Our staff back here may feel that they do not have enough 
resources. We are adding staff if we feel it is needed, but we 
feel comfortable that we can make the timeframe in terms of 
gathering information to support our decision-making.
    Mr. Oxley. That is encouraging. The leverage ratio is a 
one-size-fits-all approach to capital. It treats all assets on 
the balance sheet essentially identically. It sounds to me like 
to be the opposite of the approach envisioned under Basel II. 
Is that a correct assessment?
    Mr. Riccobono. It is. The problem, as I stated in my 
testimony, Chairman Oxley, was what we have done is leverage 
ratios are extremely important, and no one would suggest that 
we should not have it in the Basel II capital framework. But 
the problem is the leverage ratio that we currently have in 
place is in fact compatible and exists as a safety net or a 
fuse for the rules that we currently have in place under Basel 
I. All that is being suggested, although forcefully recently, 
is the thought that if we are going to move forward with Basel 
II, we need updating in our approach to capital, and we need to 
think about including there an update of the safeguards with 
respect to capital.
    You just cannot use the fuses that we put in place for a 
system that was much less, 115-volt system when we move to 120-
volt system. We need something more like circuit breakers, than 
old-fashioned fuses. That is really what the problem is with 
the leverage ratio. We can do some serious damage to our 
institutions by encouraging our lowest credit-risk 
institutions, our most conservatively invested institutions, 
encourage them to take more risk simply to take advantage or 
maximize the fact that they are going to be required under an 
old existing leverage ratio to hold more capital than the Basel 
II approach.
    If their information is sufficient and robust, it says they 
can hold less. Well, we should not then require a greater 
amount of capital that they would have to then manage to. It 
makes no sense to put that in place. So we think that a risk-
sensitive leverage requirement is necessary in a risk-sensitive 
capital environment.
    Mr. Oxley. Do we have agreement on that with the rest of 
the regulators?
    Mr. Curry. Chairman Oxley, from the FDIC's standpoint, it 
is critically important that we have a valid, functioning 
leverage ratio. When we talk about questions about the accuracy 
of models, where we are dealing with the Federal safety net, 
particularly the deposit insurance aspects of it, we think it 
is critically important to have that cushion of the leverage 
ratio, notwithstanding the state of art in terms of credit risk 
management.
    We would point especially to the history of the financial 
system in the United States, the S&L bailout, the issues with 
long-term capital management as examples of where if there are 
errors in models, there are significant consequences, and we 
need to take a conservative approach.
    Ms. Williams. Mr. Chairman, I think that we feel that it is 
a tremendous undertaking to implement Basel II. The leverage 
ratio is not on the table.
    Mr. Oxley. I am sorry. What was the last part?
    Ms. Williams. The leverage ratio is not on the table.
    Mr. Oxley. Any response?
    Mr. Riccobono. Yes, I just think it has to be on the table. 
We cannot go forward with Basel II unless we figure out how we 
are going to continue, if that is where some of us are, that we 
are just going to continue with the existing leverage 
requirement, and not broaden those consistent with the 
modernization of the capital framework. It is not going to 
work. We are going to have unintended consequences that when we 
finally figure out what we have done, it will be too late.
    Mr. Oxley. Governor Bies?
    Ms. Bies. Chairman Oxley, I think our perspective on the 
leverage ratio is that today's leverage ratio really is not 
reflective of risk because institutions have evolved. It is 
based on the balance-sheet exposures as risk off the books. But 
I think we would support the OCC's position that we have a long 
way to go along Basel II. We ought to leave our one anchor 
there in place, especially in terms of prioritization of the 
work we do.
    The full impact of Basel II does not go into effect anyway 
under today's timeframe until 2010. We will have plenty of time 
when the banks are further along on the adoption to come back 
and look at how, if we do want to change the leverage ratio, 
how would we do it, but I think it is premature today to start 
that dialogue.
    Mr. Riccobono. This needs to all be done before we set 
sail. We cannot set out for open waters and decide we are going 
to then determine whether the vessel is seaworthy. That is I 
think unacceptable.
    Mr. Oxley. So the disagreement continues, basically, 
between the two regulators.
    I yield back.
    Mr. Leach. Thank you, Mr. Chairman.
    Let me just ask Mr. Pearce a question. You are up next, 
sir. You can start now, or if you would rather wait until after 
the vote, it is up to you. You will have about 4 minutes now, 
but after the vote you would have a bit longer time. What is 
your preference? Fine. Mr. Pearce, you are recognized.
    Mr. Pearce. Thank you.
    Ms. Williams, you might not be the best one to answer. I am 
sort of lost, but we have heard testimony about different risk 
management tools. Give me a short list of risk management tools 
that are being used to help banks. If not, if someone else 
could give me a better answer?
    Ms. Williams. Congressman, banks use a variety of----
    Mr. Pearce. Just a short list.
    Ms. Williams. They look at their past experiences with 
different types of credit to try to identify where exposures 
can arise. With respect to particular types of loans, they look 
at factors that are risk factors for particular types of 
borrowers. In the consumer area, there are very, very 
sophisticated risk factors that are used in connection with 
credit scoring for retail type loans. In the wholesale arena, 
there are databases of the performance of different types of 
loans and different types of obligors that banks will look at 
in order to try to identify risk factors.
    Mr. Pearce. Thank you.
    Governor Bies, as near as I can summarize, we have the 
question of international competition and the question of 
domestic competition, and we have the question of national 
economic strength and international economic strength. Of 
those, which would be the highest priority in your mind when 
trying to solve the questions in front of us about Basel II?
    Ms. Bies. Speaking for myself, I think the most important 
thing is that we are comfortable that banks in the United 
States, whether this is their home country or foreign banks 
operating in the United States, have enough capital to cover 
the risks that they incur operating in this country. We need a 
strong, sound banking system to keep our economy strong. I 
think it is one of the reasons that the U.S. economy has done 
so well in recent years compared to some other countries is 
that we have a very strong banking system. As a central banker, 
I would put that priority first.
    But we need to realize that the world has evolved. 
Institutions now are able to globally span, in part is it 
because their customers, if they are dealing with corporate 
customers, are operating internationally. So to be effective 
and keep the world economy going, we have to deal with that 
issue. But I would say the first priority would be to look at 
the U.S.
    That is why I think it is important that we continue with 
the time framework and the work plan that we laid out 
initially, where we are working in both directions at the same 
time, making sure the Basel I changes are out the same time as 
Basel II, that we are looking at the impact on the U.S. 
industry. And then we keep working with our fellow regulators 
from other countries around the Basel table and with IOSCO 
around the securities aspects to make sure that internationally 
we are ending up with a uniform, as much as we can get it, a 
uniform approach to capital and risk.
    Mr. Pearce. You had mentioned that one of the problems 
today is that different banks are arbitraging their assets.
    Ms. Bies. Yes, the larger organizations----
    Mr. Pearce. That was a statement you made.
    Ms. Bies. Yes, yes.
    Mr. Pearce. Is that practice one that you would approve of, 
or do you think it is something that we would try to get around 
in the next regulatory cycle?
    Ms. Bies. Generally they are arbitraging it to the extent I 
think it is good because they are saying if we can syndicate a 
loan, securitize an exposure, enter into a derivative 
transaction, and have someone outside the banking system take 
on risk, then the bank is stronger and banking system is 
stronger. The important thing is to understand how it is done.
    Mr. Pearce. No, no. Stop right there. Okay, going back to 
my initial question about the tools, the risk management tools. 
So my question is, if we shift risk outside the banking system, 
and if our formulation for securing the Nation's economy, 
therefore the world's economy, is based on factors inside the 
banking system, it seems to me that if you do not have a risk 
assessment that also then brings in those outside institutions, 
entities, tools, concepts, that you are still at as great a 
risk as you were before you shifted the risk outside, and for 
us not to acknowledge that.
    In other words, I do not know much about risk avoidance. I 
am in politics and I am married, but I know that if you say if 
they move into hedge funds, and hedge funds are not evaluated 
in your formula, and I read all through this formula, and I do 
not see hedge funds.
    Do you see what I am saying? It is that we are fooling 
ourselves to an extent, that if we can just get the risk 
outside the system, that we will be okay. I worry deeply about 
that concept.
    Ms. Bies. Let me put it in a different perspective. What 
has evolved really in the last two decades is risk management 
processes where institutions can keep the risk, and these are 
sophisticated institutions, can keep the risk they understand 
best and can manage, and place the remaining risks with other 
sophisticated investors. These are sophisticated investors 
because they do have to understand what it is that they are 
acquiring, whether it is a mutual fund that is looking at the 
investor direction of that fund, whether it is going into a 
pension fund, and those fiduciary responsibilities.
    The buyers of the risk in one way have better information 
than investors in banks. If you look at data today, we get 
real-time public data on credit card securitizations that tell 
you what is happening to current delinquencies and charge-offs. 
We do not get it if that same credit portfolio is sitting in 
the bank.
    Mr. Pearce. Mr. Chairman, with your permission, I know my 
time has expired and a vote is elapsing underneath my feet, but 
when I look at the German losses in Asia, when I look at the 
banking losses in Thailand, when I look at the current exposure 
in China with 30 percent nonperforming loans, I am sorry. I 
just worry about the capital requirements, and then I need to 
really feel we are headed that way. You can respond, and we 
will put it on the record, and I will read it, but I am just 
getting out of here.
    Thank you.
    Mr. Leach. Mr. Pearce, I want to thank you for those 
thoughtful comments. We have an uncomfortable marriage at the 
table apparently.
    Let me say to our panel, we have a vote on, and I would 
like to ask if you could remain for a bit longer. We will 
recess for about 15 minutes and then return to this panel 
before we start the next panel.
    The committee is in recess subject to the vote. Thank you.
    [Recess.]
    Mr. Leach. The committee will come back to order.
    For the record, it should be noted that in the process of 
the vote, we had an emergency evacuation of the Capitol, and so 
we are reconvening at a later moment. The first panel was 
dismissed because of the emergency.
    One of the current panelists is unable to return, and so 
without objection Ms. Shaw Petrou's statement will be placed in 
the record in full. Without objection also a letter from the 
Real Estate Roundtable will be placed in the record.
    Before commencing, I want to make about 1 minute worth of 
comments, having not been able to address the first panel. I 
would just like to say that I think left out of the mix of 
discussion, with one exception, are four very big questions. 
The first question: Should there be greater attention to risk 
management techniques? That is an obvious yes.
    But the second question is, whether there is a great case 
in today's economy worldwide for a reduction in capital in the 
banking system. One has to assume that that case is positive to 
go forth with new techniques that are on the table. I do not 
assume that that is a positive answer to the question of 
whether you have a reduction in capital.
    Thirdly, is there an assumption that worldwide there is 
sophistication in the banking industry of various countries 
affected, as well as international regulators that are 
comparable in the United State? I think that is a very doubtful 
answer as well.
    And then the fourth question is, does this better prepare 
us for an international emergency, whether it be economic or 
political? I stress the political because this little event of 
the evacuation of the Capitol is symbolic of the kinds of 
anarchistic kinds of acts that could end up affecting world 
financial markets. One has to be pretty confident that there is 
no emergency that is likely to affect international capital 
markets to put into effect systems that decrease the capital in 
banks.
    Finally, I must say that one of the other questions that 
has to be addressed is whether it wise to reduce capital in 
foreign countries in the banking system, therefore putting 
pressure for competitive reasons for us to reduce capital here, 
therefore putting pressure for competitive reasons if we reduce 
it for big banks, to reduce it for small banks, and whether 
this is a wise course of action, to end up putting an enormous 
amount of power in other regulators in other countries in other 
banking systems.
    I think these are questions that really at the root have to 
be asked because the testimony of the Federal Reserve of the 
United States today included a surprising amount of assessment 
that reductions in capital were far larger than expected, and 
that comparability of standards within the most sophisticated 
banks were far wider than expected, and, therefore, there is a 
hope that over the next 5 or 10 years that they will better 
understand the circumstance, and that we can move because of 
the hope that in 5 or 10 years we are smarter than we are 
today.
    I think these are assumptions that are really open to very 
serious review. I would just like to conclude by saying, in my 
life I have always been a very, very strong Fed supporter, but 
I believe that we have gotten an incredibly interesting review 
of mathematical modeling that may have gotten out of hand and 
that today I am a very, very strong Fed supporter, but more of 
the Federal Deposit Insurance Corporation than the Federal 
Reserve Board on this issue.
    With that by opening statement, let me turn to the panel. 
We have with us Mr. William J. Small, who is chairman and CEO 
of First Federal Bank, representing America's Community 
Bankers; Dr. James R. Follain, senior vice president of 
Mortgage Valuation of Fidelity Hansen Quality; and Dr. Paul S. 
Calem, vice president for Loan Research, Loan Performance.
    Let me begin with Mr. Small. Please proceed.

STATEMENT OF WILLIAM J. SMALL, CHAIRMAN AND CEO, FIRST FEDERAL 
         BANK, REPRESENTING AMERICA'S COMMUNITY BANKERS

    Mr. Small. Thank you, Chairman Leach and members of the 
subcommittee. My name is Bill Small. I am chairman, president 
and chief executive officer of First Defiance Financial 
Corporation, a public savings and loan holding company based in 
Defiance, Ohio. First Defiance is a holding company for First 
Federal Bank, and my institution will face direct competition 
from banks which comply with Basel II.
    I appear today on behalf of America's Community Bankers, 
where I am a member of the board of directors. I thank you for 
this opportunity to present our views.
    An announcement by the bank regulators about the most 
recent quantitative impact study for Basel II reinforces the 
importance of this hearing and congressional oversight of this 
process. The results of that study highlight the adverse 
competitive effects that Basel II could have in the United 
States. As ACB testified on this issue almost a year ago, we 
believe that the development and implementation of the Basel II 
accord would present a significant competitive threat to 
community banks unless it is balanced by a carefully revised 
Basel I.
    Community banks would like to adopt a more risk-sensitive 
model such as that envisioned by Basel II. Unfortunately, the 
complexity and the cost of implementation of the Basel II model 
will preclude most banks from taking advantage of the positive 
benefits. The bifurcated capital system implemented without 
proper adjustments to Basel I will open the door to competitive 
inequities. For example, two banks, a larger Basel II bank and 
a smaller Basel I community bank like mine, could review the 
same mortgage loan application. However, under Basel II the 
larger bank would hold significantly less capital than the 
smaller bank, even though the loan would carry the same risk.
    Capital requirements should be a function of risks taken. 
If two banks make similar loans, they should have a very 
similar required capital charge. The most recent quantitative 
impact study conducted by the banking regulators on Basel II 
shows evidence of material reductions in required capital for 
participants. Capital requirements for mortgage loans could 
drop by more than 70 percent for some organizations. There are 
steep drops for home equity loans and other consumer lending 
products as well.
    These institutions compete head to head with community 
banks in the retail area. Retail lending, especially mortgage 
lending, is a fundamental business of community banks. Unless 
Basel I is revised, smaller institutions will become takeover 
targets for institutions that can use capital more efficiently 
under Basel II. ACB is pleased that the bank regulatory 
agencies have agreed to review and revise Basel I and implement 
the changes concurrently with the new Basel II accord. Changes 
to Basel I can include more risk-weighted baskets and a 
breakdown of particular assets into multiple baskets that 
reflect differences in collateral types, loan-to-value ratios, 
and other factors.
    Another alternative would be for the bank regulators to 
adopt a simplified risk modeling approach that is consistent 
with the less complex operations of most community banks. It is 
important that the agencies work cooperatively in this effort 
and that input be solicited from all affected parties. We would 
encourage the agencies to form an advisory group of bankers to 
participate in the process and to hold public roundtables on 
these very important issues. ACB plans to be actively engaged 
in this process, and we will assist the regulators in any way 
we can.
    While we expect the regulators to work cooperatively in 
revising Basel I and implementing Basel II, we support the 
legislation sponsored by Chairman Bachus and Ranking Member 
Maloney. The legislation would require a unified U.S. position 
on Basel II and would require the agencies to evaluate and 
report to Congress on several factors. It is essential that the 
views of all interested parties are heard and considered and 
that any changes to capital requirements be done correctly.
    In that regard, ACB believes that a leverage ratio should 
be retained for all institutions, although it may be 
appropriate to change the requirement from its present level. 
We also strongly support giving the Director of the Office of 
Thrift Supervision a formal seat at the table because of its 
status as a primary Federal regulator of approximately 1,000 
banking institutions with over $1 trillion in assets.
    We thank you, Mr. Chairman, and the rest of the 
subcommittee members for holding this hearing on the proper 
implementation of Basel II and the sensible revision of Basel 
I. It is vital to the competitive viability of community banks.
    Again, I thank you, and I would be pleased to answer any 
questions.
    [The prepared statement of William J. Small can be found on 
page 166 in the appendix.]
    Mr. Leach. Thank you very much, Mr. Small.
    Mr. Follain?

    STATEMENT OF JAMES R. FOLLAIN, SENIOR VICE PRESIDENT OF 
          MORTGAGE VALUATION, FIDELITY HANSEN QUALITY

    Mr. Follain. My name is Jim Follain. I spent nearly 30 
years as an economist specializing in housing and mortgage 
markets.
    My comments this morning are based upon joint work with Dr. 
Paul Calem. Paul has spent 20 years as an economist at the 
Federal Reserve Bank of Philadelphia and the Federal Reserve 
Board and studied many aspects of the banking industry. Paul 
and I appreciate the opportunity to share our views with you. 
We will summarize the major points contained in the written 
statement we submitted to the committee.
    Before getting to the primary subject of our testimony, we 
just want to express our support of the broad goal of Basel II, 
to bring out better alignment between regulatory capital rules 
and the riskiness of bank portfolios. Indeed, we have actually 
written another paper that offers support of the specification 
of the proposed minimum capital rule that will apply to an 
important asset type, the newly originated 30-year fixed rate 
mortgage for prime borrowers.
    Today, we wish to offer our opinions about another aspect 
of the proposal, the potential competitive impact of the 
proposed implementation plan in the market for residential 
mortgages. We believe that the proposed bifurcated 
implementation plan in Basel II in the U.S. is likely to have a 
significant impact on the competitive landscape within the 
banking industry in its competition for residential mortgage 
investments. The primary impetus is the sizable decline in 
minimum regulatory capital requirements for residential 
mortgages that will be available to adopting banking 
organizations relative to the requirements that will continue 
to apply to non-adopting banking organizations.
    The decline for adopters will likely trigger a regulatory 
arbitrage process in which non-adopting banking organizations 
may experience a non-negligible reduction in net income due to 
a reduction in their share of the market and the reduced price 
they earn on such investments. Based upon available data and 
plausible assumptions, we calculate the aggregate gain to 
adopters to be about $300 million per year once the Basel II 
plan is implemented. Losses to the non-adopters we calculate to 
be about $900 million per year. They stem from two forces: 
their share in the market decline and the income earned per 
dollar of debt owned declines.
    These losses would not be uniformly distributed among all 
non-adopters. The mortgage specialist among non-adopters would 
be most impacted by the proposed rule, in part, because the 
marginal amount of regulatory capital will likely be the 
leverage ratio, and not the Basel I capital rule. A subset of 
these with relatively large amounts of ARMs, adjustable rate 
mortgages, would be among those likely to be most at risk from 
heightened competition from the adopters.
    Potential and partial remedies to the problems we envision 
are possible. In particular, the capital rule pertaining to 
residential mortgages for non-adopters can be adjusted downward 
for the credit risk embedded in them. Something like the risk 
weights associated with the standardized approach would likely 
reduce substantially the potential for competitive inequities. 
These reduced risk weights would be assigned to banking and 
saving organizations with geographically dispersed investment 
portfolios and interest rate risk management systems and 
processes designed to keep such risks to levels acceptable to 
regulators.
    We would be glad to answer any questions you might have.
    [The prepared statement of James R. Follain can be found on 
page 63 in the appendix.]
    Mr. Leach. Thank you very much.
    Dr. Calem, were you going to testify or just answer 
questions?
    Mr. Calem. Answer questions.
    Mr. Leach. Fair enough.
    Let me first turn to Mr. Small, but for any of the three of 
you. It strikes me that we are in a bit of a different world 
than we have ever been in before, with the new reliance on 
derivative kinds of products. Derivatives are wonderful ways to 
reduce risk for individual institutions in individual 
circumstances, but there is an argument that sometimes the 
totality and size of the market may increase some risk to the 
system as a whole in the case of something that goes astray.
    In this circumstance, there are two very large questions 
that I have never really heard addressed on Basel II. One is, 
in a world in which the notional value of derivatives is in the 
multi-trillion dollar range, the last I heard, six or seven 
times the GNP of the United States, is there a case for 
reducing capital in the system that should be considered 
compelling? Because if you have an emergency, you need to have 
a lot of stability.
    The second question I would like to ask, and this is a 
really bizarre one because it runs contrary to all regulation 
in my lifetime that I know of. That is, there is an assumption 
that bigger institutions need substantially less capital than 
smaller institutions. The assumption goes along the lines that 
smaller institutions are smaller markets, too much 
concentration, and a bigger institution has wider portfolios, 
et cetera, and wider diversity.
    But this really can be carried to an extreme. I contrast 
capital ratios, for example, in my rural State of Iowa, which 
is considered disproportionately agricultural. It is not as 
much as people think, but it is disproportionately so, versus 
New York. Capital ratios in a community bank in Iowa in terms 
of tier one capital are very often four-fold a larger bank, 
sometimes six-fold a larger bank. And capital is the way one 
controls market presence, in other words, the competitive 
nature of the landscape. And so one of the really big questions 
is, in this world that is so complicated with the big playing 
such a large role, might there not be a case that the big 
should be required to have increasing amounts rather than 
decreasing amounts of capital?
    I would like you to address both of these questions. Does 
the fact of the threat to the stability of the system of 
derivatives mean that we should be more concerned, rather than 
less concerned, with capital? And does the fact that the big 
have surprisingly small levels of tier one capital imply that 
our real concern should be raising their capital base, rather 
than lowering it?
    Let me ask this first to Mr. Small.
    Mr. Small. First of all, we certainly support the fact that 
there still needs to be a leverage ratio out there. But I do 
believe that especially since the implementation of Basel I 
back in 1988, at least in a general sense we have all hopefully 
become much more sophisticated in our risk measurement and risk 
management tools that we use in our institutions.
    That being said, we still support the fact that we do need 
to have a minimum leverage ratio. We think it needs to be 
looked at. There needs to be some flexibility, I think, in 
where that level is set. At this point in time, I am certainly 
not prepared to speak for where we think that level should be, 
but we certainly think it needs to be reviewed.
    From the standpoint of the larger institutions and whether 
they should possibly be carrying more capital because of their 
diversity products and services and instruments that they are 
utilizing on a daily basis, again hopefully because of their 
size and their risk management procedures that they have in 
place right now, that they have taken the precautions 
necessary.
    As you mentioned in your opening remarks, nobody can 
control what happens in the event of a catastrophe such as we 
experienced a few years ago; that certainly could have a major 
impact. But for day-to-day operations, I am not going to sit 
here even as a smaller institution and argue that I think the 
larger ones should have a higher capital level.
    Mr. Leach. Let me be very precise.
    Mr. Small. Okay.
    Mr. Leach. I do not think I described it precisely. I did 
not mean more capital to the smaller institution, but more 
capital than is currently the case, with the relative 
differentiation between small and large narrowing, rather than 
widening.
    Mr. Small. In other words, are you saying should there be a 
higher capital level than what we require today?
    Mr. Leach. Yes.
    Mr. Small. In my estimation, no. I do not feel that that is 
necessary.
    Mr. Leach. Let me ask the same question of the other two.
    Mr. Follain. Sir, I am a mortgage specialist, Mr. Chairman. 
In the case of mortgages, I can tell you a couple of things. If 
a bank has a very geographically diversified portfolio, it 
probably needs about half the capital for credit risk than a 
regionally concentrated portfolio has. But the problem with 
mortgages is that most of the risk is on interest rate risk. So 
whether those diversification benefits, I do not think apply on 
the interest rate side as much as they do on the credit side.
    Mr. Leach. Yes, fair enough. That is interesting.
    Doctor?
    Mr. Calem. Yes, Mr. Chairman, Mr. Leach, I would add that I 
think the market risk and interest rate risk aspects of bank 
risk are separately addressed in the regulatory framework. 
There is a separate framework for market risk that addresses 
derivatives in the trading portfolio. Interest rate risk is 
also addressed under Pillar 2 of Basel. I think overall that it 
seems to be appropriate. The Basel II accord is really meant to 
focus on credit risk.
    I do agree that it is a legitimate concern that with all 
the focus on credit risk because of Basel II, some attention 
may be drawn away from these other risks. The framework is 
there to ensure adequate capital, but there may be a legitimate 
concern that the attention is being drawn away from these other 
risks which could be more substantial than credit risk.
    Mr. Leach. Let me just conclude partly with an observation 
to Mr. Small. The FDIC is suggesting there ought to be a lot 
more attention to maintaining a credible leverage ratio. The 
Fed today technically said in theory that was right. It strikes 
me, one of the things Basel II is doing is it is saying in an 
international setting that may not be the case, where the FDIC 
might demand it to be the case here at home.
    So it strikes me that if I were negotiating on behalf of 
the United States, which the Fed is doing, that we ought to in 
a panicked kind of way tell the Basel II committee we need to 
put more emphasis back on the leverage ratio as an absolute 
minimum requirement and that we ought to be listening to the 
FDIC very strongly in this regard because if we do not, all the 
international banks are going to be cutting back their capital 
substantially, then our large banks are going to say that is a 
case for competitive reasons they have to cut back our capital. 
Then our smaller banks are going to say that to compete with 
the big banks, they will have to cut back their capital too.
    So it ends up that the banks outside of America are going 
to be having a profound influence on the safety and soundness 
of banks within America. Then because of the derivatives world 
in which everything is international, the whole stability of 
the derivative system is going to be based on the weakest, not 
the strongest, and we are going to have a larger number of 
weaker institutions. This is a bizarre circumstance, given 
virtually every scenario that I have seen in economics about 
the notion that the world financial system is based on reeds of 
strength, assuming everything is stable.
    The minute you introduce startling instability, we have 
some problems. If you have problems, it is nice to have a 
little extra cushion. I see this as a movement away from 
cushions. Now do you see it that way, or do you see it very 
differently?
    Mr. Small. I do not see it differently. I do agree, and I 
hope that the U.S. continues to take that stance. We do need a 
safety net. We have to have some minimum leverage ratios out 
there. I totally agree with that.
    But I also think that it is time for us to reassess what 
the proper level for that is. Once we get that determination, I 
think it is important for us to try to drive that as far as the 
international market is concerned.
    Mr. Leach. Thank you. Let me just finally conclude with one 
aspect of the Fed testimony today that is truly profound to me. 
The Fed in its statement acknowledged that its requirements 
will be substantially stronger than are necessary. It said, 
however, we are going to have protection because the market 
will force people to have higher standards. That is their 
testimony. The market will force people to have higher 
standards.
    I am a little bit in disbelief. I think there is a 
distinction between the public interest and the private 
interest. The public interest is for credible capital. A 
private institution in many cases wants to go at the minimum it 
can and leverage as much money as it can because it gets a 
higher rate of return for its shareholders. I think we have to 
have public regulation that protects the public first and not 
rely on others to assume that we are going to get higher 
capital ratios and they are required by public regulators.
    I personally have never in my life read more unsure 
testimony from a regulator than I read from the Federal Reserve 
of the United States today. I think that that testimony ought 
to be read with great care by outside observers. The Fed has 
gotten involved in a process that it acknowledged in its own 
testimony is out of hand. It did not say ``out of hand.'' It 
simply said two things. It said the reductions in capital are 
far greater than it predicted, and it said there is no 
comparable standard within the banking industry for looking at 
this. That is in the United States banking industry, in the 
most sophisticated institutions.
    It drew no conclusions about worldwide. If that is the case 
in the United States, what in heaven's name is it when you 
include 40 other countries with 40 other regulatory systems? I 
think we have been presented a truly interesting mathematical 
approach to new regulation, but as interesting as it is, it is 
something that we should be profoundly concerned about.
    Anyway, I want to thank the distinguished subcommittee 
chairman, who has really led this committee in a very 
interesting way. My hat is off to him. Spencer, I want you to 
return to your chair and take over. Thank you all.
    Mr. Bachus. [Presiding.] Thank you, gentlemen, for 
persevering under the difficult circumstances. When I returned 
to the hearing, there was a line out the building. I figured it 
was people trying to get into our hearing. It must have been 
wonderful testimony.
    [Laughter.]
    I started back over here, and in the rush of people coming 
out of the building, I thought we had recessed the hearing. It 
turned out it was something else.
    Dr. Follain and Dr. Calem, let me address this first 
question to you all. Your study on the effect of Basel II on 
the mortgage industry, the competitiveness within it, seems to 
come to a different conclusion than a later study by the 
Federal Reserve. Why do you think your results differ from 
their recent Fed study? I think I know part of the reason. They 
made some assumptions that simply are not true.
    Mr. Calem. Okay, I will take that question, Mr. Chairman.
    The way I view the differences in our studies is 
essentially, like you say, a difference in some basic 
assumptions or the basic paradigm. A simple way to think about 
it, there are essentially three sectors in the mortgage market 
that are relevant to this question. There are the larger banks, 
smaller banks, and non-banks. Let's focus on the nonconforming 
market and leave aside the question of the GSEs and the 
conforming market.
    I think the Fed view is that the regulatory capital 
arbitrage that is occurring now is essentially all that can 
occur. Right now under Basel I, it is clear that capital 
requirements for low-risk mortgages are too high and, 
therefore, there is a certain amount of arbitrage of selling 
the low-risk mortgages off to non-bank investors in the 
secondary markets. We are talking now about banks' 
nonconforming mortgages.
    The Fed view is that what is occurring now essentially is 
all that can occur. When we change the environment between big 
banks and small banks, it will not have any effect except that 
the big banks essentially will no longer have to arbitrage. 
They will not have to sell what they are selling now. There 
will be a more level playing field between them and the non-
banks. The smaller banks, for whatever reason, they are either 
already selling whatever they can sell or want to sell, or 
there is going to be no change in their incentive to arbitrage.
    The way we view it is that with these three different 
parties, we agree with the first part that you level the 
playing field between the big banks and the non-banks. There 
will be less reason for big banks to engage in this regulatory 
arbitrage for mortgages and sell to the non-banks. They can now 
hold them and not have to hold as much capital.
    We feel that there is going to be a new opportunity, in a 
sense, for the small banks or new pressure for the small banks 
to lay off that risk. I think what I heard Governor Bies say is 
that smaller banks do not have those opportunities to sell to 
non-banks. They do not have as much opportunity to arbitrage 
this capital for mortgages right now. The question is, well, if 
you remove at least the barrier allowing the mortgages to shift 
between them and the large banks, won't that have an effect.
    We believe it will. We believe that there are clearly 
transaction costs in doing this regulatory capital arbitrage, 
selling loans, securitizing loans. We feel that the 
transactions costs for that activity for smaller banks will be 
significantly lower for those smaller banks vis-a-vis big banks 
than they are vis-a-vis the general market. Those loans will be 
able to transfer much more readily than they can now.
    It is a big change in the environment. At the very least, 
we do not know that the relationship between small and big 
banks is the same as the relationship between small banks and 
the non-bank sector. We feel that the transfers that are not 
occurring now will be able to occur because the relationships 
are different. There are correspondent relationships. There is 
direct competition in market share. So I think it is a very 
fundamentally different paradigm from the start, basic 
assumptions in terms of the regulatory arbitrage opportunities 
before and after.
    That said, we are perfectly willing to acknowledge that we 
cannot make precise estimates of what the shift will be. Based 
on available evidence, based on some assumptions concerning the 
responsiveness of market share to these differences in cost, we 
have come up with a number. But we will readily acknowledge it 
is an illustrative number. Small banks obviously will have a 
competitive response. Maybe they will shift into other areas. 
But the basic theory is where we differ, and I think our view 
is that these numbers do illustrate the potential for a 
substantial competitive effect.
    In fact, our numbers only look at first mortgages. When I 
was at the Fed, no one asked me the question why you include 
home equity loans in your calculation. That would have raised 
the competitive effect. No one questioned it. That was a clear 
omission. I would have questioned it myself, but no one asked 
me that.
    Thank you.
    Mr. Bachus. Okay.
    Dr. Follain, would you like to comment further?
    Mr. Follain. I generally agree. A lot of my experience is 
based on my time with Freddie Mac when I was director of 
capital management for the credit risk side. I found it to be 
an extremely competitive business. A few basis points here and 
there mattered.
    Mr. Bachus. I am sure.
    Mr. Follain. That kind of influenced my thinking. I was 
part of the alliance wars between Freddie and Fannie and big 
shifts in shares during that time. So something like Basel II 
that has the ability to change capital so much, my intuition is 
you are going to see a lot of the kind of things Paul just 
talked about.
    Mr. Bachus. Capital requirements have always affected 
competitiveness, the amount of the reserve you have to hold. I 
mean, it would almost work against market forces for it not to 
have a significant effect.
    Mr. Calem. You can make a valid theoretical argument, which 
the Fed is making, that if there are three parties, the big 
banks, small banks, and non-banks, the non-banks already have 
that competitive affect. They are already drawing away the 
loans from then smaller banks, to the extent that is possible. 
Okay?
    Our view is that with these three parties, that when you 
free another channel for that income to shift to, the big 
banks, that will have an effect. Not all of that income is 
shifting now to the non-banks. Some of it will shift once you 
open that other channel, which we feel is a channel with lower 
transaction costs, that income will shift to it. In theory, 
their argument has validity and, granted, it is very difficult 
to prove either theory.
    Mr. Bachus. Why should I as a policymaker, why should this 
Congress, why should it be concerned about potential 
competitive impacts of Basel II as a practical matter?
    Mr. Follain. I think it is a great question. There are a 
couple of reasons. The part I want to emphasize is the 
importance of interest rate risk. I am a mortgage guy. I am not 
going to talk about other kinds of things. Interest rate risk 
is two or three times as great as the credit risk in mortgages. 
Whenever you change the competitive balance, the non-adopters, 
the ones being disadvantaged, I think it is going to have an 
incentive to take more risk. How do you do that in mortgages? 
You take more interest rate risk. That is one way. There is 
sub-prime and things of that sort.
    What we would encourage you to think about--and there was 
partly a question this morning about adequate resources--I 
would just make sure that the system has enough resources to 
really measure and manage interest rate risk on mortgages 
because that is where the money is, as I used to say. I think 
as a policymaker, that is a really important issue.
    Mr. Bachus. All right.
    Mr. Small. I also think the competitive differential that 
would result from this would certainly lead to some 
consolidation in this industry that really is not in the best 
interest of the general public. When you have the larger banks 
that increase the value of their currency because of the level 
of capital that they have to carry and also looking at the 
attractiveness of the higher capital levels of the smaller 
institutions, I think it is definitely going to have an impact 
on the consolidation of our industry, much more so than the 
normal cycle of business would have. Again, personally, I do 
not think that is good for the consumer.
    Mr. Bachus. Well, the existing consolidation within the 
U.S. banking industry is already a concern to the committee. I 
think it clearly would be accelerated by the regulatory capital 
requirements of Basel II.
    Governor Bies today mentioned that if we change Basel I, I 
guess lower the capital requirements there for all the other 
banks to more align them, that that would ameliorate some of 
the differentials in competitiveness. I suppose that would 
obviously be true. But is there a problem there?
    Mr. Follain. I think for the bank that has a geographically 
diversified portfolio, a lot of things. There are ways of 
reducing the weights that would help. The problem, and it came 
up this morning on the risk adjusted leverage requirement, for 
the mortgage specialist who specializes in the adjustable rate 
mortgages, high quality prime mortgages, that would not be 
enough. You would have to do something with the leverage 
requirement, I think.
    Mr. Bachus. In fact, I think John Hawke has talked about 
that. I saw some mention of the fact that if you lowered those 
requirements, what if you lower them below what ought to be 
safe from a safety and soundness standpoint. You would not want 
to lower the requirements of Basel I if the requirements of 
Basel II are too low from a risk standpoint.
    Mr. Calem. I would reiterate that Basel II is only a credit 
risk standard. So especially when you are lowering risk 
weights, you have to put additional attention on interest rate 
risk, market risk, concentration risk, et cetera. If you have 
done that, I think once you have that monitoring in place, it 
is appropriate to lower the credit risk standard.
    Mr. Bachus. I will tell you that I am dealing with a new 
spokesman at the Federal Reserve. I can tell you that from the 
middle of last year to January when I read in the American 
Banker about your study, I had repeatedly asked them, is no one 
at the Fed concerned about competitive advantages? I was told 
by the Vice Chairman of the Fed that that was not a concern 
that had been expressed by anyone at the Fed. So I was 
surprised to see that you all apparently did not exist.
    [Laughter.]
    Unless the two of you all were doing that work in a closet 
and no one else knew about it or looked at it.
    [Laughter.]
    I do not know what you would term that or have some words 
you want to share at this time.
    Mr. Small, let me ask you this. I know you are concerned 
about community bank competitiveness if Basel II only applies 
to the bigger banks. I guess that assumes no changes in Basel 
I. It may be hard to bring Basel II to all institutions because 
of what you talked about, the cost and the complexity.
    There again, John Hawke, I will read you what he said, 
which I think ought to be disturbing to all of us. ``The Basel 
II process has generated a product of vast complexity. 
Thousands of pages of task force and working group papers years 
in the making have given rise to hundreds of rules, guidelines, 
and standards saturated with arcane mathematical formulae.'' 
That is when I asked to see the formula, and I was shocked when 
they brought it to me.
    I understand from the testimony today and what my staff 
tells me, you can change their variables within that formula, 
too, which makes it even more complex than what was displayed 
earlier.
    Here is what he goes on to say, ``They are not written by 
or for bankers or, for that matter, by or for conventional bank 
examiners. They are written for mathematicians and 
economists.'' He goes on to say that ``this complexity will 
have a cost in terms of credibility and public acceptance for 
legislators, customers, and market participants who cannot 
penetrate the new rules. Can we expect them nonetheless to love 
and respect them? I think it would be well to consider whether 
we are not approaching that point of perfect impenetrability 
that makes honest compliance difficult, if not impossible.''
    I guess if it is impenetrable to the point of not being 
able to figure it out, how do you comply with something you do 
not understand? If bank examiners cannot understand it and 
bankers cannot understand it, how do you comply with it?
    Mr. Follain. May I just give you an example of the issue? 
We understand the formulas and there are people like that, but 
what I heard this morning was essentially what I think I heard 
was this one particular variable. It is the loss given a 
default. The range of estimates on that is very wide. That is a 
very important issue. In the future, you will want to focus on 
that one.
    If you look over the last 4 or 5 years, when mortgages have 
been defaulting, the housing market has been great and they 
have not lost very much money. The OFHEO rules for Freddie and 
Fannie talk about a severity of 60 or 70 percent. So how they 
come up with that number is really critical.
    Mr. Bachus. Thank you, gentlemen.
    Mr. Calem. I would agree with Jim. I do not think the 
problem is so much the complexity of the rule as its 
application and the ability to calculate those parameters, the 
probabilities of loss severities from existing data, and the 
ability of the supervisors to validate those calculations.
    Mr. Bachus. Right.
    Mr. Small, I guess part of my question was because of the 
cost and complexity, does it make sense to maybe have a simpler 
Basil I(A) or something? I think Chairman Pryce referred to 
that, just the fact that maybe we need to simplify Basel I or 
clarify it before we go on to Basel II.
    Mr. Small. We certainly would not object to moving ahead 
with that. I do think that there is a strong case to be made 
for developing a Basel I(A), whether it is looking at more of 
the risk baskets or just from the standpoint of evaluating what 
is the collateral type, what is the loan to value, credit 
scores and so on, or whether it is a case of allowing the 
regulators to develop a more simplified methodology for 
developing that Basel I(A) level that does not have the 
complexity that Basel II has.
    We certainly feel that there is a strong case to be made 
for that and also feel that there is no reason why that should 
not be pursued as we continue to work toward Basel II.
    Mr. Bachus. Okay.
    I am told that I have to conclude the hearing. There is 
another hearing scheduled at 2 o'clock, and they have to clean 
up all this mess here that we have created. So with that, we 
are adjourned.
    I want to thank you gentlemen for your testimony.
    Mr. Follain. Thank you for asking.
    Mr. Bachus. Thank you for your contributions to this issue. 
Thank you.
    [Whereupon, at 1:50 p.m., the subcommittee was adjourned.]

                            A P P E N D I X



                              May 11, 2005

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