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




                       PRIVATE SECTOR PRIORITIES
                            FOR BASEL REFORM

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

                                HEARING

                               BEFORE THE

                            SUBCOMMITTEE ON
               FINANCIAL INSTITUTIONS AND CONSUMER CREDIT

                                 OF THE

                    COMMITTEE ON FINANCIAL SERVICES

                     U.S. HOUSE OF REPRESENTATIVES

                       ONE HUNDRED NINTH CONGRESS

                             FIRST SESSION

                               __________

                           SEPTEMBER 28, 2005

                               __________

       Printed for the use of the Committee on Financial Services

                           Serial No. 109-57



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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



                            C O N T E N T S

                              ----------                              
                                                                   Page
Hearing held on:
    September 28, 2005...........................................     1
Appendix:
    September 28, 2005...........................................    25

                               WITNESSES
                     Wednesday, September 28, 2005

Ervin, D. Wilson, Managing Director and Head of Strategic Risk 
  Management, Credit Suisse First Boston, also representing 
  Financial Services Roundtable..................................     6
Marinangel, Kathleen, E., Chairman and CEO, McHenry Savings Bank 
  (IL), representing America's Community Bankers.................     5
Petrou, Karen Shaw, Managing Partner, Federal Financial 
  Analytics, Inc.................................................     9

                                APPENDIX

Prepared statements:
    Oxley, Hon. Michael G........................................    26
    Bachus, Hon. Spencer.........................................    32
    Ervin, D. Wilson.............................................    35
    Marinangel, Kathleen.........................................    45
    Petrou, Karen Shaw...........................................    52

              Additional Material Submitted for the Record

Bachus, Hon. Spencer:
    Basel II Accord: A Guide for the Perplexed, Barnett Sivon & 
      Natter, September 21, 2005.................................    64
    Letter to Hon. Alan Greenspan, Septembeer 13, 2005...........    74
Frank. Hon. Barny
    Conference of State Bank Supervisors, letter, September 7, 
      2005.......................................................    78
International Community Bankers of America, prepared statement...    82

 
                       PRIVATE SECTOR PRIORITIES
                            FOR BASEL REFORM

                              ----------                              


                     Wednesday, September 28, 2005

             U.S. House of Representatives,
             Subcommittee on Financial Institutions
                               and Consumer Credit,
                           Committee on Financial Services,
                                                   Washington, D.C.
    The subcommittee met, pursuant to call, at 10:00 a.m., in 
Room 2128, Rayburn House Office Building, Hon. Spencer Bachus 
[chairman of the subcommittee] Presiding.
    Present: Representatives Bachus, Biggert, Feeney, Garrett 
of New Jersey, Neugebauer, Maloney, Sherman, Moore, Waters, 
Carson, Ford, Baca, Green, Clay, and Frank (ex officio).
    Also Present: Representative Kennedy.
    Chairman Bachus. Good morning. The Subcommittee on 
Financial Institutions and Consumer Credit will come to order.
    Just to give you a brief history of this committee and what 
we have been doing with regard to Basel, on May the 24th we 
conducted a joint hearing with Congresswoman Pryce, or 
Chairwoman Pryce's committee on this legislation, and we heard 
from the regulators. In addition, the subcommittee heard from 
the former Fed economist who left the Fed after their study of 
Basel's impact on residential mortgages was rejected, which we 
found quite alarming.
    The prior March, this last March we--a bipartisan group of 
Members induced the same legislation we did in the previous 
Congress, H.R. 1226, the United States Policy Committee for 
Fair Capital Standards Act, which required the regulators to 
reach agreement before moving forward on Basel II. H.R. 1226 
currently has 38 cosponsors, including Mrs. Maloney, Chairman 
Oxley, and Ranking Member Frank.
    Today, we hear from the private sector. Our subcommittee 
will hold another hearing with the regulators after they return 
from the Basel Committee meetings in Europe next week, and that 
is why we did not have the regulators. We wanted to hear from 
the private sector today and then the regulators later.
    I think the thing I would stress most about this hearing 
and about Basel II is that I believe there is a strong 
consensus from this committee that we want the regulators to 
understand that the committee is very concerned about the Basel 
II proposal, and I strongly believe they should first issue a 
Basel IA proposal and only after doing that address Basel II by 
extending the effective date for Basel II.
    At this time I will recognize the ranking member of the 
full committee.
    [The prepared statement of Hon. Spencer Bachus can be found 
on page 32 in the appendix.]
    Mr. Frank. I thank the chairman. I appreciate the 
leadership that both he and the chairman of the full committee 
have given this committee. I think this committee is--well, 
yesterday, in fact, we were congratulating ourselves 
legitimately for the role we have played--again, the gentleman 
from Alabama was a major player in this--in pushing for debt 
relief for the poor countries. I think the agreement that was 
recently reached for debt relief for the highly indebted poor 
countries owes a lot to the bipartisan work of members of this 
committee.
    Today we are talking about another area involving 
international economic activity where this committee has taken 
a role. And at first, when we began to look into the Basel 
issue, to be honest, we were treated by some--including many at 
the Federal Reserve--as ignorant peasants I guess would be the 
best phrase. We were dealing with something beyond our 
understanding and we were being parochial.
    What we found was that the way this was structured; serious 
reservations from bank regulators other than the Federal 
Reserve were being minimized, serious concerns from the 
financial services community were being ignored, and the more 
we looked into this, the more we became confident that we were, 
in fact, doing something very important and very constructive. 
And I think, again, this committee deserves some credit in a 
wholly bipartisan way. It was the chairman of the full 
committee, the chairman of the subcommittee, myself, the 
gentlewoman from New York, Mrs. Maloney, and others, who had 
worked on this. And it became clear to us that the Federal 
Reserve was going ahead without fully considering implications 
and expecting a degree of deference that is inappropriate in 
our society.
    What we now have, I think, is a genuine examination of the 
issues. In fact, along these lines, I would ask, Mr. Chairman, 
to put into the record the letter to the Federal Reserve, the 
Comptroller of the Currency, the Director of OTS, and the 
Chairman of the FDIC; and it is a letter from the Conference of 
State Bank Supervisors dated September 6th. And just to quote 
briefly, We strongly urge the Federal banking agencies to 
obtain a much better sense of the real-life ramifications of 
executing Basel II prior to giving any indication to our 
foreign counterparts about implementation.
    And in the conclusion, Basel II makes a large impact for 
the future of the U.S. financial system. Accordingly, CSBS 
strongly urges the Federal banking agencies to conduct further 
analysis of potential capital changes that would ensue from 
adopting the proposal.
    So we have the Conference of State Bank Supervisors saying, 
slow down; we have heard that from the head of the Federal 
Deposit Insurance Corporation; the new Comptroller of the 
Currency recently appointed by the President--recently 
appointed and recently confirmed, also has concerns. So we have 
very serious concerns.
    And originally we were worried about the capital charge on 
people who were holding securities. Now we have very widespread 
concern about the impact on the differential and capital 
requirements.
    One of the things that we are all agreed on, I think, here 
is that while large banks are very nice to have, we don't want 
to see the trend towards them being the only banks accelerated. 
You know, we are doing this as the Committee on Banking; in 
Massachusetts, the corresponding committee is called the 
Committee on Banks and Banking. And someone said, are you ever 
going to change your name? I said, yes, but by the time we do, 
we may call it the Committee on the Bank because there will be 
one.
    We don't want to see this, and it does appear that there is 
a broad consensus that, as now proposed, Basel II accelerates a 
trend towards consolidation. If consolidation happens naturally 
through economic forces, that is one thing; regulations 
shouldn't be encouraging it.
    And the last thing I would say is this, Mr. Chairman: One 
is that I hope we will hear from the Fed. We have heard from a 
number of responsible, knowledgeable people, both from the bank 
industry and the bank regulators--again, the Conference of 
State Bank Supervisors, the Comptroller of the Currency, the 
FDIC board. We have heard about their concerns.
    I am unclear today as to what Basel II is trying to 
correct. What are the great problems that need this attention? 
It is arguable that it may make things somewhat better, but I 
see concern on the one hand about what the consequences would 
be, and I have not yet seen any dire picture of the 
consequences of inaction. And I guess I think it is incumbent 
on those who are the advocates of prompt action on Basel II and 
the advocates of those who would disregard a lot of these 
requests for slowdown that we have gotten and for 
reconsideration, I would like for them to tell me what it is 
that is giving them this sense of urgency because as I look at 
the record and I think back about our hearings, I don't see it.
    So I think it is one more useful step, Mr. Chairman, in our 
trying to get this process done right, and I appreciate your 
continuing this initiative. And I ask, as I said, that this be 
put in the record.
    Chairman Bachus. I thank the ranking member.
    At this time we are going to hear from the panel. And Mr. 
Manzullo, I am going to recognize you to introduce--
    Mr. Manzullo. Thank you very much. I am not a member of 
your subcommittee, but I have plotted myself here because one 
of our witnesses is my constituent. And I could take this time 
just to introduce her; then I have to leave at 10:30.
    Kathy Marinangel comes from McHenry County, which is in the 
far eastern portion of our congressional district. And when I 
was first appointed to the Banking Committee some years ago, I 
got this excited call. And I stopped by her office and she 
began to share with me all the concerns going on in the banking 
industry. And I said, my gosh, I need to go to banking school; 
I just can't keep up with the extent and width of her 
knowledge. In fact, when I first heard of Basel, I thought it 
was the sweet basil that my dad put on his pasta in the Italian 
restaurant that the family owned.
    But Kathy has taken an extraordinary amount of time to 
inform me and instruct me on the issues, and I am absolutely 
thrilled that she is coming here all the way from McHenry 
County, Illinois, to share with this committee her thoughts and 
her wisdom.
    And, Kathy, welcome to Washington. I appreciate your coming 
here, and I guess we are getting together later on today. Thank 
you.
    Ms. Marinangel. Thank you, Congressman.
    Chairman Bachus. Thank you. I appreciate that, Chairman 
Manzullo.
    Congressman Manzullo is the chairman of the Small Business 
Committee and also an important member of our committee, so 
thank you.
    Our two other panelists are Mr. Wilson Ervin, managing 
director and head of Strategic Risk Management for Credit 
Suisse First Boston. And you are here representing The 
Financial Services Roundtable?
    Mr. Ervin. Yes, sir.
    Chairman Bachus. As well as, I guess, Credit Suisse First 
Boston.
    And Mrs. Karen Petrou, Managing Partner of Federal 
Financial Analytics. And you testified before this committee 
prior, have you not?
    Ms. Petrou. Yes, sir.
    Chairman Bachus. So at this time we will hear from our 
witnesses.
    The one thing I did not say in my opening statement--I had 
the wrong opening statement. When I got ready to read my 
opening statement, it was for the committee hearing tomorrow, 
so this usually goes a little smoother. And that was my fault, 
it was--
    Mr. Frank. Will the gentleman yield? Does that mean we 
won't have to listen tomorrow?
    Chairman Bachus. But I could go ahead and have given that. 
So that was a total ad lib.
    But one thing I did not say, that was in the statement that 
I intended to read was that several months ago the regulators 
announced plans to delay the Basel notice of proposed rule 
making in response to the Qualitative Impact Study 4, which 
showed huge swings in capital. Despite all that, the Fed says 
they are still committed to the January 2008 date for full 
implementation of Basel. And that is what disturbs us, the fact 
that we have gotten a lot of information which the regulators 
didn't expect, we didn't expect, and there is disagreement 
among the regulators.
    We still don't have our Basel IA proposal and we are still 
moving forward with Basel II with all these uncertainties.
    And as I mentioned, the former Fed economist that issued a 
study to the Fed--and the Fed chose to reject it--from folks 
that had been there for years and years, and they testified 
before our committee and Chairwoman Pryce's committee back in 
May. So we--and as Congressman Frank, Ranking Member Frank 
said, we are very concerned about this. We are hearing from 
numerous institutions about concerns they have also.
    So at this time we will start with Ms. Marinangel, and 
welcome all three of you to the committee.

 STATEMENT OF KATHLEEN E. MARINANGEL, CHAIRMAN, PRESIDENT AND 
CEO, McHENRY SAVINGS BANK, McHENRY, ILLINOIS, AND MEMBER, BOARD 
           OF DIRECTORS, AMERICA'S COMMUNITY BANKERS

    Ms. Marinangel. Thank you, Chairman Bachus.
    Chairman Bachus, Ranking Member Sanders, and members of the 
subcommittee, my name is Kathleen Marinangel. I am chairman, 
president and chief executive officer of McHenry Savings Bank 
located in McHenry, Illinois. We are a $250-million community 
bank focused on retail customers and small business owners. We 
compete head to head with many large national and regional 
banks.
    I appear today on behalf of America's Community Bankers 
where I am a member of the board of directors. Thank you for 
this opportunity to present our views.
    ACB and its members have taken a lead for some time now in 
raising issues about Basel II and requesting simultaneous 
changes to Basel I. ACB does not oppose implementation of Basel 
II.
    As we testified before this subcommittee last spring, we 
support the efforts of U.S. And global bank supervisors to more 
closely link minimum capital requirements with an institution's 
risk profile. However, prior to adoption, legislators, 
regulators, and the industry need to evaluate the complexity of 
the proposal, its competitive impact, and the ability of 
regulators to monitor compliance.
    We believe that a regulatory capital floor must remain in 
place to mitigate the imprecision inherent in internal ratings-
based systems; however, the precise level of the leverage 
requirement should be open for discussion.
    Institutions that comply with Basel II, and possibly 
institutions that comply with a more risk-sensitive Basel IA, 
may not achieve the full benefits of more risk-sensitive 
capital requirements because they may push up against the 
leverage ratio. We understand that the European Community is 
pushing ahead to implement Basel II and is pressing for 
agreement on certain issues.
    The U.S. regulators attending a quarterly meeting next week 
in Basel should make no commitments to their foreign 
counterparts in light of the still evolving nature of Basel II 
implementation in the U.S.
    The complexity and cost of development and implementation 
of a risk-based model likely will preclude all but a small 
number of banks from taking advantage of the more risk-
sensitive capital regime in Basel II. The best available 
evidence suggests that this will open the door to competitive 
inequities.
    The most recent quantitative impact study on Basel II 
showed significant reductions in capital requirements for many 
of the participants. Capital requirements for mortgage loans 
dropped by more than 70 percent for some organizations. These 
results caused the regulators to delay further action on Basel 
II while they conduct additional analysis. No further 
information about this ongoing analysis has been released.
    As a community banker, I, along with ACB, strongly believe 
that Basel I must be revised to have more risk-sensitive 
options at the same time that Basel II moves forward. A revised 
Basel IA needs to include more baskets and a breakdown of 
particular assets into multiple baskets to take into 
consideration collateral values, loan-to-value ratios, and 
credit scores. Credit mitigation measures and other revisions 
could be incorporated into the framework.
    Advances in technology and the availability of more 
sophisticated software would make implementation of Basel IA 
relatively straightforward for most community banks. For my 
bank, there would be no burden and a lot of benefit. The bank 
regulators also could adopt a simplified risk-modeling approach 
that is consistent with the less complex operations of most 
community banks.
    The smallest of community banks should have the option of 
continuing to comply with Basel I as it is currently 
constituted if they would prefer to remain compliant with the 
less risk-sensitive capital scheme.
    The bank regulators have listened to our comments and 
suggestions and are moving forward to develop a Basel IA. ACB 
would like to commend the regulators for initiating a dialogue 
with representatives from the industry this summer about 
possible Basel I changes. Our understanding is that an advance 
notice of proposed rulemaking addressing possible changes to 
the framework may be issued as early as next month. ACB will 
continue to be actively engaged in this process to develop 
Basel IA.
    I wish to thank Chairman Bachus, Ranking Member Sanders, 
and the rest of the subcommittee members in giving ACB this 
opportunity to present our views. There is no more important 
issue to community banks than the implementation of Basel II 
and long-overdue changes to Basel I requirements.
    I would be happy to answer any of your questions. Thank 
you.
    Chairman Bachus. Thank you.
    [The prepared statement of Kathleen E. Marinangel can be 
found on page 45 in the appendix.]
    Chairman Bachus. Mr. Ervin.

STATEMENT OF D. WILSON ERVIN, ON BEHALF OF CREDIT SUISSE FIRST 
          BOSTON AND THE FINANCIAL SERVICES ROUNDTABLE

    Mr. Ervin. Good morning, Mr. Chairman; thank you. I want to 
thank you for holding these hearings today and inviting me to 
appear before the committee.
    My name is Wilson Ervin and I am a managing director of 
Credit Suisse First Boston. I am head of their Strategic Risk 
Management Department and am presenting testimony today on 
behalf of the CSFB and The Financial Services Roundtable.
    CSFB employs approximately 20,000 people, primarily in the 
United States, and is a major participant in the capital 
markets. We have submitted written comments, but I will try and 
summarize those in my testimony today.
    The Basel II capital proposals have been the topic of 
intense discussion and debate in the financial and regulatory 
community for the past several years. The industry supports the 
objectives of the Basel process to better align regulatory 
capital to underlying economic risks, to promote better risk 
management, and foster international consistency in regulatory 
standards. The impacts of these seemingly technical discussions 
will affect banks, markets, and the economy in a deep way, and 
the committee is wise to consider the effects carefully before 
implementation.
    Before I start, I would like to note that I have personally 
developed tremendous respect for the diligence and stamina of 
the regulators who have worked on Basel II, as well as a review 
provided by Congress. They have had to address a great many 
complex and challenging issues and have been tenacious in 
trying to develop a best-practice solution for each.
    I wish to express appreciation for Federal Reserve Governor 
Bies and Vice Chairman Roger Ferguson, who met with CSFB and 
The Roundtable on a number of occasions to listen to our 
concerns. The OCC, FDIC, and OTS have also had open doors 
during this process.
    Basel II has considerable momentum, and most people believe 
that it will be likely implemented in the near future. However, 
as in all complex undertakings, the Basel document in its 
current state, it is far from perfect. On balance, we believe 
the advantages of the reform substantially outweigh the 
drawbacks, but further improvements are still possible and 
desirable.
    Today, without getting too involved in the technical 
details of the Accord, I would like to highlight three issues 
that we believe are particularly important as the Accord moves 
forward: number one, adjustments to the recent trading book 
review; number two, the practical implementation of complex 
cross-border regulation or the home-host issue; and number 
three, principles-based interpretation.
    The first topic I want to discuss is the recently completed 
trading book review. For several years now the discussion 
regarding Basel II has focused primarily on credit risk 
capital, and this area has been continually reviewed and 
reshaped in an open, transparent process. For a combination of 
reasons, it was recently determined that a separate discussion 
of capital charges for market risk inherent in traded credit 
and equity portfolios would also be necessary.
    Because of the tight timetable, the new trading book 
proposals involving market risk, the so-called "Strand 3" of 
the trading book review, have been designed and evaluated over 
a period of just months rather than the period of years that 
the rest of the Accord has been subject to.
    The first draft of the new trading book standards was just 
seen in April, with one round of comment and the final version 
in July. Not surprisingly, there remain many areas where 
regulators in the industry recognize that continued refinement 
will be necessary.
    During the development stage, regulators have had a number 
of sessions with the industry to discuss certain problems found 
in the trading book drafts. In these sessions, members of the 
BIS-IOSCO Working Group provided helpful guidance on their 
specific intentions. The industry appreciated this 
clarification greatly and concluded that the general final 
language could work in practice with the interpretation that 
they heard directly from senior regulators.
    Given the reliance placed by firms on the information 
provided in these sessions, we believe it makes sense to record 
these understandings. This will ensure transparency of the 
regulators' intention and give industry participants greater 
confidence to move forward with the investments required to 
begin implementation of the trading book standards.
    In addition, it is worth noting that the new trading book 
requirements have only recently been published, and there 
remains work to be done to flesh out how they should be 
implemented in practice.
    In addition, no comprehensive impact statement has been 
performed to date; we believe this is a key gap that must be 
closed. We suggest that all regulators take advantage of the 
existing provision deferring the effective date of this portion 
of the Accord until 2010 so that refinement impact analysis and 
final implementation can be done in an orderly, consistent 
manner. This timetable could be separate and apart from the 
rest of the trading book review and the bulk of the Accord, if 
necessary.
    The second topic I would like to address is the complexity 
of the new rules across jurisdictions, the so-called "home-host 
issue," which poses particular challenges for an international 
bank that is regulated by supervisors in multiple countries. 
CSFB, for example, will be required to implement Basel II as a 
Swiss bank, a U.S. financial holding company, a U.K. Bank, and 
a regulated financial institution in more than 30 other 
countries. Our implementation will be governed primarily by the 
Swiss Federal Banking Commission in conjunction with the 
Federal Reserve in the U.S. and the FSA in the U.K., but also 
by many others.
    Most international banks face a similar set of interlocking 
regulations in which both home and host countries interpret and 
enforce rules. This can give rise to conflicts even under an 
international standard like Basel II. At times, we have been 
given conflicting guidance by both home and host regulators 
under the existing Basel I Accord, which makes compliance very 
difficult. It is a Catch-22.
    While we have been able to resolve these issues to date, 
the potential tension between home and host regulators will 
become a much bigger issue going forward, given that Basel II 
is much wider and much more detailed. If each country decides 
to require its own local rules and data for each of the many 
calculations in Basel II, the compliance burden will go from 
bad to impossible.
    The Basel Committee has formed an Accord Implementation 
Group to deal with these issues, but to date there has been 
very little tangible guidance. We believe that a stronger 
proposal should be developed to resolve these conflicts in a 
timely and predictable manner, and we have made some 
suggestions in our written testimony.
    The last area I would like to talk about is principles-
based interpretation and the need for flexibility.
    The Basel rules are based on the financial markets as they 
work today, but they are so complex and heavily negotiated they 
will be difficult to update over time. We strongly believe that 
regulators ultimately will need to place a renewed emphasis on 
the principles behind Basel II, specifically those in the 
Pillar II section of the Accord, as a matter of either law or 
practice.
    This principles-based approach, subject to reasonable 
benchmarks and guidelines to maintain consistency, has some 
important natural advantages compared to Pillar I's complex 
"black-letter" style. This permits steady evolutionary 
improvement to keep up with markets and should, therefore, be 
more durable and relevant than Pillar I rules that are designed 
with today's market in mind.
    Addressing the question of an evolving Accord will not be 
simple. If the rules were all applied as black-letter law and 
interpreted strictly, the new rules will be both costly--since 
risk-management advances that led to Basel II won't stop 
today--and potentially irrelevant to ongoing best practice.
    One example of this relates to operational risk, an area 
that is relatively new in terms of risk management discipline 
and quantification. There is a danger that certain approaches 
can be mandated as, quote, "best practice" by regulators in 
some jurisdictions, even though development in this area is far 
from complete. It is imperative that we avoid few fixed 
requirements where they arise solely from interpretations by 
certain examiners.
    We encourage an approach that emphasizes principles and 
simplicity as the rules are implemented and a less burdensome 
"trust but verify" approach to compliance. Specifically, 
regulators will need to emphasize that compliance with the 
rules will not be based on many layers of "box checking," but 
with a spirit of the rules based on economic principles.
    We are at an important stage in the reform effort, perhaps 
the last leg of a long race. A lot of good, hard work in 
designing the framework and getting some political consensus 
has been accomplished. We have high regard for the efforts of 
the committee and the regulators who have worked so hard to 
capture best practices and risk assessment.
    CSFB and The Roundtable have tried to contribute to the 
specifics of those discussions in a constructive manner and 
submit our three proposals discussed today--trading book 
review, cross-border implementation, and principles-based 
interpretation--in that light. We believe that refinements are 
still possible and desirable and that these changes will help 
make the Accord more effective in practice.
    As a final comment, I believe that regulators will need to 
look beyond the detailed calculations embedded in the rules and 
focus on the overall quality, thoughtfulness, and the integrity 
of bank risk management to implement the Accord successfully. 
This will place the burden of responsibility back where it 
should be, on the shoulders of bank management, to demonstrate 
to regulators and the public that they are doing a good job.
    That is in the spirit of the Sarbanes-Oxley reforms in the 
United States, and I think that is a smart and durable way to 
improve financial discipline and live up to the origin goals of 
the Basel project. Thank you.
    Chairman Bachus. Thank you.
    [The prepared statement of D. Wilson Ervin can be found on 
page 35 in the appendix.]
    Chairman Bachus. Ms. Petrou.

   STATEMENT OF KAREN SHAW PETROU, MANAGING PARTNER, FEDERAL 
                   FINANCIAL ANALYTICS, INC.

    Ms. Petrou. Thank you, Mr. Chairman. It is a pleasure and 
an honor to appear before this subcommittee. I thank you very 
much for the opportunity, again, to talk about this important 
rule.
    The subcommittee, and indeed all of the Financial Services 
Committee, has done what is often so difficult: You have 
anticipated a problem and tried to step in with congressional 
leadership to solve it before it happens. And I think that has 
been of tremendous assistance as the regulators think through 
the Basel II Accord.
    My name is Karen Shaw Petrou. I am managing partner of 
Federal Financial Analytics, and we have done a considerable 
amount of work on the Basel II Accord for a variety of industry 
clients.
    As we look at the Accord and its current state, I really do 
think a very difficult decision awaits you and the U.S. 
regulators. As you have mentioned, Chairman Bachus, the 
agencies will be going to Basel next week. And I know there is 
strong impetus in many quarters to agree to the Basel II 
framework, but I do believe this will be very problematic, in 
part, because it remains still unclear what that is.
    The Financial Services Authority recently issued 50 pages 
of areas of national discretion in Basel II, and, therefore, it 
will look very different in each country that implements it.
    The U.S. has taken a particularly independent tack. We are, 
as you know, proposing to implement Basel II only for the 
largest institutions, and as your committee has established, 
this raises very serious competitiveness problems.
    We have a unique financial system with thousands of 
independent financial institutions that play a very important 
role in this Nation, and we must think that through very 
carefully. We have a leverage requirement, again unique, that 
throws Basel II into a very new framework, and it is one that 
requires quite careful consideration so that all of the work to 
go to make a risk-based capital rule is not made moot because 
of our leverage requirement.
    In short, we have a very different framework, and it will 
make it hard to take Basel II--whatever, indeed, that truly 
is--in whole or in part, and apply it only to our largest 
institutions. I do think that would be putting the square peg 
of Basel II into the round hole of our financial industry, not 
a good conclusion.
    On the other hand, however, I do also believe that we can't 
just keep Basel I. We know Basel I is not a good risk-based 
capital system. It is very crude. It permits undue risk-taking, 
and that is why the agencies rightly started the Basel II 
process several years ago.
    More importantly, like it or not, Basel II is a done deal. 
With all the variations I have mentioned, it is still a final 
framework now everywhere but here. That means, starting January 
1, 2007, banks in the EU, Canada, Japan, and elsewhere, many of 
which do considerable amounts of business here, will come under 
a new risk-based capital framework that could well make them 
merger-and-acquisition powerhouses.
    In short, if I may say so, I think we are in the midst of a 
"damned if we do, damned if we don't" dilemma. Going forward 
with Basel II as the agencies have proposed will not work; 
staying under Basel I will not work; and I think waiting is a 
dangerous strategy because the rest of the world will move on 
into this new capital framework regardless of what we do.
    If I may, then, I would like to offer what I hope is a 
middle course, things we could do now that I do not think pose 
the competitiveness problems brought about by either waiting 
and retaining Basel I or implementing Basel II for only the 
largest banks and only the most advanced forms on the schedule 
now on the table.
    First, I would suggest that the U.S. move quickly to adopt 
the credit risk provisions in the standardized sections of the 
final Basel II framework. These are relatively simple; they 
could be Basel IA. We--I think even small community banks that 
wish to take advantage of this could do so because the 
standardized option sets simple risk formulas, but has some 
very constructive incentives for recognizing risk mitigation 
and for penalizing high risk.
    We should do this for all institutions, not just some, to 
avoid the competitiveness problems. I understand that the 
standardized credit risk section is crude and in many ways 
imperfect and capital under it may still be too high, but I 
think waiting will lead us to the error of letting the perfect 
be the enemy of the good. And again, the longer we wait, the 
more Basel II elsewhere will become a potentially very serious 
competitiveness problem for banks here, even smaller ones.
    Second, I would suggest a hard look at the leverage ratio. 
I know that many feel that it would be both a competitiveness 
protection--that if big banks must hold the 5 percent leverage 
requirement now in place even if their Basel II numbers 
dropped, they would not realize this and they could not be a 
competitiveness threat--but I would say the leverage 
requirement is very easy to game; it is a simple requirement of 
capital for on-balance sheet assets.
    Large institutions can securitize assets or create so-
called synthetic ones. This is not hard to do, and it is 
easiest, of course, for the largest institutions. It is a game, 
but it is one that they are good at, so keeping a leverage 
requirement in place will not protect small institutions.
    It will also, I think, have unanticipated safety and 
soundness problems. One can make the leverage requirement work 
on a low-risk book of business by topping it off with what one 
might call "toxic waste," and then the numbers work out fine, 
but I am not sure why the agencies want banks to do that. They 
have the flexibility under current law to go into a far more 
sophisticated leverage requirement and, hopefully, ultimately 
eliminate it; and I hope that is what we do in conjunction with 
implementing both Basel IA and Basel II.
    Thirdly, the operational risk-based capital requirement in 
Basel II will, I think, have unanticipated and perverse 
incentives that would undermine effective operational risk 
management. We should have a rigorous, enforced, supervisory 
framework that ensures that institutions engage in the 
contingency planning and disaster preparedness that not only 
proved themselves on 9/11, but again were so critical in the 
cleanup from Hurricane Katrina and Hurricane Rita. There is a 
lot left to do here, and a new capital charge would divert 
essential financial industry resources from emergency 
preparedness, clearly something we must remember to take very, 
very seriously.
    Finally, I do think the advanced options in Basel for 
credit and operational risk do make sense. They are more 
sophisticated than the standardized approach, and they do 
accomplish the valuable goal of bringing regulatory capital 
better in line with real risk. We should move forward on that 
to the degree we can in the Basel II framework, but we should 
do it for all institutions, not just for the big ones. And we 
should take careful heed of our own realities--tax law here, 
for example; we should look at that as we define capital.
    We have a very proven risk mitigation environment with 
various forms of insurance and guarantees. Those should be 
reflected in capital. And perhaps we, because of the nature of 
our very sophisticated financial system, should take the lead 
in further recognition of internal models in a principles-based 
supervisory framework.
    But in closing, I would say that, like it or not, Basel II 
is about to be a reality, so we must make policy decisions to 
ensure that our institutions remain competitive and serve their 
customers in every community.
    Thank you very much. I would be happy to answer any of your 
questions.
    [The prepared statement of Karen Shaw Petrou can be found 
on page 52 in the appendix.]
    Chairman Bachus. Thank you.
    Ms. Petrou, you mentioned near the end of your statement 
Hurricane Rita and Hurricane Katrina, which obviously have 
taken a lot of the focus of the Nation on responding to the 
devastation there. And you mentioned a possible tie between the 
Basel proposal, Basel Reform and Katrina and Rita. And I guess 
that is the issue of operational risk.
    Ms. Petrou. Yes, sir.
    Chairman Bachus. If the operational risk charge in Basel II 
had been in effect presently, how would that affect the banks' 
and the regulators' ability to respond to what we saw in Texas 
and Louisiana?
    You know, they did a very good job, I think a wonderful 
job, but would Basel II--had it been in effect, would it have 
affected that?
    Ms. Petrou. I think it might have undermined the very good 
response we have seen that comes from, as you know all too 
well, backup computers, contingency planning, heroism, hard 
work, an array of factors that you can't quantify and which 
cannot, I think, be turned into a capital charge.
    A capital charge is basically money in your pocket that the 
regulators say you must have so that if things you don't expect 
happen, you can protect your institution from failure by virtue 
of that extra bag of coins in your pocket. But it takes away 
from the coins you have for backup computers, contingency 
planning, disasters, telecommunication structures, independent 
electricity, all of the things we know institutions have to 
have and which they still do not have.
    The agencies have moved forward with sound principles; they 
have done more work on contingency planning since 9/11, but 
there is a great deal left to do. And I do think a capital 
charge could divert resources from those essential tasks.
    Chairman Bachus. Thank you.
    And I would direct the members of this committee's 
attention to page 6 of her testimony, which deals with the 
standardized Basel II options and how it could have interfered.
    And I agree with the response, just the rigidity of the 
proposal in not anticipating something like this.
    In the time I have remaining, about 2 minutes, I want to 
address the competitive issue. We are all concerned about the 
adverse impact that Basel might have, Basel II on competition. 
And mainly because many banks will not adopt Basel II, others 
won't be able to, will they be at a competitive disadvantage?
    Ms. Marinangel, you mentioned that in your testimony. The 
Federal--the former Federal Reserve economist testified before 
us that they believe it will have a negative impact on 
competition due to the differences in capital changes.
    And so I would ask Mr. Ervin and Ms. Petrou, would you 
address this issue?
    Ms. Marinangel, you did address it, I think, in your 
testimony, that you believe it will have a negative effect on 
many of our institutions.
    But Mr. Ervin and Ms. Petrou, would you all like to respond 
to that?
    And you also mentioned it, Ms. Petrou, but just elaborate.
    Mr. Ervin. If I may, I just want to--this goes a little bit 
to Karen's "damned if you do, damned if you don't" problem.
    There may well be some competitiveness issues within the 
United States from implementing Basel II. We also have to be 
mindful that for large institutions such as mine, there will be 
competitiveness issues with other banks around the globe. So 
there is no magic bullet with a go-slow approach; we do have to 
deal with the reality that the rest of the world is moving to 
Basel II and that competitive equity between U.S. institutions 
competing globally and other European or Asian institutions 
will be an important thing to keep in mind as we find the right 
path forward for the United States.
    Chairman Bachus. What about what Ms. Petrou talked about, 
Basel and what I mentioned in my opening statement about a 
possible Basel IA proposal?
    And Ms. Marinangel, what about that?
    And I thought she put it very succinctly, that time is 
running, but other countries have adopted these standards. It 
could be a competitive disadvantage in our dealings with them, 
but then--
    Ms. Marinangel. Well, I would like to state that, for 
example, in my town, I have approximately 18 banks and in the 
county 39 different institutions; some of them are foreign 
banks.
    One of the competitive issues to think about--and I would 
like to do an analogy of four gas stations, one on each corner. 
If one of the gas station's price of gas is 4 cents cheaper 
than the others, where will all the business go?
    Well, in the community banks world, as well, we are out 
competing with all of the foreign banks as well as large 
regional and national banks, and because of the economies of 
scale and guarantee fees and other issues just in the mortgage 
loan area, we have to be competitive to get assets on our 
books. And so it is a very critical disadvantage for us if we 
don't have Basel IA modification so that we can remain 
competitive. And that is just in the mortgage area, not even 
considering the other assets where the banks would be able to 
hold less capital.
    And I agree, it is very critical because of the European 
countries adopting Basel II and the parliament approving the 
legislative issue on that. We really need to move quickly, but 
IA has to be considered for community banks. We need to deploy 
our capital as effectively--publicly traded banks need to do 
that, as well, to make their good--our rates to be competitive 
so that we do maintain a community banking system in the United 
States.
    I don't believe the European countries, when I was called 
by David Keith from the Global Risk Regulator, do not 
understand the community bank system in the United States, and 
it is critical that we maintain the system. And I have nothing 
against large banks. However, we do serve a different need, I 
think, in the United States, and it has to be protected.
    Chairman Bachus. Thank you.
    Ms. Petrou.
    Ms. Petrou. I certainly agree with all the comments today. 
I mean, the basic measure of bank profitability is return on 
equity, ROE. Equity is your capital, and you have to hold the 
higher of economic or regulatory capital. So when regulatory 
capital is higher than you have to have, or higher than other 
institutions are permitted by their agencies to have, you, if 
you are a large bank, small bank, sideways, suffer a 
significant competitive disadvantage, all other things held 
equal. And it is a hard one no matter how smart, how efficient 
you are to overcome.
    I know this committee is wrestling with the GSE reform 
issue, and I have been honored to testify before other 
subcommittees on that. And one of the key competitiveness 
advantages Fannie and Freddie have is their very low regulatory 
capital. We see it in the marketplace. So it is not a fiction; 
it is a reality that will hit us very soon if U.S. policy stays 
as is.
    Chairman Bachus. Thank you.
    At this time, I recognize the ranking member, Mr. Frank.
    Mr. Frank. Thank you, Mr. Chairman.
    I will confess that I may not have been paying enough 
attention. I am very disturbed. I appreciate Ms. Petrou 
pointing out that we are in this situation where Basel II, if 
it goes into effect, coerces us some. And I tell you, I am on 
the verge of charging the Fed with bad faith.
    During these conversations, when we raised issues, the 
Federal Reserve witnesses have consistently said to us, well, 
don't worry; nothing is conclusive here. And indeed, even if we 
agree to this, you will then have to have it implemented 
domestically. And we have got a kind of bait-and-switch here.
    My recollection--and I see the May comments; I didn't see 
them in time; we had other things going on, GSE legislation. 
But for Governor Bies now to tell us that we will be at a 
disadvantage if we don't go ahead really seems to me to raise 
an issue of good faith because the Fed was telling us for 
several years that this was still being discussed and that even 
after they concluded an agreement, we would still have to have 
that implemented by domestic choices.
    We are now being told that that is really not true, that in 
fact they are--having gone ahead, ignoring our concerns, 
frankly pooh-poohing us, and saying don't worry about this--now 
they are going to turn around and say, now you have got to do 
these things.
    So I am going to recommend, Mr. Chairman, to yourself, the 
chairman of the full committee and all of the staff on our 
side, I think what is incumbent upon us now is to start 
preparing for that situation and do the best we can to minimize 
this.
    And I will say this: I will feel no--ordinarily, I think in 
this committee we have been very much interested in 
international cooperation. I know we have talked with, many of 
us, the European Union and others about how to harmonize 
accounting requirements, how to prevent Sarbanes-Oxley from 
causing divergence.
    As I mentioned earlier, you, Mr. Chairman, and others of us 
on the committee, the gentlewoman from New York and others, we 
have been very active with regard to the debt situation for 
poor countries. But in this situation, I do not feel coerced by 
the argument that we have to show good faith for international 
obligations, because I think the Fed frankly misled us in this 
regard.
    And I think it is entirely reasonable for the staff of this 
committee, majority and minority, to get together, and Ms. 
Petrou has set out the approach I think we should take. I think 
it is important for us now to figure out ways that we can blunt 
the effect of an agreement, domestically, to which we are not a 
party.
    And I do not believe the Federal Reserve ought to be 
considered the entity that can commit the United States 
Government. Someone should raise this issue. In the legislation 
we filed, we said we didn't want the Fed to have this autonomy. 
They kept telling us, oh, don't worry; this is only an 
agreement framework and you are going to have to fill it in.
    We are now being told apparently--and I don't challenge 
this--the fact of that agreement and given the ability of other 
financial institutions to operate fairly freely in the U.S., in 
fact, does coerce us, does have an impact on us. And I think we 
are now entitled, in self-defense, to figure out how to avoid 
that.
    So I will be studying what Ms. Petrou suggested. I will be 
looking for other suggestions. That is, I am not ready to say, 
oh, yeah, now that Basel II is there, we are going to, in 
effect, have to concede that it is there and adjust to it. The 
Fed consistently told us that that would not be the case, and I 
think we have every right now to deal with that.
    Obviously, we can't ignore reality. What we then do is, I 
think, begin to deal with that reality. And I want to put them 
on notice.
    The argument that, okay, it is a done deal and you had 
better adjust to it will not persuade me. And instead, my 
instincts will be to try to resist what we didn't like that was 
concluded over our objection. And I really am disappointed, and 
I confess error: I did not notice that Governor Bies said this 
in May, but it is directly contrary to what we had heard from 
her and from Governor Ferguson. And that is where we are.
    So I have no questions, but to say that I would invite all 
the witnesses and others to begin working with us to figure out 
how we deal with this situation.
    And I would also say to the Fed that they have lost a great 
deal of credibility with me in this regard to have assured us--
and I have heard those assurances; don't worry; nothing is 
conclusive; nothing is; this will still have to be implemented 
by U.S. policy--and now to be told that is not really the case, 
you have got to do these things. I don't accept that, and I 
think we should do everything we can to resist it.
    Chairman Bachus. Thank you. And let me acknowledge that 
Ranking Member Frank has really led the effort on this 
committee. I think he is the most informed member of the 
committee on this issue.
    Mrs. Maloney has been very involved in this issue with 
Chairman Oxley, but it is something that members on both sides 
of the aisle, we have worked in a very bipartisan or 
nonpartisan way on this. And I think that your testimony here 
today actually kind of--as Ranking Member Frank said, I think 
it has been very valuable to us.
    And to Mr. Ervin--you, I think, said it--it is not a 
question of large institutions trying to gain an advantage over 
the smaller institutions or those that Basel II will apply to; 
it is a question of, you want to maintain your competitiveness 
with international banks and your competition, worldwide 
competition. At the same time, it--as proposed, it will impact 
negatively on some of our smaller institutions.
    And I think, Ms. Petrou--you have, I think, in a very 
valuable manner said there is an option of fixing this thing, 
and I am very much--I think that this is some very valuable 
testimony.
    Prior to recognizing the gentlelady from Illinois, Mrs. 
Biggert, who is going to take the Chair in my absence, I wanted 
to introduce, without objection--if there is no objection, I 
ask unanimous consent to introduce, first, a letter to the 
Honorable Alan Greenspan signed by Ranking Member Frank, 
Chairman Oxley, Ranking Member Carolyn Maloney of the 
Subcommittee on Domestic and International Monetary Policy and 
myself, dated September 13th, which says:
    "Dr. Chairman Greenspan, we were disturbed by the attached 
American Banker article suggesting that Federal Reserve Board 
staff are actively discouraging Federal Reserve Bank staff from 
expressing independent views on the Basel II Capital Accord. 
This is a very important issue, as you know, and it is 
necessary for Congress to be fully informed. Clearly, it is 
inappropriate for there to be any effort to interfere with the 
information Congress receives.
    "if this article is accurate, we ask that you please take 
the necessary steps to ensure that no Federal Reserve official 
interferes with Congress' access to information."
    And without objection, I would like to offer that into the 
record.
    Secondly, I would like to offer some written testimony on 
the Basel II Capital Accord, and it is called, A Guide for the 
Perplexed, dated September 21, 2005, authored by Raymond 
Natter. He was the U.S. Deputy General Counsel at the OCC for 
many years and is presently with Barnett Sivon and Natter. And 
I would like to introduce that without objection.
    And so at this time I recognize Mrs. Biggert for her 
questions.
    Mrs. Biggert. Thank you, Mr. Chairman. And it is nice to 
see Mrs. Marinangel back from Illinois, and also Ms. Petrou for 
being back again to help us here.
    My first question, though, will be for Mr. Ervin.
    It appears that a big improvement has been made in Basel 
rules to cover only unexpected credit risk, which allows the 
reserves and earnings to cover unexpected loss. And this 
probably better reflects risks without adverse competitive 
impact.
    But why isn't a comparable approach being taken for 
operational risk?
    Mr. Ervin. I think in part it is because operational risk 
is a tougher nut to crack; it is a much newer discipline. There 
has been a desire that I have heard from various regulators to 
put, as Karen said, some coins in your pocket for those events 
in order to have the right amount of capital at institutions. 
But, to date, it is very difficult to actually quantify those 
sorts of things, it is pretty hard to quantify the impact of a 
Hurricane Katrina, to assess the probability of a terrorist 
strike, or a computer virus.
    So I would say right now we are working with cruder 
approaches, frankly, in operational risk. We are still finding 
our feet. Hopefully, we will be able to come up with the kind 
of improvements that you have seen in credit risks where you 
can be a little bit more precise about how you build the mouse 
trap, but today, in operational risk, we are trying to do the 
best with a difficult problem that is still, frankly, in its 
early days.
    Mrs. Biggert. Thank you.
    Ms. Petrou, do you see any improvements in the ability to 
manage and measure the operational risk and any time frame that 
this might take place?
    Ms. Petrou. I do. And I think that the Basel II Accord has 
been a good impetus for industry attention to operational risk 
management.
    The agencies have sometimes said that the reason they 
proposed the operational risk capital charge is to get people 
thinking about operational risk. I long thought they had a 
whole lot of other ways to get the banks they regulate to think 
about the things they want them to think about. And I would 
suggest that, again, contingency planning, disaster 
preparedness, backup systems, et cetera, are the first point of 
contact.
    Operational risk is very different from credit risk because 
institutions don't take it for profit; they experience it as an 
adjunct to their businesses, and so they price for it, they 
hold reserves for it. And it needs, I think, to be treated very 
differently than credit risk as a result.
    Mrs. Biggert. Thank you.
    Then, Ms. Marinangel, I know that you are concerned about 
community bank competitiveness if Basel II applies to only the 
largest and biggest of banks. But it probably would be hard to 
bring Basel II to all institutions because of the cost and 
complexity.
    Would it make sense to proceed with a Basel I or IA 
approach for all the institutions in the U.S. even if Basel II 
is not ready to be implemented?
    Ms. Marinangel. Yes, absolutely. I agree that if Basel II 
is not ready to be implemented, a modified IA would serve all 
of the industry well, large and small, and it would make us all 
be still on a level playing field.
    Yes, it is critical to do that.
    Mrs. Biggert. How is that progressing? Who is working on 
Basel IA or modified?
    Ms. Marinangel. Well, just last month I was in Washington 
at the end of July with the four Federal regulatory agencies, 
and it was a very good session. They wanted a bank advisory 
group for input, so they took it very seriously. We were very 
happy that they wanted bankers' input as well as the trade 
group input, and so I believe that they are working on it. As 
I--last time when I was here I had developed a formula that I 
gave you as a sample that could be used, somewhat simple but 
still a good change. So they are--the regulators are working on 
it with the industry.
    Mrs. Biggert. But this would just be a domestic policy.
    Ms. Marinangel. As far as I know, yes.
    Mrs. Biggert. Okay. Thank you. And I would yield back.
    Chairman Bachus. Thank you. I appreciate your participation 
and willingness to chair the hearing, Ms. Biggert.
    At this time, I recognize Mrs. Maloney.
    Mrs. Maloney. I thank the gentleman for calling the 
hearing. It is very timely with the October 3 meeting in 
Switzerland, and I would like to be associated with all the 
remarks that really show alarm that the regulators are not in 
agreement. They are not in agreement and that they are showing 
internal conflict.
    I do want to note the American Banker article that showed 
or said that the independent views on the Basel II Capital 
Accord were not being expressed and the dissenting views were 
not being expressed, and I find that very troubling. One of the 
things we are working on in Congress now is that dissenting 
views on whether or not you go to war within an administration, 
that the dissenting views should be made public. And I urge the 
chairman really to get the dissenting views that we asked for 
in our letter. They have not come back to us from the Fed, and 
certainly we should have them before going forward.
    I thank all of the panelists, and I would like to go back 
to Karen Petrou's statement on page five that I found the most 
troubling of a lot of troubling, unanswered questions that came 
from all of the panelists, that our banks could be put at a 
disadvantage for merger and acquisition, making us likely 
targets because their capital requirements are lower than ours. 
I find that extremely troubling. I do not want to see our 
financial institutions bought by other international 
institutions, and I want to know what we should be doing about 
it. Would you elaborate on that? How can we protect ourselves 
or at least allow our institutions to be on an equal playing 
field with the international community?
    Ms. Petrou. Thank you, Mrs. Maloney.
    I think the goal would be to recognize economic capital to 
the best we can in a way that reflects our unique market. What 
concerns me very much is looking again, starting really January 
1, 2007, if not before, at regulatory capital incentives that 
will drive deals instead of the underlying market efficiencies 
that should be the cause of merger and acquisition activity.
    Mrs. Maloney. So what can we do to protect our markets or 
to have our markets on an equal playing field?
    Ms. Petrou. I would suggest that we move as quickly as 
possible to the more simple approaches in Basel II, the so-
called standardized credit risk framework, making changes if we 
need to reflect our unique reality but ensuring that our 
regulatory capital isn't higher than regulatory capital applied 
to other competitors unless there is a sound safety and 
soundness reason.
    Mrs. Maloney. I think that is completely and totally 
reasonable. We certainly don't want to disadvantage our 
institutions with greater capital requirements.
    Actually, I thought your testimony was very good because 
you actually had good recommendations. You came forward with 
specific recommendations for Basel implementation. Why do you 
think the regulators have not adopted your recommendations on 
operational risk, and what do you think will be the 
consequences of that decision, of not adopting your 
recommendations?
    Ms. Petrou. I know they have listened to many voices. They 
are in a very difficult environment in which they are hoping 
for an international agreement and I think perhaps focusing on 
that. Sometimes the details of the Basel II Accord have taken 
precedence over, if I may put it, substance. These are very 
complex rules, and it is extremely easy, because of their 
profound impact, to get very, very distracted by how many basis 
points of this we need for that or what the K should be in the 
five-page formulas for securitization capital. It has been 
difficult sometimes to get back to the real policy impact 
because the models themselves are so complex.
    Ms. Marinangel. If I might add, I think, as Karen has said, 
it comes down to the leveraging of capital. If we can leverage 
our capital and remain competitive, then we will be able to 
stay in business. When--if we can't--if the capital charges are 
greater for us than foreign banks, they would be able to buy 
our banks very quickly and deploy capital effectively and 
probably pay a higher price even for the bank, and it might be 
lucrative and attractive to the bank owners. So it is all a 
matter of leveraging capital. That is from my point of view.
    Mrs. Maloney. But, so far, they haven't made clear that 
position for our banks, so that is very troubling. And I think 
they should make that clear before they go forward.
    Ms. Marinangel. I think I agree.
    There are two approaches. One would be to try to implement 
a standardized approach, but I also believe that Basel IA would 
have the same effect, and it might be more easily and quickly 
established.
    Mrs. Maloney. Thank you.
    Wilson Ervin, you mentioned the trading book in your 
testimony. Can you elaborate on that issue and discuss how it 
may impact your firm and similar firms under Basel II?
    Mr. Ervin. This is a relatively recent development in the 
Basel process. As you know, the Basel discussions have been 
going on for a large number of years now. But it was really 
only this year that we saw some significant changes happening 
to the trading book, the books that broker dealers as well as 
large international banks like ourselves have, that provide 
liquidity in the securities markets.
    There was a concern that the rules which had previously 
been fixed under Basel I to assess capital and trading books 
were not consistent with all the new rules that were being 
developed for the credit side, so in some cases there were 
basically three strands of analysis in the trading book where 
this year they tried to come up with some changes to make those 
more in line.
    I can't argue with the premise of trying to ensure 
consistency between trading and banking books, but they have 
had to do this under pretty tight deadlines. And, in 
particular, I think that the assessment of credit risks within 
traded market portfolios--think about bond trading. Any time 
when you are trading securities issued by U.S. corporations or 
foreign corporations that have a credit risk component to them, 
the cost of some of those positions is going to be going up, 
which will have an impact on the securities market. We think 
that those proposals could use some more time, some more 
specific guidance from the regulators, as well as some impact 
assessments to make sure we really understand what we have done 
in this area.
    Mrs. Maloney. Well, my time is up, but I also was intrigued 
with your comments on the operational risk, and maybe in 
writing--my time is up now--if you could give specific 
recommendations and should it be in color one or two.
    And just--Chairman Bachus, I want to thank you for your 
leadership, but also to say that if they will not give us the 
dissenting views of the members of the Federal Reserve and the 
staff dissenting views, I think we should foil them. I think 
this is important and that we should have all the information 
before us. But I do thank all of you for your insight and for 
your work on this issue, and it has been very helpful. Thank 
you.
    Mrs. Biggert. [Presiding.] Thank you.
    The gentleman from Texas, Mr. Neugebauer, is recognized for 
5 minutes.
    Mr. Neugebauer. Thank you, Madam Chairman.
    First of all, I want to thank America's Community Bankers' 
testimony today, Ms. Marinangel, for your testimony.
    I think one of the things that, as we kind of look at this 
issue, is that there seems to be a lot of concern whether this 
issue is ripe right now. What would be your perspective as to 
do we need to move in the direction we are headed or do we need 
to stop and really kind of rethink this, the whole issue?
    Ms. Marinangel. I think that we have to rethink the issue, 
look at all the competitive disadvantages that will occur. I 
think we need to really consider whether Basel II is 
appropriate or whether something in between is better for us. I 
think that the regulators and your committee are looking at 
this very closely, and I think we do have to take some action 
because of the foreign competition for the larger banks, 
especially here and others that are in our areas. And, yes, I 
think we do need to really study this quickly and come up with 
some conclusions as a group.
    Mr. Neugebauer. One of the concerns I have is if community 
bankers, particularly in my district, are such an integral part 
of a source of capital for our small businesses and yet they 
compete on a head-to-head basis with some of the large banks 
that are also in those same markets--so my concerns are that we 
don't want to create an unlevel playing field here for our 
community banks and hurt their ability to continue to do what 
they need to do in our communities. Do you see that that is a 
possibility?
    Ms. Marinangel. Yes, that is why I am so focused on this 
issue. The community banks currently can compete because we 
offer some, we feel, personalized service. We know our 
customers well. The large banks also do a good job, as I say. I 
don't want to cause any disparaging remarks against them.
    However, some of the burdens that are placed upon us are 
the regulatory issues that cause us to spend a lot of our funds 
in that arena, and some are needed and maybe some are for us 
more burdensome because we don't have the same amount of staff 
as the large banks. And the capital issue is really critical. 
The pricing of the assets that large volumes, where they have 
advantages in pricing, that hurts us tremendously.
    The public today is very aware of pricing because of all 
the media, and so it is hard to compete and our net interest 
margins might be squeezed a little more. So we have to look to 
other sources of income.
    In the same light, we can't do the large credit card 
programs that allow the larger banks to have higher profit 
levels in the fee income area and some things.
    So, yes, it is extremely critical. I do believe the 
community banking world does serve a wonderful purpose in the 
United States, and I would hate to see them not be able to 
compete because of capital issues.
    Mr. Neugebauer. Well, I agree with that. At the same token, 
though, we want to make sure we provide a financial environment 
in America that keeps all of our financial institutions 
competitive in a global economy because we are moving--whether 
some people like it or not, we are already involved in a global 
economy. So what are some of the suggestions that you would 
have as to allowing those institutions that want to be 
competing for more global--in a global market to be able to do 
that while allowing the community bankers to, you know, to set 
their sights on the marketplaces that they want to compete in?
    Ms. Marinangel. Well, Basel really concerns risk-based 
capital. The leverage ratio is another issue, but risk-based 
capital does have some constraints because I can't run my bank 
the way I would like to because of capital constraints and I 
diversified my assets and I believe in repriceability for 
survivability. Therefore, I have to be able to compete in 
pricing our assets.
    When you have mortgage loans, for example, that are all 
weighted the same, whether they are 20 percent or 90 percent 
loan to values, and when you have commercial real estate loans, 
for example, that are all weighted 100 percent but maybe they 
are a 50 percent loan to value based on outside appraisals, 
these assets then cause us to have to do business in other ways 
because we have to weight them so highly and we can't run our 
asset mix the way we want.
    So the true pricing of assets is critical for community 
banks; the risk weighting is really critical, and that is what 
this is about, risk-weighted assets. We have to be able to hold 
capital based upon their true risk. That will allow us to be 
competitive, and it will allow us to hold less capital and 
leverage and be able to deploy our capital effectively and not 
be takeover targets.
    Mr. Neugebauer. Thank you for your testimony. I think my 
time has expired.
    Mrs. Biggert. Thank you very much.
    The gentlewoman from California, Ms. Waters, is recognized.
    Ms. Waters. Thank you very much, Madam Chairwoman.
    I would like to thank all of our panelists here today.
    I am very concerned about our community banks. I think they 
are extremely important, and they do provide personalized 
services. I wish them to be able to operate in a way that will 
allow them to continue to provide these services, and they, 
too, must be able to operate with a profit.
    I am very worried about something I heard this morning when 
you discussed Basel II and the potential for foreign banks to 
be able to buy out our community banks. That is precisely what 
I would not like to happen. I have been worried for some time 
that big banks--not just foreign banks but big banks--would 
increasingly become aggressive in buying out our community 
banks. At some point in time this may start to look attractive 
to our community banks and they may start to sell, and I 
certainly don't want that to happen.
    So I guess my question is, who in the community banking 
world, who is working on Basel IA? Who is helping to put 
together the framework so that it can have some real discussion 
and our regulators can be forced to have to deal with an 
alternative to I and II? How is that developing?
    Ms. Marinangel. If you don't mind, I would like to just 
take a first shot at that. I have been working on it since 1988 
when it was first adopted.
    But America's Community Bankers has taken the lead on this 
issue. They are the most informed. I know that ICBA represents 
small banks, but we have provided testimony and recommendations 
for many years now. But America's Community Bankers, I think, 
is the most knowledgeable that I am aware of. They have helped 
me come forth in the forums here, and they are very 
aggressively pursuing changes. I think they are very respected 
by the regulators as well in their opinions.
    Now the other top-trade groups are also now starting to 
take an active role. But it has been America's Community 
Bankers. I know that Charlotte Bahin is here and Greg Mesack 
and Diane Casey-Landry. That is who has helped me implement 
bringing this to the forefront. And since 1988, I have been 
upset because bankers never had input into this formula that 
constrains us that is currently existing as Basel I.
    Ms. Waters. Thank you. I yield back the balance of my time.
    Mrs. Biggert. I am concerned about the schedule for 
adopting Basel II. The announced notice of proposed rulemaking 
has been postponed because of the results of the QIS 4. But we 
don't know how long or whether the January 2008 implementation 
date is still firm. If the January 2008 date remains firm, it 
will have the effect of compressing the timetable by which 
implementing institutions will have to determine whether they 
will adopt Basel II or not. Do you see this as a problem?
    I will start maybe with Ms. Petrou.
    Ms. Petrou. Thank you, ma'am.
    I do. I think it is a problem if we are on a different time 
frame from the other Nations because of the competitiveness 
issues we have discussed. I also think it would be a problem if 
we then implemented Basel II advanced options as is on the 
January 1, 2008, schedule because the delays so far have given 
large institutions little time to develop models. We still 
don't know what our rules are, and I know the banking agencies 
are running, asking mid-sized institutions now, for example, to 
choose between Basel II and Basel IA. But we don't really know 
what either of them is, so I think right now it is a choice 
between, if I may, a rock and no place. Adding a Basel II 1/1/
08 implementation date into all that uncertainty I think would 
be dangerous, and that is why I would suggest the more go-slow 
approach that still gives our banks the advantage of the 
standardized options as quickly as possible.
    Mrs. Biggert. Thank you.
    Mr. Ervin.
    Mr. Ervin. Yes, I would say I guess my institution is in 
the rock part of that particular issue. As an institution 
regulated by over 30 regulators, we have to move to Basel II I 
expect by January '08 unless there is an international 
consensus to delay. It would be problematic for large global 
institutions to have to juggle two or three different regimes 
during that transition period. That just makes a difficult job 
that much harder.
    I do think there were a few areas where there are for the 
international group of banks, the larger institutions, some 
areas where a bit more time could be put into the process. Not 
all of this has to be implemented at the exact same time. We 
had some specific thoughts about the trading book review, the 
most recent of the changes for the advanced banks, that if that 
could be delayed to 2010 I think that would give us time for 
real impact testing for memorializing how it would really be 
implemented and I think could be a big benefit in terms of 
smoothing the implementation of this.
    Mrs. Biggert. Thank you.
    Mrs. Marinangel.
    Ms. Marinangel. The question again was--just briefly.
    Mrs. Biggert. The question was, because of the advanced 
notice of proposed rule, rulemaking has been postponed. Is this 
going to--and it is compressing the time for January 2008. Do 
you see this as a problem for different banks having to adopt 
Basel II or decide not to?
    Ms. Marinangel. Yes, thank you. Yes, I do see it as a 
problem.
    I know that the ANPR in Basel IA is projected to come out 
soon, and I think that will help. I know that Basel II is being 
delayed currently, and yet I think it will be a problem for the 
large banks that will be competing and will have to try to 
implement. It is going to make it harder to make a decision 
quickly. I know they are working on it now, but, yes.
    Mrs. Biggert. Okay. Thank you.
    Well, everybody seems to have left me, so I would note that 
some members may have additional questions for this panel which 
they may wish to submit in writing. And, without objection, the 
hearing record will remain open for 30 days for members to 
submit written questions to these witnesses and to place their 
responses in the record.
    I would like to thank the panel, for the two of you that 
are returning, and Mr. Ervin for being here at this hearing, 
too. I think you have the expertise that we really need to help 
us as we move forward with our hearings on this and what is 
going to happen in this regard. So again thank you for coming.
    With that, this hearing is adjourned.
    [Whereupon, at 11:26 a.m., the subcommittee was adjourned.]


                            A P P E N D I X

                           September 28, 2005

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